An early-stage valuation primer for startups

Chatting during a Startup Live event in Lisbon
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Early-stage valuation of a startup is critically important yet is far too often badly misunderstood. There are several key things you need to consider in the valuation of your very young venture.

As is the case with everything you will do with your startup, valuation is simply a hypothesis that comes from a series of educated guesses.

The first step to a simple valuation analysis is for you to figure out how much money you actually need. As in how much money you, in reality, will need to get to the reasonably big milestone at which you’re aiming in this round of funding.

Let’s first acknowledge that early-stage valuation is to a large extent a fiction. Your company is probably pre-revenue and maybe even pre-users. So, it’s worth basically nothing but it needs to be worth something because you can’t sell someone 20 percent of nothing for $200,000, which is the point of this exercise.

So let’s stick with that number. You’re trying to raise $200,000 because that’s going to take you to the point where you can raise your next investment round or, if you’re really lucky, you can be self-sustaining (if this something that’s realistic and a part of your plan).

You calculate your startup’s post-money valuation by adding new funding to your pre-money valuation. So, IF (more on this in a moment) you and the investor agree that they’re going to invest $200,000 in your startup AND you agree that this investment is based on a pre-money valuation of $1,000,000, your post-money valuation is $1,200,000 (the $1,000,000 pre-money valuation + the new $200,000 investment = a $1,200,000 post-money valuation).

Bear with me for a second as I complicate things. If you and the investor agreed to an investment of $200,000, as in our example, the percentage of your company that the investor will own varies depending upon whether you agreed that the investment is based upon your company’s pre- or post-money valuation, which you absolutely need to make crystal clear as you’re having your discussions.

Why? Because if you’ve agreed that the $200,000 investment in your business is on the understanding that they are investing based your pre-money valuation of $1,000,000, then the investor owns 20 percent of the business and you own 80 percent (20 percent of $1,000,000 is the $200,000 she invested). If, conversely, you’ve agreed that the $200,000 investment is based on your post-money valuation, then you’ve agreed that she has invested the money into a company worth not $1,000,000 but rather $1,200,000. In that case, your investor owns 16 percent and you own 84 percent (16% of $1,200,000 is the $200,000 she invested).

The easiest way for a new entrepreneur to envision this is by imagining that every share of the company is worth $1 (which it very well might be). In the example where the investment was based on pre-money numbers, your investor would own 200,000 shares and you would own 800,000 shares. In the example where the investment was based on post-money numbers, your investor would still own 200,000 shares but you would own 1,000,000 shares, which is obviously a better deal for you and in real percentage ownership terms, you’d own 4 percent more of the business.

Do remember that early-stage investments are fictive in nature. Yes, it’s real money, but it’s based on a shared belief that what you’re starting to build (that is, again, truly worth close to nothing right now) will grow into something worth much more than almost nothing. This is why experienced people on both sides of the investment table often describe early stage funding as “at least as much art as science,” which is really well-said.

As a startup founder, the more persuasive you are in your storytelling and the better you can sell your vision of what your company can become, the better deal you can get in early-stage financing.

Photo via Flickr userĀ Heisenberg Media

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Aron Solomon

Aron is a serial entrepreneur who has launched everything from the first luxury-branded education pop-up, to a global education design studio, to a thriving innovation consultancy that imparts the attributes, values, and techniques of Silicon Valley to audiences around the world. He holds an undergraduate degree in political theory, a graduate degree and teaching certificate in english and economics, and a juris doctor degree. Aron is currently a Senior Advisor at MaRS in Toronto. Find Aron's work on Digital Journal: http://www.digitaljournal.com/user/1054621

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