Valuation is the process of determining the current worth of an asset or a company. In the public markets, this is relatively easy. You look at the stock price and multiply it by the number of outstanding shares. In the world of private startups, however, valuation is far more complex and subjective.
For a founder, valuation is not just a vanity metric to brag about on Twitter. It is a critical component of your fundraising strategy that dictates how much of your company you have to sell to get the cash you need. It is the price tag on your equity.
The Art and the Science
#Valuing a mature company usually involves looking at revenue, profit margins, and comparable public companies. This is the science part. You can build a spreadsheet and use a Discounted Cash Flow (DCF) model to arrive at a logical number.
Valuing an early-stage startup is different. It is mostly art. When you have no revenue and only a prototype, there are no hard numbers to plug into a formula. Instead, investors look at the team, the market size, and the technology.
At this stage, valuation is often determined by the market rate. If similar startups in your sector are raising money at a ten million dollar valuation, that is likely your starting point. It is a negotiation based on supply and demand rather than a calculation based on current assets.
Pre-Money vs. Post-Money
#This is the most common point of confusion for new founders, but you must get it right.
Pre-Money Valuation: This is what your company is worth immediately before you receive the new investment.
Post-Money Valuation: This is what your company is worth immediately after the investment hits the bank account.
The math is simple. Pre-Money plus Investment equals Post-Money.
If you raise two million dollars at an eight million dollar pre-money valuation, your post-money valuation is ten million. You have sold twenty percent of your company. Founders need to be very clear which number they are negotiating, as mixing them up can cost you significant equity.
The 409A Valuation
#There is another type of valuation that founders encounter called the 409A. This is distinct from the valuation investors give you.
The investor valuation is the price for preferred stock. This stock comes with special rights and protections. The 409A valuation determines the fair market value of common stock, which is what you typically give to employees as options.
The 409A valuation is almost always lower than the investor valuation. This is actually a good thing. It allows you to issue options to employees at a lower strike price, giving them more potential upside. This requires a third-party appraiser to ensure you are compliant with tax laws.
The Trap of Overvaluation
#Founders often push for the highest possible valuation to minimize dilution. This seems logical, but it carries a hidden risk.
If you raise money at a massive valuation now, you set a very high bar for your next round of funding. To raise the next round, you generally need to show growth on top of your previous valuation. If you cannot grow fast enough to justify that high price tag, you may face a “down round.”
A down round is when you raise money at a lower valuation than the previous round. This is often catastrophic for founder equity and morale. Sometimes, a fair valuation is better for the long-term health of the business than a high one.