The valuations set for each round of financing can have significant consequences for startup investors and entrepreneurs. Thanks to new and improved startup resources, it’s now much easier to understand how high startups can value their company. However, the question of how high a startup should be valued is a little more complicated. To navigate this, I’ve put together a definitive guide based on my experience as an active angel investor and the resources we’ve compiled for our MergeLane accelerator. Below is a list of questions startups and investors should answer before agreeing to a valuation in an equity round or a convertible debt valuation cap (more on why understanding valuation caps is important).
First, the easy question: What is the fair market valuation, i.e., the valuation an investor or startup can get?
This can be determined by answering these simple questions:
How does this startup compare to similar startups? I think the Scorecard Method is the easiest way to answer this question. Check out Slides 11-13 of this presentation from the Angel Capital Association’s Best Practice Series: Valuation of Early Stage Companies webinar.
What is the current market condition? Economic conditions affect startup valuations. For example, startup valuations hit an all-time high in the second quarter of 2015. If I were valuing a company during the down market of the first quarter of 2016, I would look at 2013 valuation data to arrive at a reasonable price.
Next, the more complicated question of how a startup should be valued.
To start, this podcast is helpful for gaining a broad understanding of startup valuations.
Before investing, I also make sure the startup is working with a financial professional. This could be a co-founder with a finance background or an outsourced resource such as a fractional CFO. Ideally, this should be someone who understands startup finance and has worked with several VC-backed companies. I require this because I want to make sure the company has a clear idea of:
Having a financial professional to help answer these questions is crucial.
Startups should work with this finance person to answer the following:
How much capital does the company need?
To answer these questions, you’ll need to understand:
When and at what valuation will the company likely raise its subsequent rounds?
To answer this, I look at:
How much equity should the founders and employees retain?
Entrepreneurs who raise multiple rounds of capital typically retain 5%–20% equity at the time of exit. The valuations of each financing round determine where the founders fall within that range. Mark Suster wrote a great post on founder dilution that helps to explain some of this.
After understanding how much the company will need to raise in the future and the likely pricing of those rounds, you can figure out how much equity the company can afford to give up in the seed rounds. Once you have this number, you can compare this to industry norms by dividing the median round size by the median valuation in the most recent Halo Report. Adjust this for market conditions if appropriate.
Most investors look for a 10%–15% option pool, so don’t forget to include that in the equation. Where a startup falls on that spectrum depends on its future needs for talent and whether the startup will likely raise VC funding (option pool refresh is often required) before making those hires.
Sound complicated? It is.
That’s why I think it is so important to work with a financial professional and to have a good lawyer. While the cost of this might seem high in the early days, I’ve seen the return on investment 100 times over.
To recap, here’s a quick startup valuation checklist:
I invited Evan Walden of Getro to share his thoughts on recruiting top talent in the current environment and the role VCs can play to help their portfolio companies address this ongoing issue.
My colleagues Sue Heilbronner and Leah Pearlman Iaunched their Marco Polo Channel, Inside Coaching, this week. Here’s why and how I’m making the channel a part of my weekly routine.
A few of our portfolio companies considered whether to reopen their previous round or open a new round with a higher valuation. If you are considering the same question, here are the thoughts I shared with one of those companies.
Somewhere in my childhood, I learned to hide and feel guilty for my success. It wasn't until recently that I realized how much that inhibited my ability to actually achieve success.
I thought I had overcome my fear of peer pressure when I was 16, but this coronavirus experience has proved me wrong. I broke my commitment to tell the truth at a time when candor could have been of service.
Over the past few months, I've seen an increasing number of pitches from startups tackling the world’s biggest environmental and social problems like climate change, gun violence, and the mental health crisis. I'm also finding that I’m becoming more determined to invest in world-changing startups.
Kim Smith, executive director of the League of Innovative Schools, shares her thought-provoking insights to help drive racial equality in our venture capital industry, and makes a powerful call for white co-conspirators who are ready, willing, and able to fight.
I am grateful for the clarity and inspiration this emotional time has afforded me. I am more driven to do work that matters than ever before. Because we still have a long road ahead, I'm going to take an emotional breather.
I find that I have to expend three times more energy to feel productive during the holidays. This pattern tends to persist not only during the week of July 4th, but for the entire month of July.
We sourced five startups from our Fund81 VC forum members to present for our June forum. Check out this episode to hear pitches from these incredibly tenacious entrepreneurs.