Valuation of early stage startups is one of the most important areas of discussion and negotiation between the founders and investors. While the situation is less tricky for later-stage startups with steady revenues and projections, determining valuation is more of an art than a science in the case of nascent companies.
In this article, we provide investors with some pointers on how to discuss and negotiate with early-stage founders on valuation.
Earlier Funding and Valuation Details
The first obvious question to ask is whether the startup has raised any funding in the past. If so, who were the investors and at what valuation was the money raised? If the valuation as per the last round is unexpectedly higher than the valuation suggested by your due diligence, you might want to think twice.
Another related question here is whether the previous investors are participating in this round. If not, you can further pursue the discussion. But if they are, it would not make much sense to participate, should the valuation turn out to be higher than expected. Every investor hates down rounds and it would not be wise to become a shareholder in a startup with other shareholders who are dissatisfied.
Expectations on Valuation
It is always better to check directly and as early in the relationship as possible if the founders have some expectations concerning valuation. Again, if the expectation mismatch is too wide, best not to waste time and energy on an opportunity amidst a market full of more suitable startups seeking investments.
Without that kind of baggage, founders can better appreciate that investors have an asymmetrically high awareness of how the market values deals. If the founders quote a price that is not exorbitantly higher than the valuation arrived from your due diligence, that works equally well and we can proceed towards negotiations.
Highest Valuation versus the Right Investor
Startups are usually in talks with multiple investors at once. Being the belle of the ball, maybe they will even play suitors off against each other. Should you come to know in advance that other investors are pricing the startup higher or lower than what you intend, reach out and connect with those potential competitors. Understand how they arrived at the figure, and make adjustments to your proposed valuation, if appropriate.
That said, this matter can come up during discussions with founders, and you need to defend your valuation. What should you do then? Well, first, explain the risks of a higher-than-market valuation. With an overly optimistic valuation always comes equally ambitious targets or KPIs. If unable to meet those unrealistic objectives, founders will come under severe pressure, creating mistrust and complicating further investment rounds.
The ultimate objective of any startup is growth and success, and you need to emphasize that startups need much more than funding to increase their chances of success. If you can drive home this point and, at the same time, highlight the value you have to offer beyond just financing (like experience in the startup’s niche, product expertise, the possibility of making follow-on investments, connections, and so on), the job is half done.
Explain the Reasons for Offered Valuation
In many cases, the founders may feel that the valuation offered is lower than the actual market value. Or if there are no other investors being considered, they may take your first offer at whatever valuation, especially if they are cash-strapped and in dire need of an infusion.
Even in this case, an experienced investor will give a fair valuation anyway and help the startup understand the reasons behind the amount of the offer. So that the founders do not feel undervalued and in turn demotivated, set aside the KPIs and explain how you came about your numbers based on the following factors.
Valuation of comparables
This is the single most important figure that can’t be disputed. If there are relatively similar comparables, it would make the task of valuation, as well as convincing, easier for you.
It is common for startup founders to commit errors in the evaluation of their market size, which then directly impacts the valuation. You, with better access to market information, should point that out.
Expected return timelines
Startup founders will sometimes overlook this while making their calculations on valuation. If the business model is such that the expected exit will take longer than average, it can adversely affect the valuation.
The rule of demand and supply will apply everywhere, including in the startup landscape. If there are many players competing in the market, if money supply is less, then valuations drop. That’s basic economics.
It is crucial to take the founders into confidence regarding the valuation offered. As investors, part of your job is to spend time to educate and explain your side of the calculations, along with the value beyond financing you bring to the table.