Investing in startups without paying attention to its valuation…

… is like buying a car without knowing the price.

That’s a surefire way to overpay.

Today, I’ll be explaining the startup valuation process so you don’t overpay on your next startup investment. 

But before, I want to give you a chance to download my FREE ebook: Startup Investor’s Playbook.

In it, Jeff Bishop and I share some of our all-time favorite strategies for angel investing.

It’s those very strategies that lead us to this investment… 

You see, The Boardroom recently dropped $100,000 into a rapidly growing long-term rental platform.

They were raising at a $9M valuation…but plan to raise more money at a $20M+ valuation next year.

How’s that even possible?

How do they justify that kind of increase in value?

What are they basing their valuation on?

In order to help you connect the dots and understand the valuation process startups use to make those decisions…

I put together this startup valuation guide explaining it all.

 

A Guide To Startup Valuation

 

All too often, those just getting started with angel investing get hung up on a startup’s worth.

Valuation is the process of determining a startup’s current or projected worth. 

For angel investors, the projected worth is the most important — but also the trickiest!

There are many techniques for deciding on a company’s valuation. And each one will come to a different conclusion. This is why investors must be able to see more than the numbers on the surface and see the real potential behind it.

 

Why Valuing Startups Is Tricky

 

Getting an accurate valuation is difficult even for established businesses. For startups — with little or no revenue and loads of uncertainty — the challenge is even greater.

Valuations for startups are highly speculative and involve forecasting future earnings. Investors need to look at the earning potential the business will give once it reaches maturity. 

This uncertainty is what makes startup investing a high-risk high-reward venture. There isn’t one simple formula to assess the risks.

There are, however, many simple tips and tricks to vastly increase your chances of success. 

 

How Regulation Crowdfunding Makes Valuation Simple

 

While independent angel investors and lead investors must find valuations on their own, your average investor doesn’t need to. There is a much simpler alternative.

Instead of conducting lengthy due diligence and crunching the numbers yourself, you can invest on Regulation Crowdfunding platforms. There, the valuation work is already done for you. 

A website like WeFunder has strict guidelines for determining a startup’s valuation. The valuation is determined by several factors. These include:

  • Timing
  • Competition
  • Financing round
  • Industry

You can be confident in the valuation of a startup if it is supported by a good lead investor. 

A lead with a strong background in startup investing or entrepreneurship can lead you to the money. 

If they feel comfortable investing a sizable amount given the current valuation, you can be sure that the valuation is in the ballpark and can yield you a hefty return down the road.

 

Pre-Money Vs. Post-Money Valuation

 

It’s important to know what kind of valuation you are looking at. There are two types — pre-money and post-money.

  • Pre-money valuation is the value of a startup before funding. Without any outside cash, what is the company worth? With a pre-money valuation, the value comes from the idea, team, data, or prototypes that the company already has.
  • Post-money valuation is how much the startup is worth after funding. With the current level of financial backing, what is the company worth? Here, the value comes from the same things as before but also includes the company’s financial support, cash-pool, and traction.

 

How valuation is determined

 

As mentioned before, there are a variety of ways to establish the value of a startup. Let’s go over a few so you can understand how to make or assess a valuation.

1. Cost to Duplicate

 

This method draws up a valuation by estimating how much it would cost to duplicate the startup as it stands. 

For a technology startup, you could look at the cost of research and development plus the cost to produce a prototype. 

For a software company, you could look at how much it cost to have a team of programmers build the code again. 

For any company, you can look at its physical assets — deciding how valuable their inventory, infrastructure, and other tangible assets are.

Cost to Duplicate is a nice starting point for startup valuations. It is one of the most objective methods of equating valuation and can set the stage for more subjective methods to follow.

Limitations

The big problem with the Cost to Duplicate model is that it fails to consider future potential. 

It only cares about what’s on the plate today. 

It also fails to factor in those intangible assets like excellent leaders, early adopters, and brand identity that can play a big role in a company’s value. 

2. Discounted Cash Flow

 

Discounted Cash Flow involves projecting how much cash flow the startup will produce in the future. 

You figure out the cash-flow potential, decide how quickly the investment will be returned, and then establish how much that cash flow is worth. 

The value of the projection is then discounted to compensate for risk factors. That final discounted number is chosen as the startup’s valuation.

Limitations

The only problem with Discounted Cash Flow is that it is very difficult to predict long-term growth rates. These forecasts become less reliable the further you push them into the future.

3. Valuation by Stage

 

Finally, we have an approach that looks at the startup’s stage of development. Depending on which essential milestones have been met, a rough valuation is drawn up.

This is a quick and easy way to get a valuation. The more developed a startup is, the less risky and more valuable it is.

Here’s how it works: 

 

 

Depending on how fleshed out each aspect is, the number can be tweaked. 

For example, if a startup has one or two strategic alliances, but is still searching for other essential ones, the analyst could add $1 million instead of the full $3 million for that line of the equation.

Limitations

The issue with valuing this way is that it can be a bit heavy-handed. 

Valuation by Stage can give a rough estimate of a very early-stage business, but it is far from objective. 

Also, much like the Cost to Duplicate method, it leaves out the intangibles that add to a company’s value.

 

Dilution Explained

 

Something to know about startup valuations is that they are subject to change — and for better or worse — your investment will change with them.

This is because of dilution. 

Imagine that you invested in a startup and received shares in the company. Your number of shares — and your ownership of the company — are based on the company’s valuation at that particular moment in time.

Now, let’s say the startup is doing well and has grown significantly. That’s great for you! But, the startup needs more cash to keep scaling. So, it sells more shares to keep the ball rolling. 

These new shares essentially lessen your slice of the pie. 

Before, your X number of shares represented 10% of the company, but now, the same X shares represent only 2% of the company. 

You have been diluted. 

Dilution is a necessary evil of startup investing. While this may seem to diminish the value of your smart, early investment, it’s actually not that bad.

More investors in your startup is almost always a good thing! This is because they swing the valuation in your favor.

 

Valuation Swings

 

Because you picked a good startup and the valuation is higher than when you invested, those new investors paid more than you did. This increased the value of your investment.  

They diluted your shares, but they also agreed on a new, higher valuation. 

This means your returns are going up, up, up.

Also, you can be darn sure that if loads of new investors want to hop on board, then the company is doing well and will carry your investment forward, buffing it up along the way. 

Subsequent rounds of funding are an assurance that you invested well — so don’t worry about dilution.

Especially during big cultural and economic changes — like the COVID-19 Pandemic — you can find massive valuation swings. 

New developments always brush the dust off of old startups to reveal shining potential. 

For example, grocery delivery startup Instacart’s valuation skyrocketed from $7.9 billion in late 2018 to $13.7 billion in 2020. And Instacart successfully raised $225 million at that new, sky-high valuation.

If you invested in Instacart early, you wouldn’t be complaining about your diluted stocks from this new round of funding. You would be jumping for joy at the thought of your new ROI.

 

Last Word

 

Valuations may be scary for newer investors (and some experienced ones) but they aren’t as daunting once you know how to work with them.

Exhaustive assessments aren’t really necessary for most angel investments. There just isn’t enough information on the books yet to make such a projection. 

The startups we invest in are so young, that we just can’t make those calls.

In our domain, instinct and experience go a long way. You need to know how to make quick and reliable assessments. 

Eyeball the startup, ballpark the valuation. 

And if you aren’t versed enough to do that, you can follow a lead investor or join an angel investing community

Lead investors are a good indication of what to expect from a startup. If a wildly successful investor is sticking their neck out and investing heavily in a company, you know it’s a good opportunity. 

And with an angel investing community, you can learn about startup investing deals that your own mentors and peers are investing in. This deal-flow can make finding winners much easier and give you confidence in your investments.

Author: Chris Graebe

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