Why valuations matter for early-stage startups
If you’re trying to build a successful startup, you’ll need to sell investors on your business. Developing a valuation for your company will help provide transparency and give you a solid base for negotiations.
While valuations are naturally less precise in the early stages, it’s still important to come up with the most accurate number you can. In this article, we’ll explain why it matters and go over some of the key factors involved in an early-stage valuation.
Why do I need a 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.
Essentially, startup valuation can make or break a deal. Hence, it is crucial to use well-established methods to value your startup.
As a company grows, it becomes easier to evaluate based on its balance sheet, revenue, and other concrete metrics.
Valuations work a little differently for early-stage companies that don’t have as much data. In fact, we recommend using multiple valuation methods to prepare for pitch meets. This will enable you to account for more factors and develop a more precise valuation.
The most well-known methods used in valuing early-stage startups are the Checklist method, Step Up method, and Scorecard and Risk Mitigation methods. While each one is different, all three 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.
Remember, you don’t just have to show that you have a good idea — you also have to show that you’re the right team for the job
Many startups fail to attain good funding due to poor management and a weak team. Sometimes it so happens that even a team of skillful individuals 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
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. 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.
Total Addressable Market, or TAM, is a key metric for any early-stage startup. For more info, check out our guide to sizing the market for a startup idea.
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
You can get a better idea of your startup’s potential by looking at evaluations for other startups. Of course, it’s also important to understand that no two businesses are exactly the same.
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 to focus on startups of similar age within the same industry.
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.
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.
Takeaways
If you plan to start connecting with investors, you need to get a robust valuation that speaks to your company’s potential. While it’s impossible to predict the future, founders can use the strategies mentioned above to come up with a solid valuation.
Of course, you can’t issue shares or distribute equity until you’ve incorporated your business in the US. Click the link below to start your incorporation today with Firstbase.