All about: Funding Round Valuation

Introduction

Valuation is the cornerstone of the startup world. Whether you are on the founder or funder side of the table, understanding how to determine the worth of a startup is crucial. Even a relatively unsophisticated investor will understand that valuation is a key negotiation point in any investment.

While startup valuation plays a pivotal role in shaping the future of a company, getting to grips with all the pieces of this multi-dimensional puzzle can be hard to figure out. In this post we delve into the science, and the art, of startup valuation, its methods, and why it matters.

Why Valuation Matters

Valuation is not a mere number; it's a compass that guides founders and investors. For founders, it's a crucial benchmark that can impact their equity, control, and the amount they can raise. For investors, it helps them gauge their potential ROI and risk/reward ratio associated with the investment.

Setting your valuation too low is clearly suboptimal - it means that you've given away more of your business than you needed to in order to raise your funding round. This may mean that future rounds are challenging as, at some point in the future, investors may consider that you've diluted too far.

Setting your valuation too high could have a number of negative consequences:

Investors just don't find your investment attractive at that valuation and you struggle to fill your round.
You close your round but this high valuation can cause problems in future rounds - i.e. you don't make sufficient progress before the next round and that next round is either a 'flat' (i.e. same valuation as previous) or 'down' (i.e. lower valuation than previous) round. Both of these are very bad outcomes. Whilst this post is based upon VC investments, the narrative around over-inflated valuations is similarly true for angel investors (see especially message 24/30).

Common Methods for Arriving at a Valuation

Here's a closer look at the commonly used approaches for valuing startups:

Find comparable transactions: This method involves comparing the startup to similar companies that have been recently sold or have undergone funding rounds. Comparable transactions and market multiples are analysed to estimate the startup's value. Factors considered include industry trends, revenue growth, market share, and competitive landscape. This method is sometimes challenging because not all competitors have raised. And someone raising a year ago in completely different market conditions isn't a great indicator for today’s PMV either; macro conditions will have changed, and per-sector sentiment moves around a bit too.
As a function of income: This approach focuses on the projected future earnings of the startup. Financial forecasts, including revenue, expenses, and profitability, are analysed to estimate the company's potential cash flows. Discounted Cash Flow (DCF) analysis is often used to determine the present value of these future cash flows, considering the time value of money and the associated risks.
As a function of assets: This method considers the value of the startup's tangible and intangible assets, such as equipment, intellectual property, patents, and proprietary technology. The value of these assets, minus liabilities, is used as a basis for determining the startup's worth.
Using the Venture Capital Method: This approach is commonly used when valuing early-stage startups that have limited financial history. It involves estimating the startup's value based on the expected return on investment for venture capitalists. The valuation is influenced by factors such as the startup's growth potential, market opportunity, management team, and competitive advantage.
Scorecard Method: This approach involves assigning weights to various factors such as the startup's team, market size, product, competition, and traction. Each factor is evaluated and given a score, which is then used to calculate an overall valuation. The description from Jonathan Hollis at Mountside Ventures is great: “The scorecard approach adjusts the average valuation of similar startups based on a set of factors that affect the value of a startup, such as the team, the product, the market, the competition, and the stage. This method is based on the idea that the value of a startup is relative to the value of other startups in the same space. The scorecard approach can provide a more nuanced and realistic way to value a startup, but it also involves some judgement and discretion, such as the selection and weighting of the factors, the scoring of the startup, and the definition of similarity.”
As a Multiple: When you exit a business, you will likely find that your business is valued by a simple calculation: a multiple times either EBITDA or, if you are fortunate, revenue. You can negotiate the multiple and the revenue / EBITDA is often adjusted to remove exceptional items.

Challenges in Valuing Early-Stage Startups

Early-stage startups, especially those that are pre-revenue (or where revenue wouldn’t justify a sensible valuation), face unique challenges in the valuation process. Comparable businesses are hard to find, and income-based methods can be unreliable.

It's also important to note that valuing a startup is inherently subjective and can vary depending on factors such as the industry, growth stage, market conditions, and investor preferences. It is often a negotiation between the startup founders and potential investors.

Engaging the expertise of financial professionals, such as venture capitalists, angel investors, or business valuation experts, can provide valuable insights and guidance in determining a fair and reasonable valuation for a startup in the UK.

When to publicise your valuation

One school of thought is that you should not disclose your PMV in the pitch. Instead, you find an investor willing to be 'lead investor' and negotiate the PMV with them. This then forms the PMV for the rest of the round.

Alternatively, 'guestimate' where your PMV should be - by testing your pitch and PMV with a couple of angels, by looking at similar companies and finding out their PMV etc - and then go to market and see if the valuation resonates.

Sanity checking your valuation and raise

There’s a simple way of checking that your valuation and raise are vaguely sane: to calculate the dilution percentage in the round.

Normal dilution per funding round is 15-20%:

Any less than this and you are either raising an unusually small amount or your valuation is too high.
Any more than this and you should either be splitting your raise into multiple funding rounds or your valuation is just too low.

As an aside, if you publish a raise amount for a round but don’t publish a valuation, most investors will assume you are looking to dilute by 20% and do a quick calculation (raise amount x 4) to estimate your likely pre-money valuation.

Oh, Beauhurst also have a fascinating report which details the amount of equity retained by founders at different stages of their growth (Seed vs Venture vs Growth vs Established) - it is worth comparing your expected level of dilution with this report to make sure you aren't giving away too much equity or being unrealistic and aiming to give away too little.

Why is it a problem to dilute too much?

Having over-diluted founders can be a real problem for potential future investors. Why should they care? Because they want to see a motivated founding team. A founder with just 10% of equity in the company is going to be considerably less motivated than if they had 20% or more.

To give a real world example from one of my own investments how this can play out:

The company had a founder with a healthy 60% shareholding for the CEO when I invested.
This diluted significantly over the first couple of VC rounds.
As they negotiate their next round, the new VC would only invest if the founder is ‘recapitalised’.

In short, this means that the founder shareholding is increased (at the detriment of all existing investors) before the VC invests. This leads to double dilution for a single funding round (the first to recapitalise the founder, the second as part of the funding round).

Ouch.

A straightforward approach

If you are pre-seed, pre-revenue and offering SEIS, my personal way of checking a valuation is sain very straightforward:

Start with the average: Look at Beauhurst's 'average' valuation (£1.4m or so currently for pre-seed) as your starting point. Great businesses should be valued higher than this, businesses with unresolved issues, less.
Get your ducks in a row (and make sure they’re polished): It’s important to make sure you've got SEIS/EIS advance assurance, a solid pitch deck, a forecast model showing a clearly considered and sane forecast and finally a Term Sheet.
Amend the average valuation: Revise the figure by adding / subtracting a suitable amount for each of the following factors:

Traction: you’ve got a shiny pitch deck and a bright idea, but you’re not at revenue yet, reduce by £200k, if you’ve got an PMV launched with happy customers, do nothing; You’ve started to get revenue, add £200k.
Team: you've got a PhD owning product development and a few exited founders on the team - great, add £300k. It's just you? Reduce by £100k.
Protection: you've got patents filed, trademarks in place - great, add £200k. None of this (or not applicable), reduce by £100k.
Potential exit: do you have a clear exit strategy and a route to returning investors well over 10x their money? Great, add £200k.
Sizzle: is this in a hot part of the market (i.e. at the time this article is published, anything AI, but that will change over time)? Add £200k.
Scaleability: Is it SaaS / recurring revenue / highly scalable? Add £100k.
Grants: Do you have substantial (ie > £100k) grants to make the equity funding go further? Great, add 100k.

Or in short, an investor may go through their 'mental checklist' of things they consider when deciding whether to invest or not - my own checklist is below. They'll work out which items are most important to them and move your valuation from a fixed point (£1.5m in my case) depending upon your characteristics:

As you can imagine, I see a lot of startups and this is the process I mentally go through to test a valuation. It's vaguely related to the scorecard and Berkus Valuation Method for Startups but crucially sets the starting point on a scientific data point - Beauhurst averages.

In short it means a very polished business (still pre-rev/pre-seed) could justify up to £2.6m or so if everything was perfect. A business with challenges and no sizzle might find themselves at £800k. It's rare to see lower than this number.

Varying Valuations

Don't forget, you don't have to use the same valuation for all stakeholders. You may, for example, wish to thank an advisor for work already done or incentivise an active / strategic investor by offering them a certain discount.

What not to do Part 1: Get fixated on irrelevant 'comparables'

We routinely see the following initial behaviour:

"My friend's startup in San Francisco raised $Xm at a $XXXm valuation pre-seed, pre-revenue". The US market is very different from the UK (or indeed anywhere else in the world).
"Seedrs valuation tool says our pre-seed pre-revenue business is valued at £4m". Unfortunately, we find that several of the valuation tools output a very high valuation compared with reality in the market.

What not to do Part 2: Test your valuation on your top ten potential investors

A surprisingly common mistake. Get your v1 pitch deck and forecast ready, guess at a valuation and hope for the best, starting to work through your potential investors, best first.

Why not? Well, if you've got something wrong in any of your materials, it's rare to get a second opportunity to pitch...your potentially best investors will walk away.

Much better to test your pitch, deck, model and valuation via a less important set of investors first...Incorporate the feedback and then go for the top ten.

What not to do Part 3: Swing for the fences and expect to negotiate?

If your starting point is crazy, then lots of investors will just walk away. To use an analogy, if I'm going to buy a car and I've got a budget of £50k, say. I'll happily look at a car at £55k, on the basis that I'll be able to haggle down a bit. If I see a car for £100k, I won't even bother.

If you are a 'normal' pre-seed / pre-revenue startup and not in a crazy-hot part of the market and you openly value yourself at £3m then most investors will just walk on by. They know that your valuation should be ~£1.5m and won't bother trying to negotiate you to where you should be.

What not to do Part 4: The Bonkers Valuation Example

As a bonkers example of what NOT to do, I saw a valuation report once (it was a rebadged Equidam):

Business was pre-revenue. And, to be candid, the business was lacking in any kind of sizzle. Hadn't developed a product yet, so had a shiny (well, even that...) pitch deck and that was it.
⁠Product would be designed, developed and launched in a year.
⁠Seeking £70k initial funding.
Forecasted to achieve Year 1 £203m EBIT. Yes, this is bonkers.
They did 3 valuations. Scorecard came up at £1.5m, Checklist method = £1.22m, the VC method = £640m.
⁠Despite the HUGE range of valuations they did a weighted average (40/40/20) of the three figures (=(1500000x40%)+(1220000x40%)+(641000000x20%)) to come up with a £129m valuation.

How FounderCatalyst Can Help

FounderCatalyst can help you in several ways throughout your funding journey, and offers a set of valuable tools and resources to assist founders and investors in their startup journey:

Valuation Models: We’ve got a great set of valuation methods available in a spreadsheet and an associated guide, both courtesy of Active Ventures.
Equity Calculator: If you want to quickly view the impact of various valuations / raise amounts on your dilution, then check out our equity calculator.
CapTable Modelling Tool: If you want to understand the journey of a founder's share ownership and the dilutive impact of multiple rounds.
Sanity Check Your Valuation with real investors: We can help you hone your valuation by talking with real investors who can provide their completely unfiltered view.

Startup valuation is a complex but vital process that sets the course for a company's future. Whether you are a founder aiming to attract investment or an investor seeking the next big opportunity, mastering the art of valuation is crucial.

FounderCatalyst's resources and practical guidance can be your compass in navigating the dynamic landscape of startup valuations, ensuring that your decisions are grounded in reason and data.