What is Valuation and The Impact on Your Ownership

What is the appropriate valuation of your business? And why does it matter? This typically arises in the context of raising money for your business. When you are raising money, the value of your business will determine the percentage of your business you will give to investors in exchange for their capital. Generally, your business is worth what somebody is willing to pay for it. And the methodologies applied by one buyer in one industry may be different from the methodologies applied by another buyer in another industry. That being said, there are certain considerations and methods that are used rather consistently by the investing community.

“Valuing early-stage businesses is more of a negotiation art rather than a mathematical equation.”

Factors That Impact Valuation

The valuation of an early stage company will be determined by a combination of factors. Below are some of the factors to consider:

  1. Industry Demand. The industry in which a company operates will be extremely important in determining valuation. If a company operates in a “hot” industry, it is likely that it will be able to achieve a higher valuation compared to another company in a different industry at the same stage of development and current traction. This is because in a “hot” industry there will be a greater demand to make investments and more money ready to be invested resulting in higher industry average entry valuations.
  2. Market Size. The larger the market in which a company operates, the bigger the potential upside of an investment. Therefore, the bigger the market, the bigger the potential valuation a company can command and vice versa. If your product lies in a high demand industry with low market supply, investors will come knocking with offers aplenty. If you operate in an overly saturated market with numerous competitors, your chances of attracting investors are slim unless you have a distinct competitive advantage. Investors will get a glimpse of your business’ value by assessing your earning capacity based on market demand.
  3. Stage of Development. If a business is still just an idea then it is very unlikely it will get the same valuation as a company that has a product in the market with customers or user base.
  4. Traction. If a company has evidence that it is gaining amazing traction with really high growth rates then this will demonstrate to investors that the business is on to something and could result in a higher valuation.
  5. Talent Potential. In addition to market potential, your company’s talent also plays a role in valuation. The more relevant experience your company’s leadership has, the more likely you’ll achieve product/market fit. Since most investors prefer to see early evidence of market traction, your talent plays a pivotal role in establishing that early traction and in turn attracting investors. An amazing team with high profile or experienced key members will be able to command a higher valuation as the higher the quality of the team, the more likely they will be able to build a successful company (or so their track record would suggest). For many investors the team is the most important factor in determining whether or not to invest.
  6. Future Financing. Considering how many rounds of finance a business will need to reach an exit point is another important factor. Companies should avoid giving away too much equity too early, so that the founders and the team is incentivized to take the company all the way there. Investors understand this and take it into account.
  7. Unit Economics: At the early-stage it is highly unlikely the company will be profitable. Being able to demonstrate good unit economics for your product/service is important to show investors that your company will be profitable in the future.
  8. Comparable Companies. Look at comparable companies and industry exits. Looking at these will enable you to make a judgement on what a potential exit scenario could look like. Once a company has an idea of a potential exit scenario it is possible to work back towards a present valuation.
  9. General Economy. When the economy is performing badly (i.e. during a recession), it is likely that there will be less appetite to be invested in a high risk asset class such as early stage companies. Consequently, it is likely valuations during these periods will be lower than when the broader economy is performing well.
  10. Investor Demand. The biggest determinate of the valuation of a company can often be investor demand to get in on the deal.
  11. Urgency. If a business needs finance urgently then it is likely that their valuation will be lower than a company that does not. This can appear a bit desperate, especially if you’re looking at a significant down round, so we’d suggest not resorting to this.

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