Starting Point For Startup Valuation

Summary

The motivation for writing about startup valuation is obvious; it is essential to everything we do. We encounter situations where funding rounds are prolonged due to large bid and ask spreads, which are heavily influenced by unrealistic expectations. Most importantly, prolonging the closure of a round takes time away from more productive work and is, therefore, costly to startups.

Determining Initial Valuation

A key aspect of raising an equity round is determining the valuation. With a valuation, a startup can receive an equity injection; otherwise, the company must rely on other types of funding. In the early days, valuation could not rely on startups’ financial numbers, as there was nothing to show. We use the following framework to determine a valuation range in such a case.

First, we look at the team. Here we consider if the team can execute together and how motivated they are. Checking this is abstract, but there are indicators on which we can rely. A concrete example is: are the founders committed full-time to the startup with little or no pay (until cash flows allow it)? This serves as proof that they believe in the company so much that they are ready to invest all of their time in the startup. For example, Trado Capital’s founder Olli Sirkiä refused a good option to focus on his entrepreneurial venture: when he was leaving McKinsey and starting his own company, he was offered an option to return to McKinsey within the next year skipping all interviews. Olli refused — his logic was that success is the only option when there’s no safety net.

Secondly, the idea’s potential value. In this regard, we look at market size. Usually, pitch decks have information about TAM, SAM, and SOM. Market size should be calculated realistically, as it serves no one to lie to themselves. Additionally, we screen how much competition there is. We like that there is some competition, but not too much. A small amount of competition tells there is room for new players, but having too much might mean acquiring market share is costly.

Third: the solution. Here we focus on looking at how good and developed the solution is. There are many ways to determine this. One method is to check how extensively trial or paying clients are using the solution. Furthermore, we put weight on thinking whether the solution is a “must-have” or “nice-to-have”. Before contact center software, call centers used telephone directories to screen for contact details, enter them manually, and then call. This is where the initial idea for Leaddesk was born: it was quite evident that software increased the number of calls an agent could make daily.

Bridging The Valuation Gap

With the previous three points, a startup can have an initial valuation. Most decks include these three points, and therefore investors expect them. However, founders tend to overemphasize their impact on valuation, resulting in large bid and ask spreads. There is only a limited amount of pre-money valuation those points can support. For an increased early-stage valuation there has to be something additional. Here are a few tips to bridge the gap between bid and ask:

1. Showing exceptional traction in the market — extraordinary ARR / CAC numbers (for B2B SaaS) or unit economics.
2. Access to large amounts of free non-dilutive capital, which can boost enterprise value and potentially skip a funding round.
3. Fast-track access to some markets, especially a protected one — e.g. a large client signing a contract to buy the solution when it’s ready.
4. The founding team is doing a second run in the same space.
5. The business already generates significant revenue or EBITDA and can be valued based on numbers.
6. Anything else of concrete value — e.g. a SaaS company bridging the gap with early numbers (ARR = €200k × multiple of 5 increases initial valuation by €1M).

If you cannot show any of the previous points and struggle to find investors or close a round, it might be an indication that you are setting the valuation too high. Investing in startups is extremely risky, so early investors look for greater returns. Any of the previous points decreases riskiness.

There are, of course, technical methods to artificially pump up the valuation. However, utilizing such methods makes everything more complex and shifts focus from the most important aspect: the business itself. Besides, these methods typically misalign shareholders’ interests.

Conclusions

Having a solid team, a large but non-competitive market, and a solution that is a cure is expected. If you are raising with an outstanding valuation, the deck should have something that stands out in the eyes of investors. A good startup has the following:

• Solid team working full-time in the startup — no side hustles.
• Large enough market that even a smaller share is a home run. Competition should exist but not be overwhelming.
• The solution is a “must-have” and a cure.

With those three points, you are ready to raise equity with a normal valuation.