The 3 MOST COMMON Components of a Startup Valuation
Startup valuations are typically coming from a mix of places. I've seen the three most common components are local market gut pricing, broad market real pricing, and financial calculations.
1️⃣ Local market gut pricing is like supply-side economics where local investors within a region are looking for very specific types of deals and therefore are setting their floors and ceilings on valuations. An example of this would be investors not looking at your deal until your valuation is below a $3M cap either on your SAFE note or in your round for an early-stage company. Obviously, there are exceptions, but unless you're going to local investor conferences and publicly asking what these numbers are, you are most likely shooting your pitch deck into the aether where, just like a physical resume without a cover letter, you're getting thrown in the trash by the hiring manager.
2️⃣ The next thing to consider is real market pricing. Startup valuations are charted all over the world by sectors and demographics. Sometimes these valuations are higher than average and sometimes they are lower. Your valuation is probably being affected by these numbers primarily because of the following: financial calculations.
3️⃣ There are three kinds of calculations that we can look at for more traditional valuation methods: like-company pricing, real assets, and discounted future revenues. A good ProForma projection can provide some well-developed future revenue projections which can be discounted to find the Net Present Value of an idea. You can also look at the profit multiple of the idea after a 5-year ProForma to see what sort of value the company could have. Like-company valuations take an idea of exits and IPO values from companies like the startup in question and then discount those values by their probability with a heavy weight on dissolution and liquidation of the company. In a liquidation event, real assets then become the last valuation metric to check. Real assets are all the properties and revenues of the business today - primarily pulling values from accounting.
All in all, these financial calculations when looked at with the other two lenses of valuations gives us a pretty fine-tuned value for various regions and markets. The margin for error is always there when making what is essentially educated guesses. However, we can look at these margins through the lens of Game Theory. The investor wants a low valuation because they can get a better deal while the entrepreneur wants a higher valuation so they can maintain more of their company. If the valuation is too low, the investor could hurt future rounds. If the valuation is too high, the startup could have a down round where the investor loses out. So, if we work together and have productive conversations regarding what valuations are and where they come from, we can make better deals happen for everyone.