How to get the numbers right when valuing your business

Stats from the United States suggest that only half of all series A funding rounds are successful. Series A funding rounds often start at $1 million of financing but can stretch to millions more, particularly if there’s been a long and successful period of boot-strapping or multiple bridge financings beforehand, writes Ben Chong.

We’ve all seen startups on the TV show “Shark Tank” eaten alive by potential investors for seemingly outrageous valuations.

Often their pitches take an even more unforgiving turn when founders are unable to validate their numbers. But coming up with an attractive yet sensible valuation that appeals to investors is no mean feat.

Of great importance is making sure that the founders’ own stake is not overly diluted by future funding rounds, otherwise their incentive to remain in and grow the business goes out the window.

A good rule of thumb is that founders shouldn’t give away more than 30% of their business in any funding round.

The seed stage is arguably the most difficult stage to value a business but there are a number of valuation principles that can help put founders on the right track to getting the investment they need.

There is some science but there is also a fair amount of art and ‘gut feel’ that will lead to an investment.

For early stage investors, three factors are non-negotiable table stakes for most angel or venture capital (VC) investors:

A strong team of co-founders who possess tech, domain and commercial expertise, and show signs that they are moving and learning fast;
A product that has had some early wins with a proof of concept, good traction during a period of boot-strapping, and enthusiastic take-up by early users; and
A large market, with a size providing potential for high growth.

VCs such as ourselves fund around one percent of the businesses we meet or hear from, so we – like many others – rate start-ups according to the factors above to whittle hundreds of potential opportunities down to a small number we will examine more closely.

For an early-stage business, there are two common mechanisms for raising capital: a priced round, and a convertible note. A priced round is straightforward and involves the founders agreeing on the current valuation of the company and the investor acquiring a percentage of the equity in return for their business. In the = case of a convertible note, investors “loan” money to a start-up as its first round of funding, but – rather than having the money repaid – the investment later converts to shares based on a discount to the valuation of the next priced round.

What’s reasonable?

So what is a reasonable valuation, and how can founders and investors agree on the numbers in the early stages, where there is limited track record funded only through boot-strapping?

In Australia, businesses entering an early-stage incubator or accelerator, where a priced round is employed, can be valued anywhere from $300,000 to $1,500,000. A number of incubators or accelerators employ convertible notes, leaving the valuation to investors of the company’s next round of financing.

Future cashflow is one indicator of the value of a business in early-stage funding rounds. A business with a strong pipeline, projected to make $1 million in sales over the following year, might value itself anywhere between five and 10 times this projection.

But what makes an investment worth a 5x multiple versus a more attractive 10x multiple? This is where factors such as historical and projected growth rates, the mix of recurring and non-recurring revenue types, customer concentration, and customer acquisition cost to customer lifetime value (CAC/LTV) ratios become important.

It’s also where some investors favour art over science where the result reflects the confidence of the investor and their conviction in the business meeting the three factors outlined above.

If a startup can’t gain traction before its seed funding runs out, it’s usually “game over”. But for those who are performing well, a small proportion are able to continue growing their business without further investment while the remainder will seek a series A funding round to take their business to the next level.

A 50% success rate

VCs look for different attributes when considering a series A investment. Founders need to demonstrate that their start-up is not just a great idea but the early stage of a great business.

The valuation is based on the quality of the team that has been built thus far, whether seed capital was used efficiently, and whether traction is building. Investors will also look for early indications of a scalable sales model capitalising on successes in one or more marketing channels.

Although there is no industry standard methodology for valuing series A start-ups, a series A funding round valuation will reflect operating metrics such as revenue, revenue growth, churn and pipeline. These metrics are important, as too are comparable deals within the sector.

Fundraising is difficult in the early stages and valuations are a primary challenge. A valuation that is too high may result in downward pressure in the next funding round (series A, B or C), otherwise known as a “down round”.

This often occurs when overexcited founders and investors underestimate the amount of time it takes to achieve key milestones. If the valuation is too low, the founders find themselves feeling robbed of their equity, so getting the right valuation is just as important for the founder as it is the investor.

In the absence of a silver bullet, investors and founders must focus on a valuation that recognises the early successes as well as the future potential.

There will always be a trade-off between how much equity a founder is prepared to part with and how much investment they need to get to the next level, and a founder should close the deal when they feel that the balance has been struck.

This post was written by Benjamin Chong, partner at venture capital firm Right Click Capital for Start Up Daily and is republished here with permission.