Startup valuation is one of the most debated topics in the venture capital (VC) world. It has bred different schools of thoughts, various valuation methodologies, and varying operating environments.
As much as I will like to discuss all the technicalities of valuation, they may not be of much help to you. So I will tell you the parts you need to know.
Based on knowledge gathered from over 4 years of experience in working as an investment banker in Nigeria and about a year investing in technology and technology-enabled businesses in Africa, I believe that:
Valuation is both an art and a science!
Don’t get me wrong, there are scientific ways of determining valuation – complex and simple formulas- but the factors that determine the actual valuation in which a deal is done are subtle but really important. I will discuss these things in this post.
As an investor, the last thing I discuss with an entrepreneur is valuation. Before jumping to the valuation question, I like to be comfortable with the business, the opportunity, and the strategy amongst others. I like to understand the competitive environment and risks, as well as risk mitigation strategies. I further probe into the entrepreneur, to understand what drives him and his ability to run the business. Depending on my level of conviction, I then determine the amount I am willing to put at risk and at what price.
From what I have observed, the most common valuation methodology is “POOTA”. Wondering what POOTA means? Plucked Out Of Thin Air. Anybody can ask for any valuation he wants. All you need to do is pluck out your valuation out of thin air, and that becomes your valuation.
The principle of POOTA is that you determine how much you want to raise, then you ask yourself, “How much dilution do I want from this raise?” Let’s create a hypothetical scenario:
Startup messaging platform (iChat) wants to raise $100k. The founder thinks he should only give the investors 10% of the business now. Based on this decision, a valuation has been implied. The company is valuing itself at $900k pre-money and $1m post-money. Simple!!
That said, effective valuation however, is that valuation which both the entrepreneur and the investor(s) eventually agree on. During the capital raising process, the founder meets an investor who convinces him of the value he is adding to the business, and as such, wants a lower valuation. They both then agreed to raise the same $100k at a $500k pre-money valuation. This implies that the investor will get 16.6% of the business rather than the 10% the entrepreneur desired. Hence, the effective pre-money valuation for iChat is $500k
Bear in mind though, that valuation alone is not usually enough. Perhaps the deal terms are far more important than the valuation in which the deal is done. I heard a senior VC investor say to an entrepreneur:
“You pick your valuation, I pick the terms.”
I believe this is very instructive. This investor is not particularly worried about a high or low valuation. He believes he can right the wrong on the pages of the term sheet. Trust me, this is the truth. Depending on the requests I get, I might write a series on demystifying the term sheet, but for now, let’s focus on valuation.
For this first post, I will highlight a few non scientific factors that significantly affect valuation:
1. Founding Team – This is a critical contributor to your valuation. The more the investors are comfortable with the quality, execution ability, relationships and overall competence of the founder or founding team, the easier the acceptance of the valuation and in fact the ability of the startup to raise financing.
Andela is a great example of this; it is a great business, but greater is the quality of its founders. Investors will trust their ability to execute and more importantly, create liquidity for them sometime in the future.
2. Previous Investors – Have you ever asked why one of the biggest goals of a Nigerian technology entrepreneur is to get into Y Combinator, 500 Startups or Techstars? This is because it boosts their valuation upon return. If you are investing in a startup that has Y Combinator as an investor, you will probably put in the Y Combinator premium on your valuation amount.
So it is important that you get quality investors early enough. Additionally, angel investors are good, but if you can get an institutional investor to back your business early on (even at a discount), you will reap the rewards in subsequent rounds.
3. Potential Investors – Whenever you ask many entrepreneurs how the capital raising is going, they most times hype the progress, talking about how investors are lining up to fund them. A lot of times, experienced investors will see through an entrepreneur if he is lying about the progress.
On the other hand, if indeed you have strong investors lining up to fund your business, the investor you are talking to will factor in the other investors to determine the amount to commit as well as the valuation.
4. Courtship on Exit – This phrase is used for lack of a better term. It describes the scenario where a startup has a strategic investor who could possibly provide exit liquidity for other investors.
A hypothetical case: Imagine GoJek is an investor in Nigeria’s MaxGo for instance. The valuation of MaxGo will sky rocket at the next funding round simply because of that strategic investor. In the same vein, if Netflix invested in IrokoTV, Jason will never have a problem raising his next financing round at a valuation he wants.
In my next article on this topic, I will explain some of the empirical calculations that go into determining your startup valuation. This would be helpful, because investors like to ask entrepreneurs how they arrived at their valuation numbers, so it is important that we learn it.