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Published on: June 3, 2020
Know your worth: Getting the right valuation
Figuring out a valuation for your business can be a daunting prospect for entrepreneurs. It takes indescribable amounts of work to make it as far as you have, with long days and late nights.
After all your hard work, it’s time to raise funds to take your business to the next level. However, how do you get your valuation as high as possible, while still seeming reasonable to investors?
What happens if the valuation is too high or too low?
Let’s start with a low valuation. Stating the obvious, a low valuation means you give away more equity than necessary. This might not make too much difference in this round, but remember that probably need to do 5 or 6 funding rounds on the road to success. Giving away just a little too much equity each time results in a lot by the end of that journey. However there is another big issue: being undervalued can attract the wrong kind of investors, those who don’t understand your company, or don’t believe strongly in your success (see an article on the importance of finding the right investor, recently published by Alex Green, Globacap’s head of strategic partnerships).
On the other hand, a valuation that’s too high will steer investors away. Even if you do get a few investors that bite, it will make the next funding round you do much harder, and remember – you’ll need to do at least 5 or 6 funding rounds on your journey. It also sets expectations extremely high, even if you’re Google, it will be hard to deliver on those expectations.
All these problems are of course compounded in the event of an economic downturn which, such as in the case of a global pandemic, can happen unexpectedly. There are quite a few examples, from silicon valley and elsewhere, of tunnel vision on unicorn valuations coming back to bite startups down the road.
How do I calculate the right valuation?
This depends on the stage of your business, we’re focusing on earlier-stage businesses below.
First and foremost, valuation always starts with forecasting revenue. There are two ways to forecast revenue: (i) ‘top-down’ and (ii) ‘bottom-up’.
This starts with what’s known as your ‘addressable market’. This is the total value of revenue that can be extracted from the market you’re targeting. In other words, what the maximum possible revenue that you and all your competitors could earn from your market.
Let’s say that’s £50 million.
Then make a reasonable assumption about market share. Let’s say there are some competitors in your market, with an average market share of 5% each. However, you believe your business is better and you can justify why – maybe you could capture 10% market share.
Therefore, that’s £5 million revenue.
To forecast your revenue this way, start with estimates around the amount of paying customers you can acquire and how much revenue you can charge from them.
For example, say your business is an online marketplace for matching plumbers with people looking for plumbers. Let’s say that you think you can capture 50,000 users in your area, and charge them £2.00 each time one of them books a plumber through your site. And, let’s assume that each user needs a plumber around once every two years. That means 25,000 bookings per year at £2.00 each, which is £50,000 revenue per year.
Then add in your expansion – for example, let’s say you reasonably believe you can achieve 10x user growth within 2 years. That means your revenue after 2 years should be approximately £500,000.
Once you’ve reached that point, then perhaps additional revenue growth could come from: (i) geographic expansion, and (ii) additional services (e.g. charging plumbers to promote their listing to the top of a search on your site). After those additional assumptions, let’s say that you get to forecast revenue of £3m within 5 years.
Finding a valuation
Once you have a forecast revenue figure, then your valuation is a simple multiple of that revenue number.
What multiple to use depends on the type of business. Here are a few examples:
- A mature, stable, cash-flow generative business will often receive a valuation of 2x revenue
- A high-growth startup completing a Series B round could get between 10x and 20x revenue
- When Google listed its shares in 2004, it had a valuation of $23 billion and revenue of $3.2bn (that’s 7.2x)
- And an extreme example: Facebook recently bought Giphy for $400m … though Giphy still has no revenue to date (in this case Facebook based its valuation on the future advertising revenue that Giphy could add to the Facebook group)
In order to find a reasonable revenue multiple, its best to find example of recent investments. This can sometimes be hard to find for early stage businesses – some detective work is required. Find comparable businesses to your own, that are at similar stages of growth and recently received investment. Do they have similar revenue expectations? What valuation did they achieve?
How will a VC investor value your company?
Venture Capital investors typically look at:
- Your total addressable market
- What competitive edge do you have, and therefore how much market share could you reasonably expect to capture
- Valuations of comparable companies
They combine and use these factors to: (i) work out a reasonable valuation, (ii) then determine what their likely upside if they invested in your business.
Pre-money vs Post-money
Most experienced investors will discuss your pre-money, it’s important to know what this means.
‘Pre-money’ refers to your company valuation before receiving investment. ‘Post-money’ refers to your company valuation after receiving investment.
- Your company is currently worth £10m, this is your ‘pre-money’ valuation
- You receive investment of £2m
- Your company is now worth £12m, this is your ‘post-money’ valuation
It’s quite straight-forward after you know what it is! However, when most inexperienced investors talk about valuation they’re generally referring to the post-money valuation.
There are two other big factors that go into swaying a person’s opinion on your company’s valuation:
- Your brand image
- Market conditions
Brand image: the better your brand is perceived in the market, the more trust develops in the minds of potential investors that you can achieve your targets. Therefore, with lower risk, investors feel more comfortable paying a higher valuation. There’s a reason why all the most recognisable brand names consistently received the highest valuations when they were still early stage companies – they got their brand image right from day 1.
Market conditions: events like the covid-19 pandemic have shocked the market, causing all valuations to fall. It’s impossible to control, and often impossible to plan for, these kinds of external shocks. As unfortunate as they are, everyone is suffering in the same way.
We have a checklist that might help on your journey, to ensure your business ticks the boxes of today’s investors. Download our free checklist today.