Valuing your startup is tough. While there is no easy answer, this blog aims to help you make an informed decision, and perhaps more importantly, be able to justify that valuation to potential investors. When you’re ready to take investment, there are generally four points to consider:
- How much should I raise?
- How much equity should I release?
- What drives my valuation?
- What’s my target valuation?
The questions are mathematically intertwined, so let’s unpack the first two points, then visit valuation.
1. How much should I raise?
Some advisors say raise as much as you can, take the money off the table. I say plan to raise enough to give you an 18-month runway. Raising is hard and costly in terms of time and money, so understand what you need to hit your milestones, think about giving yourself a buffer and breathing space, and be realistic about the amount that would in fact place too much pressure on you in terms of deliverables and managing investor expectations.
Any shorter than 18 months’ runway and it’s going to be hard to hit KPIs or show any real traction, which means you are going to be unable to justify your next round valuation. It’s called a runway for a reason – if you don’t have lift off before you reach the end, things will come to a sudden stop!
It’s important to remember that funding your monthly burn isn’t the reason your investors committed, so when you are asked about why you are raising £x, position your answer to growth milestones and not survival, the resources you will need to achieve these and the length of time it will take to get there.
2. How much equity should I release?
Forget Dragons’ Den, startup equity investment really doesn’t work like that in the real world. My general rule of thumb is that founders should sell between 10% and 20% of their equity at the first external investment. I’ve found that this parameter works leaving founders enough holding for dilution from future rounds – and what an early equity investor is looking for in terms of return.
They are placing bets on you with the expectation that most of startup investments yield zero return. They are exposed to a high-risk/high-potential scenario, hence will likely want a decent slice of equity to get a meaningful return if things go well, and also to have a meaningful level of influence on key decisions.
3. What drives my valuation?
The ‘fundamentals’ are the key drivers of valuation, and how these will change in the future, and the certainty of these expected fundamentals. Growth in revenues, profit and cash generation are the key metrics, but there are outcomes, we need to look at the drivers.
With confidence in the clarity and achievability of expected fundamentals, investors are ready to believe in the company’s financial model and forecasts. The level of certainty is directly correlated with the level of risk.
The younger the business, the more uncertain and the less reliable its strategy, certainty of execution, and financial forecasts. To value your early-stage venture, focus on the factors that have an impact on the ability to deliver the vision and business strategy. I call this the risk ladder.
The risk ladder
I’ve focused on ten key rungs on the risk ladder working with early-stage ventures. My experience shows each has a relative weighting, and these can vary for each venture, depending on age, sector and self-funded resources, but typically give a scorecard to consider:
- Team: 15%
- Innovation: 10%
- Size of opportunity: 10%
- Business model: 10%
- Traction risk: 10%
- Product: 10%
- Go to market: 10%
- Unit Economics: 10%
- Cash burn: 10%
- Exit route: 5%
The more risks you address satisfactorily, the higher the valuation and the more ‘investment-ready’ for investors. You should focus on tackling those risk factors to reduce the perceived uncertainty. Let’s work through some examples.
Team Investors are putting their cash behind the team, so for me this is the key risk. How many co-founders are there, do they have complimentary skills, have they worked together before? Do they have the required leadership skills? The more expertise and relevant set of skills the lower the execution risk.
Product Do you have an MVP? Has your product been tested and validated by customers? Do you have a product roadmap, the team in place to build the product? If your product is not there yet, there is a risk that you never deliver the right product or that someone else does before you.
Go to Market How do you plan to find customers – direct sales, or a network of partners? What evidence do you have that there is a product to market fit? How does that traction materialise – through revenues or usage? Depending on your go to market strategy, do you have the relevant skills like sales, marketing, or business development to implement your strategy?
Unit economics Be sure you understand how you are going to get to breakeven and then profitability. How much are we selling and at what price is one thing, but more importantly, how much do we spend to acquire a customer? All the metrics around customer acquisition and lifetime value are key metrics which investors have knowledge and expectations about.
Cash burn My view is that the financials in an early stage startup mean little. The numbers are so uncertain, but it is the ability to prove that there can be significant future revenues and profits that investors are seeking. It starts with the plan and ambition. Everyone expects uncertainty, but the medium-term consistency of your financials is key. You need to show how on a monthly basis, you are going to deliver your plan.
Exit route When an early stage investor is trying to determine whether to make an investment and what the appropriate valuation should be, what she basically does is gauge what the likely exit size will be for venture of your type and within the industry in which it plays, and then judge how much equity she needs to fund to reach her return, relative to the amount of money she puts in throughout the company’s lifetime. Visibility of exit potential is important for some but not all investors. It is worth assuming an exit in around five years to ensure you can demonstrate your value creation potential.
4. What’s my target valuation?
The biggest determinants of your startup’s value are the market forces of the sector in which you play, the willingness for an investor to pay to get into a deal, and the level of desperation of the entrepreneur looking for money. So, basically lots of words to justify a gut feeling.
Some investors are led by their head, others by the heart. Most, of course, have never run a fish and chip shop so hold no practical experience of leading a business making decisions on people, pricing, marketing, cash – but they’ll still tell you where your business plan and financial model are wrong.
Either way, there’s no substitute for data-driven decisions, and thanks to available data showing what happens across a range of funding round sizes, you can be well placed to not just come up with a number but justify it. I’ve seen patterns highlighting staged valuation bands as follows:
- Idea Valuation: £500k You can aim for this valuation with three foundations: you’re a founder with domain knowledge and experience, holding insight on your target market to underpin your venture, with proof points on the problem you’re solving and target customers; you can sell; you can present a plan for a team with named individuals to hire.
- Prototype Valuation £750k You’ve spent six months refining the idea, doing user testing, building a working prototype. You’re somewhere between ‘Idea’ and ‘Launch’, and have started to build your team
- Launch Valuation: £1m You’ve spent a year building the product, probably not paying yourselves a salary, plus you’ve invested your own money/time in the project. You’re close to launching, you now want to raise money for that last mile of product development and for launch marketing.
Often, early-stage startups are valued somewhere in the middle of these three bandings, meaning founders don’t get as much as they anticipated, and investors pay more than they initially wanted to invest. After evaluating everything, even with the most effective pre-money valuation formula, the best you can hope for is still just an estimate.
- Traction Valuation: £2m You’ve launched and you’re seeing good signs of early traction, showing a formative customer acquisition model that is repeatable and scalable to get investors excited. Investors want to see a significant potential value increase – say 10x their investment. Make sure that your business plan and financial forecasts show what traction is achievable.
- Revenue Valuation: £3m+ Unlike Silicon Valley, where the vision of being a unicorn is often enough to get investors interested, UK investors like to see revenue. if you’re not showing revenue, getting funding in the UK beyond Prototype stage is going to be tough.
- Scale Valuation: £5m+ To get to this point, you need to have product/market fit, proof of repeatable and scalable demand, a clear path to scale all aspects of the business model, and a new business acquisition engine.
Once there is evidence of consistent and growing revenue, pre-money valuations can rise to £5m or more. Note that Silicon Valley numbers will often be much higher so don’t be tempted to use those, or investors will think you’ve been drinking too much Silicon Valley loopy juice.
So where do we go from here? Well, you now have all the valuation drivers. Your valuation is going to be a combination of your plan and the risk ladder analysis of that plan and where you sit in the ‘status’ bandings highlighted above. So, the best you can do is address your risk ladder and create scarcity value by scoring high on most dimensions.
Ultimately, your startup valuation is whatever you and your investors negotiate. Every startup is investment ready at a certain price, it’s a question on what the risk appetite of your investors is – the higher their risk appetite, the lower the expected valuation. Valuing your startup is much more a matter of negotiation than a mathematical exercise.
A successful outcome depends upon highlighting your value creation potential and your ability to mitigate risks. This paradox exists because investors base their expectations for future performance. As the Red Queen said in Lewis Carroll’s Through the Looking Glass, it may take all the running you can do just to stay in the same place.
Valuation is an indicator of the ‘wisdom of the crowd’, a signal of the investment community’s perception of your startup’s future growth and profitability. Understanding your investors’ judgment is important for several reasons, but primarily because it gives you a baseline for your strategic plans.
Once you have gained a better understanding of the bar you are expected to clear, you can turn your attention to meeting and exceeding those expectations. Remember the bigger picture. Funding gives you the resources to build value, without it, you may not have that opportunity. Stick within the accepted boundaries and expect the same from your investor.
However, let me end the blog on a personal note. There is one thing that I really bemoan about the culture of fundraising, is the belief that if you can raise a round, then you should go and raise the biggest, highest valuation round that you can and that’s what success looks like.
I really don’t think that’s right.
I don’t think that’s good for startups. I’m a big believer in taking an ‘agile financing’ approach: raise an appropriately sized round and go from there. Build the product, the team and early adopters, the fundamentals. If you do this, my hunch is that you end up with a simpler product which you will bring to market faster. I think that’s what founders should do and not raise money too early.
