Quantitative attributes that determine your startup valuation
Startup valuation is neither a simple nor straightforward process. This is because it is different from valuing established companies and because a startup operates in highly risky and uncertain environments.
An established business has customers, revenue and historical data to help potential investors understand the risks and expected ROI when putting their money into such companies. A lot of variables and unknowns are already worked out and defined, which makes such investments safer and predictable. In addition, there are multiple well-established criteria and methodologies to evaluate an established business, which helps with the investment efforts.
With startups, investors in most cases work with promises. Customers are not well defined and most of the times non-existent. No history of revenue and statistics to help with marketing efforts. If the executive team is new and young, there will be problems that will become visible only when the startup gains speed.
There are multiple methods and services available that could help your startup with the valuation process, but there are a few basic things any startup needs to cover and have information about, before approaching an investor.
Your product or service state of development
The more developed your idea is the less risk for failure. An investor wants to minimize the failure of not delivering a product for his/her investment and having at least a prototype gives the investors a higher sense of security than simply having an idea.
There is no guarantee the prototype or product been already developed is the right product-market fit, but it shows that your team can deliver. In addition, this means you are determined and invested time and most likely some of your own money in your own idea.
The best option for an investor is to be working with a product or service that already generates revenue. This eliminates the initial most risky period and may be narrowing down the goals to simply scaling your business.
What is the size of your industry
The bigger the industry you are trying to get in and offer a product or service, the better. The thinking behind it is that if the market is big enough, there will be room for your startup to grow. This will definitely impact your startup valuation since this shows potential.
In addition, it is helpful if you are in an industry which is or recently has been in fashion among investors. Investors look at each other and follow big names in the investment community, which creates these “fashion waves” of investments and it definitely helps if your startup product or service is in one of the favorable industries at the moment.
“Nice to have” vs. “Must have”
What kind of product or service are you creating? The common description of the category products and services fall are “nice to have” and “must have”. The category your product falls in will be very impactful on the valuation of your startup.
If your product is in the “nice to have” category, you will most likely have a hard time convincing investors to join your company. It also impacts your startup valuation, because such products and services tend to be less valued by customers, which in turn means investors will have less ROI or longer time to acquire that ROI.
Your service or product needs to help a lot of people or companies (if it is B2B) do what they do better, faster, and cheaper. This is considered “must have” product and will impact your startup valuation positively.
Size of the sub-sector of your market
Investors look for big markets to invest in.
Big markets are more forgiving, allow more room for errors and for more players. How big a market needs to be to be a good size? It depends on many factors, but a good “rule of thumbs” is that a market with at least $1B in annual revenue is worth exploring.
Is your market growing or shrinking
Investors look for lucrative ROI on their money. That is probably the most important number they are interested to see when talking about investing in your startup. Each investor or investment entity has different requirements to make their efforts worthwhile.
One of the factors that can show good potential for high ROI is market growth. When the market is growing, it indicates there is interest in what is being offered and customers are ready to spend more.
Each investor (and VC) has its own idea for market growth, which makes him/her comfortable to invest. Usually, 10%+ growth per year is considered a good market to be in.
This number, of course, depends very much on the market maturity, but if there is no at least 10% growth per year, you probably are not in a good market. Some investors are even more aggressive and only invest in markets with 30%+ growth per year. So, be sure you have caught a growing trend in a good size market.
Who is your primary competitor
Competitors are important. If you don’t have any competitors, you are most likely too early to market. You will be absorbing all the expenses to educate customers to use your product and you will have to be ready for significant marketing and operational expenses to cover this period.
Another, not very favorable situation would be if there are large companies with huge R&D budgets and established distribution channels. Unless you are looking to be quickly acquired by such companies, this is not a very good position to be in.
Probably, the best competitors landscape to be in is with other startups or small companies trying to achieve something similar to what you are doing. This validates the market, shows potential and customers will be educated by multiple players in this field.
This may sound counterintuitive, but just to confirm it – next time you buy coffee or go to a restaurant, look around and notice how many other coffee shops and restaurants are around, in the same area, probably offering similar products.
This is relatively simple to understand. Investors want to see that you are aiming for big revenue numbers.
But make sure you are not presenting numbers too big because that will make investors very suspicious and think you have not done your homework. If you show really big numbers, make sure you warm up your investor with verifiable data, before you say the number.
On average, investors want to hear that you will be able to bring at least $5M in revenue the first 12-18 months and you are aiming to acieve about $50M of revenue in 5 years.
How quickly you can grow and what is your scalability model
Simply put – can you grow your margins faster than your expenses. If your marginal gross margins increase rapidly (like in a software business), you are on a good path. This means at some point for the same dollar you put in (expenses) you will get more than you were getting during the last cycle.
Second best growth model is more like a hardware company – a more gradual increase, which requires substantial investments to keep the growth, but growing none the less.
Anything less than this is not going to attract investors. Keep that in mind.
You need to show that you have a team to work with you and get things done.
Having a team shows you managed to persuade other people to invest in your idea. Your team is dedicating all their resources and efforts towards one goal. As an investor working with a team means collaboration, more ideas, better agility, and accountability. A single founder is never a good sign (personality issues, lack of dedication, limited resources, too risky if the founder loses interest in his/her idea).
Ready business plan
This is an interesting topic. Some investors don’t care about a startup having a business plan, others will not even start talking to you if you don’t have one.
The rationalities behind each of these approaches are simple. A business plan survives until its first battle with real customers and never survives. It is worth less than the paper it is printed on.
On the other hand, a business plan helps you put your expectations and vision about your business in order and in one place. It is mostly designed to help you as a founder, not the investors. The value of the business plan is to help you think through the cash flow needs for your startup to operate, which will help you explain your investment needs. Keep in mind it is a living document and never “done”.
It is probably a good idea to have a business plan handy, it will not hurt to have such a document and mention it to the investors.
These are just the minimum points a startup needs to cover to make sure the team is ready to answer the questions about their startup valuation confidently and with competency.
Investment in a startup is inherently very risky and as a startup owner, you need to show that you understand very well the business environment, competition and customers and you are ready to mitigate the risks to maximize your investors’ outcome.
Investors are putting their funds in, expecting a serious ROI, not available by any other means. This puts immense pressure on startup teams to deliver high value in a short period of time. Being prepared and ready before your startup valuation process, will only ensure that your idea and the team are on the right track.