Startup Valuation Guide: How Founders Determine Company Value

A Founder's Guide to Startup Valuation

If you're raising capital at the pre-seed or seed stage, you and your investors have to agree on your startup's value.

"How much a company is worth now, or we project it to be worth at exit, determine how much money as an investor I'd be willing to invest into a company and at what shares," says Salome Mikadze-Struk, co-founder at Movadex and a Knight-Hennessy Scholar at Stanford University.

Here's what you need to know when you negotiate your company's valuation.

The VC Valuation Method

Established companies might be valued using their revenue and assets, but that data is often incomplete or premature for new startups. So instead, investors use the Venture Capital (VC) method. This method sets a valuation based on how much money investors put in and how much equity they're getting in return.

For example, suppose you're raising $1 million from investors who are gaining 20% of your equity. The $1 million investment is 20% of $5 million, so your company is worth $5 million after the investment comes in. That's called the post-money valuation.

Your pre-money valuation is what your company was worth before the investment. It's defined by this equation:

Pre-money valuation = Post-money valuation – investment amount

So in this example, $5 million minus $1 million gives you a $4 million pre-money valuation.

Factors That Affect Valuation

Valuation depends on many variables, some of which are out of your control as a founder. What's going on in the economy influences how much risk investors are willing to take and how large a piece of the pie they want for their investment.

From a founder's point of view, it might be better to sell a smaller share of a company and hold onto more equity. But investors may not agree to those terms, as they don't stand to gain as much at exit and thus aren't receiving as much compensation for risking their capital.

Wilkinson gives the example of a founder who wants a $10 million valuation but only intends to raise $1 million. "It's like, well, how do you justify that you're only selling 10% of the company? Have you sold a business before and made your investors money?" Wilkinson says.

And when inflation is high or a recession looms, investors might insist on a lower valuation so they receive a higher percentage.

"If it is a market that's really hard to raise money, which right now for some founders it is, you might have to sell 25% or even 30% of your company in some cases to raise money," Wilkinson says.

Investors typically consider your company's metrics when arriving at a valuation. "There are some sector-specific nuances that investors look for," Shah says. For example, if you have a SaaS company, you'll need to show your monthly recurring revenue. For a direct-to-consumer brand, customer acquisition cost is relevant.

Metrics don't override the VC equation, but particularly impressive data can help sway negotiations in a founder's favor. "In many ways, valuation becomes an art, not a science," Shah says.

Sales of companies that are similar to your startup can also inform valuation talks. "Most of the time VCs are looking at a matrix of market competitors. They look at the recent deals in the same sector and geography," Shah says.

The Valuation Timeline

Ideally, a founder secures a lead investor who prices a fundraising round. The lead investor creates a term sheet that states the valuation, how much they are putting in and how much remains to be raised from other investors.

"That is the gold standard; that's called the market-setting valuation. And then the founder will work to fill out the rest of the round," Wilkinson says.

The process of connecting with an investor typically starts when a founder shares a pitch deck with a VC firm. An analyst or associate reviews the pitch decks that come in.

If the VC firm wants to proceed, it schedules a few meetings with the founder to discuss their startup's concept and strategy. If everything looks good, the VC requests data from the founder and reviews it. There may be some back and forth as the VC asks for additional data or clarifications, and this due diligence is usually completed within a few months.

The VC and founder then negotiate the valuation and agree to the terms. The VC generally posts the term sheet within 60 days.

"From start to finish, it's roughly about four to six months," Shah says.

Alternatively, a founder might propose a valuation and try to gather several smaller investments based on it. This founder-set valuation might bring investors on board if the founder's proposal is in line with how investors would value the company.

Who to Consult When Valuing Your Company

Guidance from professionals and mentors can help you navigate your company's valuation.

First, hire an attorney who specializes in transactions. Consider getting recommendations from other founders who have closed deals. And to crunch the numbers, you'll likely want to work with a CPA or a fractional CFO.

Try to get input from advisors who have experience in the world of venture capital but who aren't investing in your company themselves.

"It is also a very good idea to have someone who used to be or currently is an angel investor or a former VC or even current VC, someone who has been in that field, just to give you an honest opinion without being biased. Because all of the opinions you're going to get from potential investors and angels are still going to be in favor of their own investment path. So you want to have as much of an independent overview as you can," Mikadze-Struk says.

Founders who have achieved successful exits can provide useful insights, too.

"Having not just today's strategy, but your longer-term strategy is important. And an advisor who has done a business where they took in capital, they operated it, they grew it, they were successful with it over time, is a really valuable resource for a founder to be able to talk to," Wilkinson says.

If you don't have any advisors at that stage, the next best option is to talk to other current founders who have a bit more experience than you. So if this is your first time fundraising, try to talk to founders who have already raised three rounds of capital.

Is a Higher Valuation Always Better?

It's often best not to aim for a sky-high valuation or raise more money than you need. If your company's performance doesn't live up to that valuation, you could run into trouble on your next funding round. That's because investors expect your company's valuation to grow each time you raise capital.

Ending up with a lower valuation or a lower share price in a subsequent round is known as a "down round," and it can harm your company's image.

Another reason not to push for an overly high valuation is that some investors won't be interested in backing your company if they feel its valuation is outside the norm. Excluding those investors from the get-go could limit your opportunities.

"Just cutting out VCs because you don't match them for ownership stakes may be a wrong strategy because VC funding or angel funding is not just about cash. It's also about the resources, the value, the network that you get," Mikadze-Struk says.

Keep in mind that valuation is not the final verdict on your company's potential. It's a price that reflects market conditions and investors' appetite for risk at one point in time.

"Think of it as a risk transfer price, and fetch the best price that you can," Shah says.