The art of valuation: how to price your startup for investment

When it comes to early-stage startup valuation, a number of key factors, methods and negotiation strategies are critical to securing funding from investors

Valuing a startup is a challenge that founders and investors both grapple with. In the dynamic world of early-stage investment, determining a startup’s valuation is often more art than science. Unlike established companies with a track record of financial data, startups lack years of historical performance to rely on. Consequently, there is no one-size-fits-all formula for valuation. Instead, it becomes a creative and subjective exercise that takes into account numerous factors, some of which are unique to the startup ecosystem. 

In this article, with the help of advice from UNSW Founders Investments and Portfolio Manager and experienced investor Beste Onay, we’ll uncover some of the methods for valuing an early-stage startup as well as general valuation tips and tricks.

Many factors influence a startup’s pre-money valuation. If a startup is already generating sustainable revenues, the valuation method might resemble the established models, such as revenue and earnings multiples, used to value mature companies. In this scenario, increasing revenue streams reduce the financial risk associated with failure and enhance the prospects of a significant exit. However, for early-stage startups without the luxury of years of financial data, determining a fair valuation can be a more creative endeavour. Founders and prospective investors must rely on subjective determinants and assessments of potential. In this context, the art of startup valuation truly comes to the forefront.

For founders seeking funding and investors considering early-stage startups (especially angel investors), understanding what factors an investor looks for when valuing such ventures becomes paramount. The journey of valuation often entails a blend of vision, market opportunity, team capability, and the art of the deal. It’s about finding that sweet spot where both founders and investors see a compelling future and a fair distribution of ownership. In the world of startups, where innovation and potential often outweigh past performance, mastering the art of valuation can be the key to unlocking the resources needed to turn a visionary idea into a thriving business.

Understanding startup valuation

Valuation, in the context of a startup, refers to the monetary worth assigned to the company at a specific point in time. It’s a critical factor that determines how much ownership you must give up in exchange for investor capital. Startup valuation isn’t a one-size-fits-all approach; it depends on various factors, and different valuation methods can yield varying results. 

“Your valuation will determine how much equity you will give away to investors and other shareholders, including employees. It can, therefore, be used as a tool to attract and incentivise talent,” said Ms Onay. “It should be noted, however, that most founders prefer to keep their valuation confidential from the wider public for reasons including – protecting company strategy and position in the market and for negotiation leverage.”

Balancing act

While it’s tempting to aim for the highest valuation possible, it’s essential to strike a balance between a fair valuation and investor attractiveness. Overvaluing your startup can deter investors, as it may appear unrealistic or too risky. Conversely, undervaluing your startup can result in giving away more equity than necessary.

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“If you overvalue your company, you might create unrealistic expectations among stakeholders, including investors, employees, and customers,” said Ms Onay. “This can lead to challenges in meeting these high expectations and potentially harm the company’s reputation and credibility. You also risk having a down round or lower-than-expected valuation when raising capital again, which can further impact the company's reputation and morale. Many investors hope to see companies double their valuation between rounds.”

Negotiation and flexibility

All investors, regardless of their experience and expertise, typically push back on valuation. “I recently hosted an event with a panel of investors," said Ms Onay. "A founder from the audience asked an investor, ‘What are your views on startup valuations?’ Without hesitation, the investor said, ‘They are too high’. The room erupted with (nervous) laughter, learning that this was the default view. Founders should be prepared for this.”

Investors aim to strike a balance between securing a reasonable ownership stake and ensuring that the startup has enough capital to fuel its growth. In an ideal scenario, founders should maintain a significant degree of control over their startup, particularly as they progress to the Series A funding stage. Having founders with substantial equity stakes serves as a powerful incentive, motivating them to pour their energy, time, and resources into the venture. If a potential investor expresses interest but has concerns about the valuation, consider whether adjusting the terms could be mutually beneficial.

“In terms of equity stake, founders should aim to collectively maintain around 50 per cent equity ownership at Series A,” said Ms Onay. “Investors will recognise if a company has given away too much equity early on, and either steer clear of it or try and help 'clean up' the cap table (e.g., by buying out other investors).”

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Changing valuations

The valuation changes with each funding round. As startups progress and attract more investment, the valuation at each stage reflects the company’s growth, potential, and market dynamics. This means that the valuation process isn’t a one-time affair; it’s an ongoing evaluation of a startup’s worth.

Valuation methods

Market valuation: This method involves comparing your startup to similar companies in the market. It takes into account metrics like revenue, growth rate, and market share. For example, if other SaaS startups in your sector with similar growth trajectories are valued at 5x revenue, you might use this as a benchmark.

Income approach: This approach calculates the present value of future cash flows your startup is expected to generate. It’s often used for mature startups with predictable revenue streams. Example: If your startup is expected to generate $1 million in annual cash flow for the next five years, discounted at a rate of 10 per cent, the present value would be approximately $3.86 million.

Cost approach: This method considers the cost of building your startup from scratch, including intellectual property, technology, and human resources. It’s less common for early-stage startups but can be relevant if you’ve invested significantly in product development. Example: If you’ve invested $500,000 in developing a unique software product that could contribute to your startup’s valuation.

STAGE and Berkus approach: The STAGE approach assigns a value to each development stage of your startup, with specific dollar amounts attached to each milestone achieved. The Berkus approach assigns a set value to five critical factors: sound idea, prototype, quality management team, strategic relationships, and product rollout or sales. Example: If your startup has a working prototype, the Berkus approach might assign a value of $500,000 to this milestone.

Raise-restricted approach: This approach acknowledges that early-stage startups often face significant risks. It involves raising capital at a lower valuation initially, with the promise of a higher valuation once specific milestones or goals are achieved. For example, you may raise $500,000 at a $2 million valuation with the understanding that if you reach a user base of 100,000 within a year, the valuation will be adjusted to $5 million.

YC approach: Certain accelerator programs, such as Y Combinator, have addressed the complexity of valuing early-stage startups by adopting a straightforward approach. They uniformly assign a standard valuation of either $1 million or $1.5 million to all the companies participating in their program. Their investment typically ranges from $50,000 to $150,000, equating to an ownership stake of approximately 5 per cent to 10 per cent.

VC approach: A valuation method commonly employed by venture capitalists. In this method, investors, typically seeking an exit within three to seven years, begin by estimating the anticipated exit price for their investment. Subsequently, they work backward to determine the post-money valuation at the present moment, considering the time frame and the risk undertaken by the investors to ascertain the expected return on investment.

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“There is also the 20 per cent approach," said Ms Onay. "Consider how much capital you need to achieve your next big milestone. This amount equals 20 per cent of your equity. For example, $1 million required equals $5 million post-money valuation (or $4 million pre-money). You should do some research, talk to people, try various valuation methods and then adjust accordingly.”

Startup valuation is a complex process that requires a blend of financial analysis, market understanding, and negotiation skills. Striking the right balance between ambition and realism is key to securing investor interest while ensuring that your startup is appropriately valued. Keep in mind that startup valuation is not static; it evolves with each funding round and as your company achieves milestones. Continuously reassess and refine your valuation strategy to align with your startup’s growth trajectory and investor expectations.

This article is republished with permission from UNSW Founders. UNSW Founders sparks innovation within students, scientists, and alumni by centring on nurturing ideas, enhancing skills, and fostering networks. This dynamic environment gives rise to 50+ fresh startups annually. Explore further details, upcoming events, and opportunities at UNSW Founders here.