9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 1/14

ABOUT SUBSCRIBE BUY WORKSHOP, SF

Slack - a messaging appfor teams, integratingwith the tools youalready use.ads via Carbon

Latest

How Hillary Clinton Started

Tweet 2,331 Anna Vital     < Jul 1' 13 >

How Startup Valuation Works –Measuring a Company’s Potential

How would you measure the value of a company? Especially, a company thatyou started a month ago – how do you determine startup valuation? That is thequestion you will be asking yourself when you look for money for yourcompany.

3.5kLike

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 2/14

Enough Money To Start a Company?

The Hacker's Guide to Investors

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 3/14

Do Things That Don't Scale In Startups

The Anatomy Of Determination

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 4/14

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 5/14

Let’s lay down the basics. Valuation is simply the value of a company. There arefolks who make a career out of projecting valuations. Since most of the time youare valuing something that may or may not happen in the future, there is a lot ofroom for assumptions and educated guesses.

Why does startup valuation matter?Valuation matters to entrepreneurs because it determines the share of thecompany they have to give away to an investor in exchange for money.  At

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 6/14

the early stage the value of the company is close to zero, but the valuation hasto be a lot higher than that. Why? Let’s say you are looking for a seed investmentof around $100, 000 in exchange for about 10% of your company. Typical deal.Your pre-money valuation will be $ 1 million. This however, does not mean thatyour company is worth $1 million now. You probably could not sell it for thatamount. Valuation at the early stages is a lot about the growth potential, asopposed to the present value.

How do you calculate your valuation at the early stages?

1. Figure out how much money you need to grow to a point where you willshow significant growth and raise the next round of investment. Let’s saythat number is $100,000, to last you 18 months. Your investor does nothave a lot of incentive to negotiate you down from this number. Why?Because you showed that this is the minimum amount you need to grow tothe next stage. If you don’t get the money, you won’t grow – that is not inthe investor’s interest. So let’s say the amount of the investment is set.

2. Now we need to figure out how much of the company to give to theinvestor. It could not be anything more than 50% because that will leaveyou, the founder, with little incentive to work hard. Also, it could not be 40%because that will leave very little equity for investors in your next round.30% would be reasonable if you are getting a large chunk of seed money. Inthis case you are looking for only $100, 000, a relatively small amount. Soyou will probably give away 5-20% of the company, depending on yourvaluation.

3. As you see, $100,000 is set in stone. 5%-20% equity is also set. That puts the(pre-money) valuation somewhere between $500,000 (if you give away 20%of the company for $100,000) and $2 Million (if you give away 5% of the

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 7/14

company for $100,000).4. Where in that range will it be? 1.That will depend on how other investors

value similar companies. 2. How well you can convince the investor that youreally will grow fast.

How to Determine Valuation?

Seed Stage

Early-stage valuation is commonly described as “an art rather than a science,”which is not helpful. Let’s make it more like a science. Let’s see what factorsinfluence valuation.

Traction. Out of all things that you could possibly show an investor, traction isthe number one thing that will convince them. The point of a company’sexistence is to get users, and if the investor sees users – the proof is in thepudding.So, how many users?If all other things are not going in your favor, but you have 100,000 users, youhave a good shot at raising $1M (that is assuming you got them within about 6-8months). The faster you get them, the more they are worth.

Reputation. There is the kind of reputation that someone like Jeff Bezos hasthat would warrant a high valuation no matter what his next idea is.Entrepreneurs with prior exits in general also tend to get higher valuations. Butsome people received funding without traction and without significant prior

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 8/14

success. Two examples come to mind. Kevin Systrom, founder of Instagram,raised his first $500k in a seed round based on a prototype, at the time calledBrnb. Kevin worked at Google for two years, but other than that he had nomajor entrepreneurial success. Same story with Pinterest founder BenSilbermann. In their cases, their respective VCs said they followed their intuition.As unhelpful a methodology as it is, if you can learn how to project the image ofthe person who gets it done, lack of traction and reputation will not prevent youfrom raising money at a high valuation.

Revenues. Revenues are more important for the B-to-B startups than consumerstartups. Revenues make the company easier to value.

For consumer startups having a revenue might lower the valuation, even iftemporarily. There is a good reason for it. If you are charging users, you aregoing to grow slower. Slow growth means less money over a longer period oftime. Lower valuation. This might seem counter-intuitive because the existenceof revenue means the startup is closer to actually making money. But startupare not only about making money, it is about growing fast while making money.If the growth is not fast, then we are looking at a traditional money-makingbusiness.

The last two will not give you an automatically high valuation, but they will help.

Distribution Channel: Even though your product might be in very early stages,you might already have a distribution channel for it. For example, you mighthave sold carpets door-to-door in a neighborhood where almost every residentworks at a VC firm. Now you have a distribution channel targeting VCs. Or youmight have run a Facebook page of cat photos with 12 million likes, now that

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 9/14

page might become a distribution channel for your cat food product.

Hotness of industry. Investors travel in packs. If something is hot, they may paya premium.

DO YOU NEED A HIGH VALUATION?

Not necessarily. When you get a high valuation for your seed round, for the nextround you need a higher valuation. That means you need to grow a lot betweenthe two rounds.

A rule a thumb would be that within 18 months you need to show that you grewten times. If you don’t you either raise a “down round,” if someone wants to putmore cash into a slow-growing business, usually at very unfavorable terms, oryou run out of cash.

It comes down to two strategies.

1. One is, go big or go home. Raise as much as possible at the highestvaluation possible, spend all the money fast to grow as fast a possible. If itworks you get a much higher valuation in the next round, so high in factthat your seed round can pay for itself. If a slower-growing startup willexperience 55% dilution, the faster growing startup will only be diluted 30%.So you saved yourself the 25% that you spent in the seed round. Basically,you got free money and free investor advice.

2. Raise as you go. Raise only that which you absolutely need. Spend as littleas possible. Aim for a steady growth rate. There is nothing wrong with

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 10/14

steadily growing your startup, and thus your valuation raising steadily. Itmight not get you in the news, but you will raise your next round.

SERIES A

The main metric here is growth. How much have you grown in the last 18months? Growth means traction. It could also mean revenue. Usually, revenuedoes not grow if the user base does not grow ( since there is only so much youcan charge your existing customers before you hit the limit).

Investors at this stage determine valuation using the multiple method, alsocalled the comparable method, well-described by Fred Wilson. The idea is thatthere are companies out there similar enough to yours. Since at this stage youalready have a revenue, to get your valuation all we need to do is find out howmany times valuation is bigger than revenue – or in other words, what themultiple is. That multiple we can get from these comparable companies. Oncewe get the multiple, we multiply your revenue by it, which produces yourvaluation.

INVESTOR’S PERSPECTIVE

It is important to understand what the investor is thinking as you lay down onthe table everything you have got.

1. The first point they will think is the exit – how much can this company sellfor, several years from now. I say sell because IPOs are very rare and it isnearly impossible to predict which companies will. Let’s be very optimistic

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 11/14

and say that the investor thinks that, like Instagram, your company will sellfor $1 Billion. (This is just an example. So do not get caught up in howunrealisict that is. This is still possible.)

2. Next they will think how much total money it will take you to grow thecompany to the point that someone will buy it for $1 Billion. In Instagram’scase they received a total of 56 Million in funding. This helps us figure outhow much the investor will make in the end. $1 Billion – $56= $ 940 millionThat is how much value the company created. Let’s assume that if therewere any debts, they were already deducted, and the operational costs aretaken out as well. So everyone involved in Instagram collectively made $940Million on the day Facebook bought them.

3. Next, the investor will figure out what percentage of that she owns. If shefunded Instagram at the seed stage, let’s say 20%. (The complicated piecehere is that she probably got preferred shares, which just means she getsthe money before everyone else. Also, there might have been a convertiblenote as part of the funding, which gave her the option to buy shares lateron at a set price, called “cap”.) Basically, all of these are just anti-dilutionmeasures. The investor that funded you early on does not want to getdiluted too much by the VCs who will come in later and buy 33% of yourcompany. That’s all that is. Let’s assume in the end, like in How StartupFunding Works, the angel gets diluted to 4%. 4% of $940 million is $37.6Million. Let’s say this was our best case scenario.

$37.6 Million is the most this investor thinks she can make on your startup.  Ifyou raised $3 Million in exchange for 4% – that would give the investor a 10Xreturns, ten times their money. Now we are talking. Only about a 3rd ofcompanies in top-tier VC firms make that kind of a return.

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 12/14

DOES THE VALUATION REALLYMATTER?Consider two scenarios – Dropbox vs. Instagram.

Both Dropbox and Instagram started as a one-man show. Both of them were orare valued over $1 Billion. But they started with very different valuations:

1. Drew Houston went to Y-Combinator, where he received about $20K inexchange for 5% of Dropbox. Valuation 400K (pre-money).

2. Kevin Systrom went to Baseline Ventures and received $500k in exchangefor about 20% of Brbn (predecessor of Instagram). Valuation $2.5M.

Why were the valuations so different? And, more importantly, did it matter inthe end?

OTHER THINGS THAT INFLUENCEVALUATIONOption Pool. Option pool is nothing more than just stock set aside for futureemployees. Why do this? Because the investor and you want to make sure thatthere is enough incentive to attract talent to your startup. But how much do youset aside? Normally, the option pool is somewhere between 10-20%.

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 13/14

The bigger the option pool the lower the valuation of your startup. Why?Because option pool is value of your future employees, something you do nothave yet. The options are set up so that they are granted to no one yet. Andsince they are carved out of the company, the value of the option pool isbasically deducted from the valuation.

Here is how it works. Let’s say your pre-money valuation is $4M. One million iscoming in new funding. Post money valuation is now $5M. The VC gives you a“term sheet” – which is just a contract that contains the conditions upon whichthe money is given to you, and which you can negotiate. The term sheet saysthat the VC wants a fully diluted 15% option pool in the pre-money valuation.This means that we need to take 15% of the $5 million (post-money valuation),which is $750, 000 and deduct it from the pre-money valuation ($4 million minus$750,000). Now the true valuation of our company is only $3.25 Million.

Sources:

Halo Report

NASDAQ and NYSE listing requirements

AVC – Fred Wilson’s blog

Read more on: funding, money, startup

Written by Anna Vital

Information Designer and Infographic Author

56kFollow

9/12/2015 How Startup Valuation Works ­ Illustrated

http://fundersandfounders.com/how­startup­valuation­works/ 14/14

© 2015 Funders and Founders How To Credit Us Terms Privacy Facebook

< How To Start a Startup >What Our 7 Billion WorldPopulation Does