Definition: Valuation is an estimation of the worth of something, especially one carried out by a professional valuer.
In the startup funding world, pre-money valuation refers to the value of a company not including external funding or the latest round of funding.
In contrast, post-money valuation includes outside financing or the latest capital injection.
For example, an entrepreneur might value their business at £500k before any funding is taken on. This means the pre-money valuation is £500k. The company then takes on £250k of external funding, resulting in a post-money valuation of £750k. It is important to know which is being referred to, as they are critical concepts in valuation.
Valuing and deciding how much equity to sell in a company that you’ve put your heart and soul into is not easy. Generally, when building your business pitch deck, you’ll need to make three key decisions:
1) How much money should I raise?
2) What percentage of the company should I sell?
3) What company valuation should I use?
All three questions are mathematically intertwined, so there are two approaches you can take:
a) Decide how much money you want to raise and go forward from there; or
b) Start with how much of your company you want to sell and work backwards.
Option 1: Decide how much money you want to raise
Some advisors say you should raise as much as you can. VCs and investors will usually say you should plan to raise enough to last 12-18 months before you need to raise money again.
Raising is incredibly hard, so understand how much you need to hit your KPIs, think about what would be nice in terms of breathing space, and be realistic about the amount that would in fact place too much pressure on you in terms of deliverables and managing investor expectations.
The reason for a 12-18-month runway is that, realistically, you’ll need to be on the fundraising trail six months before you’ll have new money in the bank, and you’ll need to show growth between now and then to get new investors interested. Any shorter than 12 months’ runway and it’s going to be hard to hit key milestones or show any real traction which means you are going to be unable to justify your next round valuation. It’s called a runway for a reason – if you don’t have lift off before you reach the end, things will come to a sudden stop!
So, if your starting point is figuring out the cash you need, then simply look at your monthly burn rate, add in the team members you plan to hire, marketing-spend, development costs, etc., and then look at your monthly burn rate again. Now multiply this by the number of months’ runway you need. Remember to factor in a buffer for the unknown, as anything can happen, and usually does, in startup land!
At this point, it’s important to remember, that although you have used the above as the calculation, funding your monthly burn isn’t the message your investors want to hear. So, when you are asked about why you are raising £x, remember to correlate your answer to milestones and not just survival, the resources you will need to achieve these and the length of time it will take to get you there.
Option 2: Decide how much of the company you want to sell
As much as Dragons’ Den makes for great TV, here in the real world, equity investment doesn’t work like that. The general rule of thumb for angel/seed stage rounds is that founders should sell between 10% and 30% of the equity in the company. These parameters weren’t plucked out of thin air, they’re based on what an early equity investor is looking for in terms of return. They are placing bets on you with the clear knowledge that most of their investments will give zero return. They are exposed to a high-risk/high potential scenario, hence will likely want a decent slice of equity to get a meaningful return if things go well, and, also, to have a meaningful level of influence and control of key company decisions if they don’t.
So, how should you value your company?
If you were to ask different VCs, they’re likely to come up with a wide variety of responses, including:
- Pitch us a number, if you’re ballsy enough and can justify that valuation based on your vision, and you and your team’s ability to deliver it, great, we’re in!
- The biggest determinant of your startup’s value are the market forces of the industry and sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money. So, basically lots of words to justify a gut feeling.
- Go to Crunchbase, search your nearest competitor, mirror their raise history and take your valuation up or down depending on whether you are pre- or post-revenue, pre- or post-launch.
- Multiply the amount you want to raise by 3 or 4 to get the valuation.
Some VCs are led by their head, others by their heart. Either way, there’s no substitute for a data-driven decision, and thanks to available data showing what happens across a range of funding round sizes, you’re now well placed to not only come up with a number, but to justify it as well.
UK company valuation estimator
Analysis of UK deal data reveals distinct funding patterns that highlights staged valuation bands. This might not accurately represent your startup environment if you’re outside the UK, but at least this will give you an idea of what’s going on in Europe and outside the US:
Stage: Idea Valuation: £300K-£500K
You’re looking to raise £50K to £100K to get your idea off the ground – this is when family & friends come in, as well as your own funds. Don’t forget to get grants – there are many out there, some are free, others have some terms linked to equity stake or some form of repayment in place.
Stage: Prototype Valuation: £300K-£750K
You’ve spent six months refining the idea, doing user testing, building a working prototype. You’re somewhere between Idea and Launch, with a valuation to match.
Stage: Launch Valuation: £500K-£1M
You’ve spent a year building the product with your co-founders, probably not paying yourselves a salary, plus you’ve invested £50K of your own money/time in the project. You’re close to launching, you now want to raise money for that last mile of product development and for marketing.
Stage: Traction Valuation: £1M-£2M
You’ve launched (congrats!) and you’re seeing good signs of early traction, enough to get investors excited. You have revenue plans, but nothing to show yet.
Stage: Revenue Valuation: £1M-£3M
Unlike Silicon Valley, where the vision of being a unicorn is often enough to get investors interested, UK investors (and probably others outside the US) like to see revenue or at least the promise of imminent revenue. Conservative or sensible? Probably both, but either way if you’re not showing revenue getting funding in the UK beyond Prototype stage is going to be tough. Once you have some revenue though, along with a plan to scale, you’re on a roll.
Stage: Scale Valuation: £3M+
To get to this point, you need to have figured out product/market fit, proof of repeatable business, and large market demand provable by data, a clear path to scale and new business acquisition, and have identified customer acquisition cost and customer lifetime value. You’ll know when you get there. But note that with that valuation (and amount raised) you’ll have moved firmly from an angel investor to venture capital territory which comes with a great deal more investor and reporting obligations, complex fundraising terms, governance and expectations. Something to note before joining the top table too soon.
Bear in mind that valuations differ wildly by industry, nature of business and multiple other factors; Ultimately, it is how much you and prospective investors agree on how much your company is worth.