Startup Valuations

This post is meant to be an informative overview of startup valuations: what they are, how they’re decided, and why they’re important. My experience has been focused on early stage investing, but most of these concepts appeal to later stage companies as well.

What is a valuation?

A startup’s valuation is an estimate of the total value of that startup. Investors and founders haggle over this number until they agree, at which point they can exchange a chunk of cash for a chunk of the company. A company’s value before an investment is called the pre-money valuation; _its value after an investment is called the _post-money valuation. 

For example, let’s say Fivesquare thinks it’s worth $5m. Fivesquare has a good team and is almost ready to release its product to the public, but it needs cash in the bank for marketing and for hiring several engineers to create its Android and iOS apps. Fivesquare starts talking to investors and is able to raise $750k. In this case, the pre-money valuation is $5m and the post-money valuation is $5.75m. After the investment, the original founders own 87% of the company (5000 / 5750) while investors own 13% (750 / 5750). Ideally, both parties are happy because they believe that Fivesquare can reach a much higher value (e.g. $25m or $100m) now that it can afford to do more marketing and to hire more engineers.

Pre and post are common shorthands for pre-money valuation and _post-money valuation, _respectively. For instance, someone might talk about “raising $3m at a $9m pre,” which means their company was worth $9m before receiving a $3m investment that brought the value of the company up to $12m.

How are valuations calculated?

Startup valuations are more art than science. Deciding what a startup is worth is like like deciding what a very unique, expensive house is worth. If you have a common type of property, like a 1-bedroom condo in Santa Monica, it is easy to accurately estimate its price by looking at comparable properties that were recently sold in the same area. However, calculating the value of a startup is more like figuring out the value of an 8-bedroom villa on the outskirts of Malibu. Perhaps there was a 6-bedroom house sold nearby, but it was a bit smaller. Or there was an 8-bedroom mansion sold in the same area, but that was three years ago when the real estate market was in shambles, plus that property was a little closer to the beach. When comparables are few and far between, the best you can do is make an educated guess.

That said, there are many factors that can influence a startup’s valuation:

  • The quality of the founding team. How much experience do they have in their current industry? Do they have good connections? Do they have leadership experience? Do they have a great team that a larger company might want to acquire even if the startup’s product is a failure?

  • Founding team’s track record. Have they started companies in the past? How did these companies perform?

  • The size of the market. Is the company trying to dominate a tiny $5m/year niche, a healthy $300m/year market segment, or a giant multi-billion dollar industry?

  • The strength of competition. Is the company competing in a crowded field? Is it competing against other startups, or against giants like Amazon and Google?

  • The state of the company’s product. Is it still just an idea? In private beta? Publicly available?

  • Existing traction. How many users do they have? How fast is usage growing?

  • Existing revenues. Does the startup have any revenue? How much? How fast is it growing?

  • Special competitive advantages. Does the company have any unique advantages? A unique advantage might be something like a new technology that no one else has, an exclusive partnership with a big company, or a proprietary data source that’s not available to anyone else.

  • Supply and demand. If many investors are interested in a startup then its value will tend drift higher; if not, its value is more likely to be pushed down.

Valuations can be set in one of several ways. For example, a founder can open with an offer like “we’re raising $1m at a $5m pre.” Alternatively, a founder can let their main investor set the terms. In that case, the founder might announce that she’s raising $1m - $1.5m and investors can make offers which the founder will consider ($1m at a $4m pre, $1.5m at a $5m pre, $1m at a $6m pre, et cetera). The largest investor (also known as the lead investor) typically negotiates the terms of the investment while smaller investors agree to go along with those terms. 

Why do valuations matter?

For an investor, a startup’s valuation determines the eventual return on investment. For example, if you invest in a startup at a $6m post before Facebook buys the company for $12m, then you’ve doubled your money. However, if the post-money valuation had been $4m instead of $6m then you would have tripled your money.

For the founders, a startup’s valuation determines how much of the company the founders still own after accepting an investment. If a company raises $1m at a $6m pre, you own 6/7 (86% ) of the company. If you raised at a 4.5m pre, then you own 4.5/5.5 (82%) of the company.

Generally speaking, investors and founders want to maximize their equity stakes, so investors want lower valuations while founders want higher valuations.

How much do valuations matter?

Different people place different amounts of importance on a startup’s valuation. 

Some startup founders are valuation insensitive, which means they are very willing to negotiate on price if it means they can work with the investors they want to work with, or if offering a lower price will significantly speed up the fundraising process (which is traditionally an unpleasant time suck). Valuation sensitive founders take the opposite view.

Some investors are valuation insensitive, which means they want to invest in the best companies regardless of the valuation. Other investors are valuation sensitive and need to feel like they’re getting a good deal in order to invest.

Valuation insensitive entrepreneurs can work with either type of investor and valuation insensitive investors can work with either type of entrepreneur. If both parties are valuation sensitive then it can be hard to reach an agreement.

Rules of thumb

In Silicon Valley at the end of 2013, a startup that’s still building a not-yet-released product might raise at a $3m-$6m pre. A startup that already has a product developed and is starting to get its first customers might raise at a $5m-$8m pre. A startup that has a live product and growing revenues (but is not yet profitable) might raise at an $8m-$12m pre. A very strong founding team can double or triple a valuation when a startup is just an idea. Consumer startup valuations are very heavily tied to number of users and user engagement. Enterprise startup valuations are very heavily tied to market size, revenue from pilot customers, and how difficult it is to acquire each new customer. Graduating from a startup accelerator – especially Y Combinator – can greatly increase a startup’s valuation.