October 15, 2018
As a VC, I often get asked about the valuation of startups. It is also a topic that we @Superherovc frequently end up discussing with entrepreneurs. But is it so important? It kind of is.
Those who have studied in business school are well aware of different valuation models like discounted cashflow (dcf), dividend discount (ddm) and comparative models (cm) to name a few. However, these are aimed for analysis of established companies with traceable history and therefore usually do not work with startups. Sometimes (thank god rarely) we meet with entrepreneurs, who try to justify their expectations for high valuation using some variation of dcf usually including a very aggressive hockey stick for growth. Sorry guys, just does not work. These hockey sticks are imaginary only… unless you have a time machine. Since startups usually do not have any history when they look for seed funding, regular models are not applicable. There are a lot of tools though. So how to define the valuation of a startup then? Are there any models for startup valuation?
The starting point is quite simple, you need to define how much money you need. That must be based on a plan as to how much is needed to execute and what will be achieved. The plan must cover 18–24 months and preferable have 2–3 different scenarios. Be realistic. As VC´s usually want to have ownership between 15–25% against the money they invest, that is your default dilution. If you are going to have a single investor, they can settle for 15–20%. With a syndicate, you should be prepared to dilute up to 25%. Anything more is really not a good deal. Not for you, not for the investors. Why? Because entrepreneurs will make it or break it, not the investors. Therefore excessive dilution just does not work. Preserve your Cap Table.
So, the valuation is quite simple to calculate. Let´s say you raise 1 M€ and you give out 20%, your valuation is 4 M€ pre-money. Now the question is can your traction justify that valuation. There are some guidelines for valuations like “pre-product 0,5–1 M€” and “initial traction 1–2 M€” etc. Also in SaaS businesses, the multiples have recently been around 6–9 x revenue. So if you have 30 K€ MRR, your valuation should be around 2–3 M€. But these are just indicative, ultimately it is deal-making. And the best way to get a higher valuation is to increase traction.
As said before, preserve your Cap Table. We quite often see startups where the initial FFF (Family, Friends and Fools) and/or angel rounds have already pretty much destroyed the ownership structure. As a rule of thumb, founders and the key people should own 80–90% after FFF and angel rounds, 70–75% after the Seed round and preferably at least 50% after Series A. Also avoid exotic structures like having old, existing family companies as owners — rather establish a new company to pool ownerships if needed. Also do not use your existing passive companies for your business, rather establish a new one. Why? Because especially in Europe, there's a lot of public funding available for startups and that is usually only aimed for companies less than 7 years old. So do not exclude those opportunities.
Finally, it matters who you raise the money from, also financially. As VC math is quite complex (worth a separate blog post), make sure you understand the game your investors want to play. As a small fund, we @Superherovc are primarily not looking for unicorn home runs (we would naturally be super excited to get one). For us a median exit (last year 61 M$) works OK. Should you raise money from a large international VC fund… well they always go all-in. Why? Because a 61 M$ exit does not move a needle for someone having a 500 M$ fund. So think carefully what's the game you want to play.
As a summary, valuation is important but usually over-debated. The important thing is not to get as high a valuation as possible but rather optimize the valuation. Should you manage to raise your 1st VC round at a high valuation, it also raises the expectations very high. And limits the number of next round VC´s since they usually do not want to execute down-rounds. I have also seen many potential startups destroyed by unrealistic valuation expectations. A company has been raising money for a long time (usually unsuccessfully), while competition has in the meanwhile conquered the market. Not very smart.
Should you want to know more about valuations, there is a lot of material in the interweb. One example can be found here: http://www.fiban.org/uploads/7/8/5/7/78578870/guide_to_finding_an_angel_investment.pdf
Wishing you success at fundraising,
Juha Ruohonen, Partner Superhero Capital