September 30, 2021

Startups and the importance of early-stage valuation

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Over the past few years, the startup culture has attracted more and more attention - with more founders entering the ecosystem and looking for ways to enhance and improve the overall experience.

We are currently in an era of constantly emerging innovations, information exchange, and technological progression. With young adults being more passionate about their ideas than ever, the world of startup founders is ever-growing.

Over the last decade, the global business industry has witnessed many novel startups across sectors, with more and more founders rising every day. In the midst of a thriving setup like this, upcoming startups must adopt a comprehensive skill set and innovative growth methods.

With new innovations comes a new set of obstacles. It is crucial that founders adapt and cater to the changing demographics, digitization, and economy.

Any successful entrepreneur would tell you that the key to a successful business is to find the right investor during the early stages of the startup.

Several startups have failed in the initial years, despite having highly accomplished founders. Choosing the right investor is imperative - it will set a solid foundation and determine the future of the business.

As a first however, setting up a proper company recognized as a legal entity is important to the valuation process. If you are yet to register your business, you may not find much value in this piece.

If you are a founder of a novel startup looking to find the right investors for your business this article will help you answer the questions that will inevitably arise during every investor pitch meeting:
What is your startup’s valuation?
And, of course, the follow-up question: How did you arrive at your current valuation?

Simply put, a startup’s valuation is the process of quantifying the worth of a business. Valuation helps entrepreneurs and investors determine the equity in exchange for funds during the first official equity funding stage.

The significance of money in the world of business cannot be exaggerated. Attaining a strong economical foundation for your startup is crucial for success in its upcoming years. Funding is one of the main factors that determine the life cycle of any startup.

Essentially, startup valuation can make or break a deal. Hence, it is crucial to  use well-established methods to value your startup.

The valuation will be highly dependent on the startup’s life stage. When valuing startups in early stages with no historical sales records, valuation methods will require factoring in a different set of criteria compared to the valuation equation used for a later stage startup.

It is recommended that founders use multiple valuation methods to prepare for pitch meets. This will help present the true worth and capability of the startup.

This article will focus on exploring and understanding the crucial factors to the valuation of an early-stage startup and startups with minimal traction.

The most well-known methods used in valuing early-stage startups are the Checklist method, Step Up method, and Scorecard and Risk Mitigation methods. All these methods consider the following common factors:

1. Team

If you’ve already begun to prepare your pitch deck, you might have realized the prominence of the team slide - the slide that illuminates the brains behind the startup.

Investors are interested in collaborating with a strong and motivated team. Make sure you play to your strengths and showcase them as effectively as possible.

Your team is a primary criterion in the valuation process at all life stages of the startup, making the team an even more crucial factor in the valuation of an early-stage startup.

According to investor logic, a weak team would mean bad execution, hence, a failed business.

A lot of startups fail to attain good funding due to poor management and a weak team. Sometimes it so happens that even a team full of skillful members fails due to poor team dynamics.

It’s critical to carefully curate a team full of motivated, inspired, and talented individuals.

  • Founders with experience in the industry
  • Founders with management experience
  • Founders with startup experience
  • Founders with good working relationships with one another
  • Diverse expertise between the founders

The key is to hire professionals who have a knack for startups and add to the dynamics of the team. Look for people who are not only skilled and experienced but also have great communication.

Tip: Gaps in the team can be filled with employees, advisors, and mentors who possess skills that will enrich your team’s valuation.

2. The target market

The next cause of concern for investors is the size of the opportunity. Is the cost worth the benefits? Is the target market large enough for the investment to make sense?

As the founder, identifying the target market for your company is an important responsibility. A common mistake by fledgling founders is expanding their target market to a point where everyone falls under it.

They expect that a large target market would encourage investors, but this would do the opposite more often than not. Identifying a specific, more focussed target market is extremely necessary. A market where your product serves a purpose fills a gap or solves a major pain point for customers.

Once you’ve identified your target market, the next step is to evaluate the size of this market. Generally, you would find reports published in market research journals.

The publishers of these journals usually charge outrageous prices, but you could reach out to the authors (their contacts are generally provided in the report), and they’d be more than happy to send you a copy.

“TAM,” “SAM,” and “SOM”; are key metrics for measuring your target market size. You can learn more about them through our article on the topic.

Read more about target market analysis here.

3. Investment record

For investors to feel safe to invest in your startup, they must be assured that you’re confident enough to take the risk yourself.

Not only do investors want to see that you have invested your own savings in the startup, but the effort you’ve put in to convince those around you, like family and friends. And if you’ve managed to land a few angel investors, then even better.

Nevertheless, it would be best if you were careful not to give an impression that you have been irresponsibly generous with your shares. Investors realize that every round of investments means liquidation of shares and also an increase in valuation. Neither of which are beneficial.

4. The industry and competitors

The valuation of your startup is greatly dependent on what industry your company would be competing in.

If you’re in the education industry, it does not make sense to evaluate yourself against a company in tech or finance. While researching, it’s important that we place focus on startups of similar age within the same industry.

Knowing your competitors and their products would help you improve their shortcomings and build trust with your customers.

Furthermore, understanding the valuations of startups similar to yours would provide you with some idea of your startup’s valuation.

The step-up and scorecard methods are used to estimate a company’s valuation. Both these methods take the average valuation in your industry as the basis for the calculation.

Read more about some of the popular methods of valuation here.

Startup Falcon’s AI-powered, automated valuation calculator, was built based on the above logic.

The specialized valuation form that investors/entrepreneurs fill on their online platform inspects the quality of such qualitative aspects of the startup as the ones mentioned above (quality of the founding team, past investments, target market size, similar startup valuations, and more).

Their engine then quantifies the qualitative answers from the form to determine the final valuation amount per valuation criterion (team, product, business model, legal) and per valuation method. Providing both investors and entrepreneurs with a valuation they can use with confidence.

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