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Five Fundamental Truths about Start Up Valuation

Entrepreneurs need to put a value on their startups in order to raise money, and investors need to put a value on their investments to generate liquidity. This article attempts to provide some guidance in startup valuation

Valuation is highly context specific:

Both entrepreneur and the investor are betting on the future. The future is unknown. The entrepreneur and the investor could both individually and collectively misjudge what the future might turn out to be. If the business is in the middle of a bull market, the business might be able to justify a huge valuation because everyone believes in the hype of how great the future will turn out to be. On the other hand, if the business is in the middle of a slump then the valuations may be very low as the overall industry and market sentiments are down.

Investors will also look at:

  • The stage of the business
  • Is the business in a growth market or saturated market
  • How much capital does the business need across its lifecycle

There are five fundamental truths regarding the valuation of early stage businesses by potential investors:

  • A pre-money valuation is an outcome of negotiation, rather than a mathematical calculation of discounted cash flow or any other metric of potential company performance.
  • Investors’ views on valuation are in some way based on a perception of risks and potential return of the investment
  • Pre-money valuation is just one of many funding terms and conditions important to investors and companies, and not necessarily the most important one.
  • Financial forecast - Although it’s difficult to forecast revenue at a startup, the entrepreneur needs to value and finally defend the valuation of the business
  • Valuator should think like a Venture Capitalist who is focused on return on investment. In the simplest case, the entrepreneur should estimate the exit event, consider the required ROI, consider future dilution and then calculate the present value of the business.

Important thing to remember is that the valuation in early rounds can set the bar on the valuation for future rounds of fund raising. At the time of future rounds, there might be more tangible ways of valuing the business and these might lead to a value that is lower than the valuation you negotiated in early round. This mismatch can only hurt the business and make the entrepreneur's life difficult in raising additional capital.

The valuation should be fair to both entrepreneur and the investor. It should give the entrepreneur enough incentive and upside to make the start-up a success. It should give the investors enough stake that they see it as a meaningful investment that is worth their while spending time and resources on.

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