What is Startup Valuation?
Startup valuation, like most of the business world, is part science and part art. In a nutshell, valuation is our forecast of where the company is heading. This means no matter how structured your valuation is, it is still negotiable. Investors, or you, might reason that the forecasts are overestimated or underestimated, affecting your final valuation number significantly.
With this in mind, you should carefully consider whether you should be aiming at a high or low valuation number. At first sight, the answer may seem very clear: I am selling part of my company for money and therefore I should charge as much as I can. Walking through the consequences, however, will show you that it is a strategic decision with long-term consequences.
“Your incentive as a founder to increase or decrease the
startup’s valuation varies based on your long-term strategy”
This article is a quick walkthrough of the most affected factors that come to play: the expectations from the company, the ownership structure, and the potential for future investments. Both founders and investors care deeply and behave differently with changes in these factors.
1. Expectations from the Company
Higher valuation directly means higher expectations from the company. High valuation could be due to forecasting that the company is going to conquer and break huge milestones. It could also be due to being too optimistic about the industry’s future and predicting the startup will grow along. Either way, the valuation of the startup is a reflection of the expectations from it.
“It’s simply to say that managers and investors alike must understand that accounting numbers is the beginning, not the end, of business valuation.” – Warren Buffett –
High valuations usually drive the founders to aggressive strategies to meet the high expectations. The business might be doing too well from comparing companies, but investors will be frowning if the business is significantly under the expected threshold.
To avoid such a stressful environment, founders should aim at getting the valuation “just right.” Startups need to enjoy healthy, long-lasting growth. Aggressive strategies might work for the short term, but basing the startup’s entire future on them is too risky. Low expectations too destroy morale and may prevent the startup from reaching its true potential. Being realistically optimistic in your forecast is the key.
2. The Ownership Structure
Normally the valuation and the fund amount are negotiated independently. If the amount raised is fixed, increasing the startup valuation means the investor gets less equity. This is why, generally speaking, investors are better off by driving the valuation down.
To the founders, raising capital dilutes their ownership. They start with 100% ownership and control over the company, and with every fundraising round their ownership decreases. Therefore, they are better off agreeing on a high valuation to sell less of their company.
Nevertheless, there is a vital factor that comes into play that founders should not ignore. Venture capital firms, angels, or other types of investors usually provide support and go the extra mile for their startups. After all, every startup they invest in is part of their portfolio and they care about its success. Getting on the right foot with the investor with enough equity stake in your startup is vital for future collaboration and support. If they own a low percentage of your startup, they have an incentive to give less time to your startup and more to the rest of their portfolio.
The ownership structure should give everyone, including founders, enough incentive to do whatever it takes for the startup’s success. It’s no different from salaries and employees’ benefits. Founders should not seek extreme valuations especially when they expect to count on their investors.
3. Future Investments
Before seeking a high or low valuation, you should take into consideration the future plans for the startup. Your plans may include seeking future funding rounds or to be acquired, both of which depend on your valuation.
High startup valuation gives room for future funding rounds since founders still have enough equity to sell. If you give your early investor too much equity in the first round, it will drive future investors away.
Low startup valuation is a better strategy if you’re not looking for future rounds and instead seeking an acquisition. Setting the startup’s valuation at a reachable price for potential acquirers is key to a successful exit.
Final Thoughts
It is understandably tempting to accept or negotiate a high valuation as a founder. It gives you and your team a sense of validation about the startup and what you’re doing, not to mention the potential media exposure and the leads coming from it.
This is only one path to go. It is definitely great for the short run. It may even be the best in the long run. The key is to match your decision for valuation with your vision for the future, including aligning your startup’s stakeholders with this vision.
To conduct your valuation, you can use VeFund’s automated valuation calculator. It will not require a prior understanding of technical concepts. You will only need to provide the needed inputs and a detailed valuation report will be ready for you. Test multiple scenarios as much as you want!
As a guide for your strategy, here is a table summarizing all we talked about with additional implied factors:
Frequently Asked Questions (FAQs)
When is a lower valuation better?
Lower valuation is better when you’re planning for acquisitions, planning to keep investors engaged, or preferring a less stressful environment.
How to negotiate a high valuation?
Negotiating higher valuation can be done by stressing the potential of your startups. The higher your preparation, the higher your chances. Get your numbers for expected returns straight as well as the qualitative features in your startup.
How does valuation affect ownership?
The higher the valuation, the more ownership percentage you get to keep as a founder.
