During a downturn in the economy, investors with money in financial vehicles like mutual funds and ETFs may have a portfolio that has substantially declined in value. Since they have less money overall, their motivation to invest in risky assets suffers.
From an investor's perspective, valuations are more reasonable when it's harder for startups to raise money. For example, a beverage startup that contacted me had a valuation of $45 million when valuations were through the roof. A year later, when the economy was quieter, its valuation was $10 million.
Another company contacted, also as an example, that I spoke to in the diagnostics space de-risked their offers by demonstrating great progress and more favorable data. But because the economy had weakened, its valuation still fell from $35 million to $20 million.
Investors will often evaluate valuations both on their own and as part of an investment group. This results in a collective due diligence process that aims to arrive at fair valuations through group management with diverse backgrounds. The benefit for founders is that if a single investor refers you to her group, others in the group will often invest as well.
understand the market
While evaluating potential investments as an investor or analyst, I make sure it's a product or service that I care deeply about and educate myself on the company's market. I want to see a fair valuation of the business and a well-defined market worth at least $100 million. I also assess whether the product or service has a significant competitive advantage.
When looking for investments, you have to make sure that your valuation is realistic for the type of innovation and segment, and aligned with the state of the economy.
To determine your valuation, you must understand your market.
If your company has a minimum potential market threshold of $100 million (TAM), I want you to clearly explain to me how the new company's innovation solves a big problem in that space that has no solutions or is substantially better than existing products and if can scale quickly.
Determine the company's valuation
When I'm considering an investment, "What's your valuation?" is one of the first questions I ask.
Valuation has two main concepts: pre-money and post-money.
The valuation pre-investment is the value of the company before receiving the capital, and the valuation posterior indicates what it is worth after said injection of funds.
So if you want to invest $1 million in a company that is currently valued at $10 million, that will be your valuation prior to the time you invest. After the $1 million investment, the company's valuation will be $11 million.
Investors will often receive shares of your company in exchange for their investment. To calculate the value of each share of your company's stock, you take the prior valuation (the price the investor is willing to pay for each share) and divide by the total number of shares outstanding.
So if I want to invest $1 million in a startup that has a pre-valuation of $10 million and 1 million shares outstanding, I'll have to pay: $10 million / 1 million shares = $10 per share.
A pre-money valuation that is too high for no good reason can disqualify your business from being considered a fair investment.
A founder who graduated from an elite business school recently told me that his early-stage fintech company was worth $50 million pre-investment. The startup had two employees who were in business school full time; it had no intellectual property, no minimum viable product, and the founder only had a general idea of his go-to-market strategy. I ended the meeting shortly after it began because the factors the founder used to establish the valuation were unrealistic.
The Berkus Method
Venture capitalist Dave Berkus has developed a formula known as the Berkus Method to value start-ups before generating revenue. It is interesting to test it to help determine the valuation of your company.
Using the specific Berkus example, start with $2.5 million and allocate $500,000 to each of the five key success metrics: idea, prototype, team, strategic relationships, and product/service launch, including sales.
Although it is intended for VCs, the Berkus formula is equally valid for individual investors, which is why I mention it.
Venture capitalists also use the comparable transactions approach, where they consider other transactions in the same industry involving companies of a similar size to arrive at a fair value for the startup in question.
Let's say you have an AI or ML startup and your research shows that several similar companies in the industry recently sold for 10x revenue. Knowing the past earnings and sales price of these companies can help an investor determine the potential value of their investment in your company.
These methods share a similar feature in that each asks, “How much do you buy comparable companies within an industry for?”
Be an informed founder
The startup ecosystem is a fascinating world to be a part of. You and your founding team have an exciting, revolutionary product. When looking for investments, make sure your valuation is realistic for the type of innovation and market segment, and is in line with the state of the economy.
A fair valuation that feels good to both the founder and the investor will lead to a win-win partnership.
