Startup Valuation: How much is your startup worth?
Valuation is a sensitive topic for both the investor and the entrepreneur and both sides work hard to optimize it. In general, the greater the risk, the lower the valuation. A startup by definition is working on an unmet customer need using limited capital and human resources and can fail if customers do not adopt at scale its innovative technology or new business model. Depending on the stage of the startup, investors would like to be compensated accordingly for taking the risk. As the startup matures and continues its journey attracting loyal customers and figuring out a repeatable sales model, the risk decreases, and valuation rises. Failure rate of a startup at different stages in its lifecycle is shown in the table below.
Startups are typically classified into Seed Stage (Angel and Seed rounds), Early Stage (Series A and B), and Growth Stage or Late Stage (Series C and beyond). Valuation approaches vary based on the stage of the startup, software versus hardware offering, industry vertical, geographic location, macroeconomic environment, customer and revenue traction and so on. According to Pitchbook, in 2021, in the US, the median valuation of a Seed stage startup is $9m whereas the median valuation of a Series A stage startup is $35m. In India, the median valuation of a Seed stage startup is $3m and the same for a Series A stage startup is $15m.
Valuations for early-stage startups are typically based on the following factors
· Market: Attractiveness of the market, growth rates, total addressable market size
· Team: skillset of the founding team, prior experience at successful startups
· Technology: Differentiated technology or business model
· Traction: number of paying customers, pilot projects completed, number of signed commercial contracts
Late-stage startups are valued based on several performance metrics such as
· Growth Rate: Annual Recurring Revenue (ARR) growth rate, new ARR vs expansion or upsell revenue, churn, quarterly growth rate in number of customer accounts
· Revenue Mix and Quality: Product vs. Services revenue mix, customer concentration
· Customer Metrics: Average revenue per customer, Customer Acquisition Cost (CAC), Customer Lifetime Value (LTV)
· Sales Metrics: pipeline coverage, sales cycle, win-loss ratio
· Path to Profitability: Gross margin, Opex — spend on Sales and Marketing (S&M), Research and Development (R&D), and General and Administrative (G&A), EBITDA
· Precedent Transactions: Prior financing or M&A transactions involving similar companies in the same or adjacent market, valuation multiples of public companies
· Demand and Supply economics: how many investors are interested in investing in the company, how many similar companies are there in the market, etc. The more the demand from investors, valuation gets pushed up.
Another way to arrive at a valuation estimate is to look at the expected dilution of founder ownership at different financing stages. Ownership percentage is how an investor gets compensated for taking risk. An investor demands a higher ownership percentage during the early phases of a startup because of higher expected failure rate. The picture below from index ventures shows the ownership dilution in US startups across funding rounds. In a Seed round, the investor takes about 25% ownership. If the round size is $2m, that translates into an $8m valuation.
Some entrepreneurs, especially during the early stages focus more on maximizing valuation and may be tempted to accept the term sheet from any venture firm offering the highest valuation. Valuation should not be taken in isolation; it should be considered in conjunction with other rights and protective provisions the investor is receiving such as what type of stock is being offered — common, preferred, or participating preferred, liquidation preference, anti-dilution, control provisions, and other terms. Founders, when evaluating term sheets from multiple parties, should also consider how the venture firm would be adding value towards the growth of the startup. Founders should speak to a few of the CEOs from the venture firm’s portfolio to understand the firm’s contribution towards the startup’s success.
Article also published on CEO Insights