Valuing a start-up is a tricky business, and like most early decisions you will make, how you value your company will impact it all down the line. It would be nice if there were a formula as to how to do this. In fact, one of the videos listed below (How do you value your startup?) suggests that venture capitalists have such a method.
I’m not certain I believe it. There are so many unknowns, and to use the suggested method involves so much guesswork that I believe valuation is more an art than a science.
Moreover, all the formulas I have heard of pretend that the valuation is a static exercise. But, of course, it isn’t. It is a game that runs over several stages. (I should be clear that here I am speaking of valuations of technology companies that have, or hope to, attract venture capital.)
In the technology market, you may get very early stage funding that doesn’t formally value the company. This can be in the form of SAFE’s (Simple Agreement for Future Equity), convertible loans, and other mechanisms. But you will definitely have to agree to a valuation at the time of your first equity investment – which almost certainly will take the form of preferred stock.
That sets an initial investment valuation – but nearly all preferred stock comes with certain protection mechanisms in case the valuation is wrong. So a venture capital investor can afford to appear generous. If the true valuation is lower, then the price will be adjusted later.
How does this happen? Well, there are several ways. One of the most important is what is called an anti-dilution clause. If, in the future, additional equity is issued at a lower price the investor will be able to increase the number of shares he or she holds so effectively the new lower price will be applied to the original investment retroactively.
Another way this happens is that the investors in your next round are often your current investors. And if they think your performance between rounds hasn’t been up to snuff, that round will be a down round – meaning that your valuation will be lower and their average price per share will more closely reflect a lower and presumably more appropriate valuation of your company.
So what to do? First of all, look to valuations of other companies. Some of the best information can be found in the Wilson Sonsini Goodrich and Rosati Entrepreneurs Report, which can be found at www.wsgr.com. I have a high degree of confidence in this data because I used to edit that publication and believe the methodology it employs is better than most other sources of data. But you can also find information at Pitchbook, Techcrunch and elsewhere.
I’d also check out the following.
What % of My Company Should Investors Get? (6.13 minutes)
Short, but good. Jay is a serious guy.
How do you value your startup? (9:40 minutes)
Startup Clinics – Knowledge Base
This describes a Venture Finance formula, which you should probably know in case someone uses it against you. You might also want to watch this:
Startups Valuation Using The Venture Capital Method | Harvard Business School (2:36 minutes) https://www.youtube.com/watch?v=rZHlTEknXHM by Bluebook Academy.com
And to understand some of the valuation terms used, watch this:
Pre And Post Money Valuation Explained For Entrepreneurs – Harvard Business School (3.41 minutes)
This is a simple explanation of pre-money versus post money valuation and how to use them to calculate the number of shares to issue.