Every founder wants to believe that his or her startup is poised to be the next hot company to skyrocket to the top of the valuation charts. Establishing the value of most established companies can be a fairly straightforward process thanks to the availability of quantifiable financial and market data. Financial analysts use industry-accepted formulas and ratios to review financial performance data to determine a value that will be accepted by most finance experts. But when it comes to valuing a startup with no revenue or track record, the process becomes much more complicated and subjective.
There are a number of different models used to determine the pre-money valuation of a startup. Depending on the model used and the party carrying out the process, the valuation of a startup can vary wildly from one iteration to the next. Because of this, Angels, VCs and other investors use several different metrics to as much as possible, determine the validity of the valuation. They also use these metrics to conduct their own valuation analysis. Understanding some of these factors can help you as a founder, develop a more accurate valuation for your startup.
The size of the potential market for the product or service must be large enough to support sales projections. It must also be large enough to be proportionate to the sales projections given the proposed market share the startup believes it can capture. This in part, will be determined by whether or not the startup is targeting a new or existing market. An existing market has demonstrated, measurable demand and established players, each of which holds a particular share of the market. A startup’s sales projections are based on capture a portion (percentage) of that existing market. If the total market is $500 million, a startup may aim to capture 10% ($50 million) of that market over five years. That figure is potentially realistic (depending of course on any number of different variables). However, if the projections are based on capturing a significantly higher percentage of the market, an investor may understandably be skeptical. Very few new entrants are able to launch in an existing market with well-established players and quickly become market leaders. It’s not impossible of course—there are many examples demonstrating that new entrants can quickly dominate the market—but for most startups, this isn’t going to be the case. In any case, investors will correlate a realistic, attainable market share with the proposed pre-money valuation.
In cases where a startup is actually creating a new market, then situation is very different. In this case, since it doesn’t yet exist, founders must convince investors of the market’s growth potential. The company MonoSol is one example of a company that essentially created a market for its products. MonoSol is the manufacturer of the water-soluble film used in laundry and dishwasher detergent pods. These pods were unheard of just a few years ago but today, they are commonplace. Though a privately held company, MonoSol commands more than 90% of the detergent pod market with estimated sales of more than $250 million annually. For products such as this, the challenge is demonstrating the validity of the projected market size. I have worked with startups with products or technologies that essentially create a new market where one does not currently exist. To demonstrate validity in these situations, we presented the larger, broader market and then showed the calculations for how we determined the potential market size for the new product or technology. There is no standard formula for validating the potential size of a new market but for investors, the key factor is to show a logical rationale for your calculations.
Pre-money valuation is strongly impacted by the amount of traction the startup can demonstrate. Founders can demonstrate traction in various ways such as revenue, customers or users. Traction is a key metric for validating the pre-money valuation of a startup. How you demonstrate traction is entirely up to you but in any case, choose the metrics that best tell the story of your momentum and be creative. Below are some examples of how startups can demonstrate traction:
- Stage in the startup lifecycle: Traction can be conveyed by demonstrating the startup’s stage in the lifecycle. A startup with a product that has been developed and tested has more traction than a startup with a product that is still in the idea or conceptual stage.
- Revenue or profitability: Key metrics of interest to investors include revenue growth, average sales or gross margins and net profits.
- Intellectual property: Strong protection for innovative or revolutionary intellectual property can demonstrate traction to investors.
- Customers or users: Paying customers who have actually used the product and have provided positive feedback. Ideally, you want to show growth in the number of paying customers or users. Non-paying registered users or beta-users who are using or have used the product and have provided positive feedback. Even though these are non-paying customers or users, as much as possible, you want to show engagement and growth to demonstrate that these users are willing to become paying customers.
- Pre-orders: In some cases, it is not possible to have real, paying customers because the startup has yet to produce the actual product. This is very common for startups that use crowdfunding to raise capital. There are many success stories of startups that were able to produce compelling pitches that built excitement for their product and gathered pre-orders while raising funds for development, production and launch.
- Partnerships: Depending on the industry or product, some startups are able to show traction by demonstrating the number of partnerships they have established. How these partnerships are defined will vary greatly depending on the type of company or industry but they may include branding or marketing partners.
- Advisory board: Some startups demonstrate traction by assembling an advisory board that includes well-known names or industry-recognized professionals. However, in most cases, merely having an advisory board—even if it includes recognized names—may not be enough for many investors. To add credibility and demonstrate that they are not just advisors in name only, you should strive to show involvement, engagement and commitment on the part of these individuals.
These are just some of the ways in which startups demonstrate traction. Be creative and come up with the metrics that are most reflective of your startup, industry, product or sector. In your Pitch Deck, as much as possible, use graphs, tables or charts to visually represent your traction.
Reputation and experience of the team
Founders with an established reputation and a strong track record of success with startups have a much easier time validating their pre-money valuations than inexperienced entrepreneurs. Past successes in launching and growing startups helps establish credibility among investors. But even if the founder does not have personal direct experience with startups, there are ways to demonstrate sufficient capabilities to ensure success. If the founder doesn’t have experience with startups or business management, then it is critical that he or she assemble a qualified team of individuals who do have relevant experience, background and qualifications, particularly with startups.
State of the industry
The state of the industry in which the startup is launching is an important factor in pre-money valuation. A startup in a hot, fast-growing industry with huge potential for growth will have a much easier time validating its pre-money valuation than one entering a slow-growth sector. Investors will also look at the stage of the industry, the number of established players and the number of new entrants. Some of the questions that investors consider include:
- How long has the industry been hot?
- How long will the growth last?
- Is it ready to cool down?
- Is a market shift on the horizon?
- Are there external factors (e.g., regulatory, etc.) that may impact market growth?
- Are consumers or users still excited about the market?
- Who are the established players in the industry?
- How crowded is the field?
- Is the startup offering a solution that is sufficiently innovative to shake-up the market?
- What are the barriers to entry?
- How many new startups are entering the industry?
Stage of the company
I am adding this last one more for emphasis than anything else. As I have mentioned before, all-too-often I see founders seeking funding for their startups long before they are ready. If you expect investors to take your pitch seriously, then it is absolutely critical that you have the corporate foundation (e.g. legal structure, licenses, trademarks, patents, etc.), team and other essential elements in place before you seek funding. You may only get one good shot at making your pitch so don’t blow it by approaching investors before you are ready.