Daniel's notes on Startup Valuation

As your startup makes progress, launches its products, adds new customers, and streamlines supporting operations, it is reducing the risk associated with the startup surviving and ultimately succeeding. This risk reduction adds value to the startup and at each round of equity funding that value should be growing. Along the way, as outside investors buy into the startup, founders give up a portion of their equity to the investors.

If you are discussing your startup's valuation with investors it means a lot of other things are right: large market size, great team, IP on track, milestones achieved, good exit potential, and so on. Most investors need check marks in the yes column on these items before they consider letting go of cash. If these things are not right, or at least repairable, then investing at even a low valuation does not make sense for the investor.

Series A, Series B, etc: Series A is a term used to mean many things, but typically, a Series A is the first Venture Capital level investment round. Additional investments from institutional investors follow the same pattern, Series B, Series C, and so on. Also note that VCs are in the business of investing other institutions money, not personal money, as is the case from angels or friends and family investors.

Equity. The ownership of the startup—who owns how much. In the most common sequence, the founders own 100% equity of the startup at formation, then give up chunks of ownership to outside investors in exchange for cash investments. Portions of equity are also given to key employees in the form of stock options as additional compensation for their contributions to the startup's efforts.

So when do you need to establish a pre-money valuation of your company? - Starting Equity Investor Discussions: Scheduling investor meetings and making funding pitches drives the need to establish a pre-money valuation of your startup. While funding structures such as convertible debt can be used to delay the need to establish your valuation, most angel investors are likely to push you to give at least a ball park range for your startup's pre-money valuation.

Establishing a Stock Incentive Plan: Many startups set aside a pool of stock options to be used to reward early employees for taking on the risk of joining a startup, and to offset lower than market rates for salaries and other benefits. Stock option pools influence the overall ownership picture of the startup (tracked in a capitalization table) and should trigger valuation discussions among the founders. While stock options do not directly influence the valuation of the startup, they are calculated into the number of fully diluted shares outstanding, and therefore affect ownership percentages of all shareholders.

Equity Split Discussions Among Co-Founders: One of the essential steps in startup formation is establishing the ownership split when the startup has multiple startup founders. Before entering discussions with outside investors like angels or VCs, founders should have a clear agreement on who owns how much of the new venture. Two questions need attention prior to taking on new investors: 1. What is the equity split between founders-50% / 50%, 20% / 20% / 60%, and so on, and 2. What is the premoney valuation of the company?

if the investor agrees to invest $1,000,000 in the startup, how much ownership (equity) does that buy? You can calculate the answer in a simple sequence: 1. Assign a value to the startup before the investment dollars are injected. This value is called the pre-money valuation of the startup. 2. Add the investment amount to the pre-money valuation. The result is called the post-money valuation. 3. Divide the investment amount by the post-money valuation to give the equity percentage owned by the investors. This percentage is also called the founder's dilution amount or percentage.

Founders working to raise equity funding from investors are eventually confronted with two key investor questions: 1. How much of an investment does the business need in this round, and; 2. How much equity are you willing to give up for the investment? The answer to these questions also answers a third key question on the investor's mind: 3. What is your valuation?

Calculate the implied dilution percentage: Divide the raise amount by the post-money valuation, giving the founder dilution percentage, or how much equity founders are willing to give the investors in exchange for the cash injected into the startup venture. Investment Raise Amount / Post-Money Valuation = Founder Dilution Percentage

Too High, Too Early: Founders occasionally encounter enthusiastic (inexperienced) investors willing to value the startup at high levels early in the startup's lifecycle. For example, establishing a $4,000,000 valuation for an idea-stage startup with no paying customers and an inexperienced founding team falls into the too high, too early category. If the startup requires additional investment rounds, the high early valuation increases the chances of a down-round valuation, or more likely, no funding at all from experienced investors.

Lack of Customer Validation: Many investors expect an early-stage startup to be engaged with potential customers, even if working versions of the product are still under development. Having actual customers validates that the product solves a significant problem and customers are willing to pay for it, which is the Holy Grail sought by investors (and founders alike.) Establishing a sizable valuation prior to building a customer track record is a mistake to be avoided at all costs.

Valuing the Idea or Market Potential: The startup team and the milestones achieved in a startup should be at the core of all valuations. Having experienced founders with prototypes developed, technology proven, paying customers, IP issued, skilled team recruited, and so on matters; these milestones add real value to a new venture. In contrast, ideas, business plans, and forecasted market sizes in themselves offer little value to investors. Think twice before assigning a valuation to an idea-stage venture and pitching to investors.