First things first: Why Early-Stage Startup Valuation Matters
Valuation for early-stage startups affects fundraising, equity allocation, acquisition potential, and success. Factors such as below determines the value of an early-stage startup,
To make educated decisions and garner the interest of the right investors, startups must have a firm grasp on the importance of valuation.
It is important to understand that when VCs back early stage startups, there is very little data — performance or financial that is available. The VC is fundamentally betting on the team, the size of the problem they are after, and their ability to create and execute on the product / solution to the problem they are after.
Challenges in Early-Stage Startup Valuation Methods
Startups, particularly those in emerging industries, have unique challenges that might render conventional analysis methodologies ineffective. The following are such challenges that early-stage startups must overcome.
1) Insufficient historical data
In the early stages, companies require significant financial data. However, using financial data for predictive purposes is more challenging and riskier. During the initial years, companies often experience negative cash flow as they strive to generate more revenue while incurring high overhead costs. Additionally, technology marketplaces may require more context due to limited available data.
2) Lack of Comparables
Startups frequently propose ground-breaking technologies or unique business strategies that may lack proven standards or comparables. It is difficult to locate comparable businesses for value reasons due to this uniqueness.
3) Elevated Failure Rate
Studies show that 90% of new businesses close their doors within the first decade, indicating a high level of uncertainty. Therefore, startup valuation must reflect this reality. There is a strong correlation between a company’s longevity and the likelihood of bankruptcy. The time it takes for a startup to progress from concept through the minimum viable product (MVP) stage to a fully commercialized product varies widely.
4) Dependence on Funding Rounds
To support their expansion, startups often rely on multiple rounds of funding. Valuations may fluctuate between funding rounds based on investor opinion, market conditions, and the company's development, complicating the valuation process.
How do you make sense of Startup valuation?
a. Understanding Uncertainty
There are three categories of uncertainty: estimation uncertainty versus economic uncertainty, micro uncertainty versus macro uncertainty, and continuous versus discrete uncertainty. Estimation uncertainty can be reduced by gathering more or better information, while economic uncertainty is harder to mitigate. Micro uncertainty focuses on the company itself, such as its business model, while macro uncertainty encompasses factors beyond a company’s control, like interest rates and government policies. In most valuations of publicly traded companies, macro uncertainty dominates the discount rate. Continuous uncertainty involves fluctuations that occur regularly without a major impact on a company’s cash flow, such as exchange rate fluctuations under normal conditions. Discrete uncertainty, on the other hand, involves rare events that can have disastrous effects, like a sudden 75% devaluation of a company's main operating currency.
b. Pricing an Early stage startup
Valuation at this stage is a simple arithmetical calculation. No VC, whether they operate in the seed stage or Series A or finance growth rounds, uses techniques like the Berkus method or Scorecard Valuation method or First Chicago method or even anything resembling the DCF method. The eventual valuation emerges once the VC and the founder agree on the funding quantum and desired stake.
The $ funding amount is the perceived amount thought of by the seed VC to get the startup to the next stage (Series A). The % equity stake is what the VC has determined as the desired target stake to hold after the initial round.
c. How Multiparty staging works?
Staging works like this: Angels / microVCs back idea-stage or near idea-stage startups to reach the stage at which a seed VC would fund them. The seed VC funds the amount that should propel the startup to reach the stage at which a Series A VC backs them. The Series A VC then funds them to get to the stage at which a Series B backs them; and so on till the IPO. Each stage has a funding amount (and a stake target) along with a rough set of qualifying criteria. Eventually as the startup gets closer to listing, the valuations converge with those of similar listed entities.
d. Focus on the Stories
Entrepreneurs often overestimate the value of their company. However, one should take this into account as it may reflect the founders' level of ambition and serve as an interesting qualitative measure of their chances of success. A good valuation combines narratives with numbers. When valuing a company, every number in your valuation should have a narrative attached to it. Similarly, every narrative about a company should have a corresponding number attached.
e. Aswath Damodaran on Valuing Late-Stage Startups
Damodaran recommends homing in on a few essential variables. For young companies, he focuses on six factors. The first three apply to the business model: revenue growth, target operating margin (to capture profitability), and sales-to-invested-capital ratio (to reflect how efficiently growth is captured). The other three metrics are related to risk. One is what does it cost you to raise equity. And the second is how much does it costs you to raise debt. The last risk-related metric? The likelihood that your company will fail.
The component to measure riskiness itself is cost of capital. With higher growth and higher reinvestment, Damodaran expects to see higher risk. A valuation that shows high growth, low reinvestment, and low risk should raise questions. If there are internal inconsistencies, we need to have solid reasons for them.
Conclusion
Rules of thumb for founders to consider while raising pre-seed round for Indian founders:
Each VC fund has a sweet spot for its typical preferred cheque size, and its stake target. This is often a range, and not specific figures. We at Malpani Ventures, have a $100K–500K preferred cheque size, and a 10–15% stake target. We have determined from our investing experience, that this amount is sufficient to cover 15–18 months of burn (revenue less expenses) in the companies we fund, and within this period, they will be able to raise the next round (from a Series A VC).
We would recommend founders to find the right investors who best align with their vision and plans for executing the business. Most founders will want to (& should) raise at the highest valuation possible, however, that should not be the only criteria for seeking investment: Seek an investor who not only pays a fair price but helps you polish your rough thesis into actual execution.