Content series about startup topics with a focus on valuation and funding round
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. Unrealistic expectations heavily influence the spread. Most importantly, prolonging the closure of a round is time off from more productive work and therefore costly to startup.
Determining Initial Valuation
When raising an equity round a key aspect is finding the valuation. With a valuation a startup can take an equity injection; otherwise, the company must rely on different types of funding. In the early days, valuation cannot rely on startups’ financial numbers as there is nothing to show. In such a case, we use the following framework to determine a valuation range.
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 the option: 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, to market size, 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. If the call center wanted to stay in the game their only option was to buy a contact center solution instead of going forward with the status quo.
Bridging The Valuation Gap
With the previous three points, a startup can have an initial valuation. Indeed most decks include the three points, and therefore investors expect them to be included. However, founders tend to overemphasize the impact of these points on valuation, resulting in large bid and ask spreads. There is only a limited amount of pre-money valuation the previous points can support. For an increased early-stage valuation there has to be something additional. Here are few tips that you as founder can use to bridge the gap between the bid and ask:
- Showing exceptional traction in the market. For this, you will need extraordinarily good salesmen to show great ARR / CAC numbers (for a B2B SaaS) or unit economics. If you need help budgeting or struggle with sales check our previous blog
- You have access to large amounts of free non-dilutative capital. In addition, the capital boosting the enterprise value, you may be able to skip a funding round
- You have fast-track access to some markets, especially a protected one. Here proof could be a large client signing a contract to buy the solution when it’s ready
- The founding team is doing a second run in the same space
- Business generates already a significant amount of revenue or EBITDA and it can be valued based on numbers
- Or anything else that has concrete value. For example, a SaaS company could bridge the gap with early numbers, let’s say ARR = 200 keur, and then a multiple of 5 on the ARR increasing the initial valuation by 1 Meur
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. In the end, investing in startups is extremely risky and therefore early investors look to gain large amounts of stake for their investment. Any of the previous points decrease the riskiness.
There are, of course, technical methods to artificially pump up the valuation. However, utilizing such methods can make everything more complex and shift focus from the most important aspect: the business itself.
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 then the deck should have something that stands out in the eyes of investors. However, if your startup cannot show any unfair advantage compared to others then it should be reflected in valuation. We want to emphasise that the six points are something to bridge the gap between a normal and a high valuation. 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 of the market can be considered a home run – competition is not overwhelming
- The solution is a “must-have” and a cure
With those three points, you are ready to raise equity with a normal valuation. In our next series, we will talk about the fifth and sixth points. The topic will be about valuation based on numbers.
Author: Sami Aho