HOW TO VALUE YOUR STARTUP

May 2023 | Jon Zaikowski

When companies are fundraising, one of the most critical factors is the value of your company. It is certainly true that “what a company is worth depends on who wants to buy it,” and the more people that are attracted to your company, the higher the valuation that you can expect. Conversely, one of the most common reasons for New York Angels members to pass on an otherwise attractive deal is that the valuation is not in line with where the company actually is today. Part of the challenge is that valuations are both an art and a science. There are many objective measures available, but it’s difficult to say a company is “really” worth $16M (rather than, say $15M or $17M). This article provides some best practices and tips to help you determine your company’s valuation.

The Gold Standard – Revenue Multiples

The most defensible method to value a company is the “revenue multiple” method. To calculate your valuation, start with the revenue of the company over the past 12 months, then multiply it by a number (a little like price-to-earnings for publicly traded companies) that reflects how much future growth and profit an investor could expect from your past results. The difficulty is clearly, what should that number be? Higher multiples are afforded to rapidly growing businesses or companies in “hot” sectors (like AI, or previously crypto). Lower multiples are attached to some sectors (e.g. food and beverage), low margin industries like retail, or businesses which are harder to scale.

How do you determine the correct multiple for your company? To start off with, these numbers are based on generally accepted assumptions about the economics of your industry, such as the “stickiness” of the products, typical margins, or regulatory hurdles. For B2B SaaS companies, 10 is generally regarded as the accepted number, meaning a SaaS company with $1M in annual revenue can justify a $10M valuation. However, objective factors such as the rate of growth, and market penetration, as well as subjective factors, like the experience of the founder, can change this number in either direction.

On the other end of the spectrum, consumer product companies typically only command 2-3x revenue multiples for a variety of reasons. The product has a direct cost of sales, which reduces margin and increased uncertainty. D2C businesses need significant marketing dollars to be successful, while retail focused companies are at the mercy of other players, like distributors and retailers.

The best way to calculate your multiple is to identify similar startups in your space that have been funded or acquired. The ratio of their revenue to their valuation shows what others consider to be a fair revenue multiple. Unfortunately, this information is not always publicly available and can be difficult to find. Resources like Crunchbase and Pitchbook can help, although these services aren’t free and the information isn’t always complete and/or accurate.

What if there isn’t (enough) revenue?

Many highly valuable startups have little to no revenue. Most therapeutic drug and many medical device companies fall into this category. Companies that rely on network effects and virality for user growth may also not seek to monetize until they have hit a critical mass. Furthermore, most companies will be at $0 revenue while still building something meaningful and real. So how do you determine the valuation of your company in these cases?

Start with traction - what have you accomplished to date but hasn’t yet delivered any revenue? Maybe your app is the hottest thing out there and your downloads and daily active users are skyrocketing. Maybe you are deep into discussions with a major distributor or marquee customer. As a founder you should position these achievements as a launchpad for future revenue. When will your app deliver subscription or advertising revenue? When will the contract from this launch customer hit your P&L? It’s not easy to assign a value to these things, and at this stage valuations are more art than science. But if you can convince investors that you have a path to revenue growth, then the metrics above become relevant. The investors will expect a lower valuation on these multiples because there is additional risk, but at least you have an approach to determining a valuation.

But what if there isn’t even a Product?

If you are in the position where you have exclusive rights to an incredible piece of intellectual property, or have unbelievable relationships, such as knowing every supplier and purchaser in a specific industry vertical, but no product, can you still raise money? The answer is “yes,” but the way in which your company is valued becomes even more imprecise. Now your job as a founder is to persuade investors, not only that you will be able to sell your product but that you will also be able to create it. Again, valuations will depend upon the future expectations of revenue and profits, however, this time the investors will expect not only a risk-discount for the sales portion, but a technology-risk-discount for the creation of the product. As a founder, you can put yourself in the best position to justify a valuation to investors if you can cite similar companies whose valuation (either at funding or acquisition) is known.

Let’s agree we don’t know!

Another option is to kick the can down the road and raise without a set value. A favored method of raising funds at the “Friends and Family” stage is to use a financial instrument without a value. One investor gave the rationale for this as, “You don’t want to force Auntie Bettie to accept your valuation.” Founders can raise funds without specifying a valuation by using either a SAFE or uncapped note. Each instrument will offer the investor a discount (usually 20-30%) to a valuation determined by a future round.

Sounds easy, doesn’t it? Why don’t more companies do this? This is where there needs to be a balance between a deal that is good for founders and one that is equally interesting for investors. Many investors may not consider a 20% discount as adequate compensation for a successful path to the next round, when the alternative would be a total loss of funds. Consequently, more frequently protections are built into these methods (like caps, liquidation preferences, and interest rates) designed to give investors more certainty. However, this is a topic for another article.

Final Thoughts

At the end of the day, angels are looking to invest in viable businesses with the potential for significant growth. If your company has no revenue or is unable to make a profit, it’s likely not a good investment. Consequently, even if there is no product or little revenue, your job as a founder is to persuade investors that your company can earn revenue and deliver profits in line with widely recognized valuation metrics.

Choosing an appropriate valuation is difficult but necessary to raise funds now and in future rounds. The difference between a $9M and $12M valuation may not seem like much at first glance, but on a $100M exit, a $25k investment would yield $70k more with the lower valuation - clearly a significant difference for an angel investor. NYA members will frequently challenge founders over a company’s valuation. NYA members always want to see:

1)    Valuations based on legitimate reasoning, i.e. not just numbers plucked out of thin air; and

2)    Discussion on valuation, with flexibility, if appropriate.

If you can stick to these two principles, like the hundreds of startups already funded by New York Angels members, you will come to the right valuation for your company in the end.