7 Key Factors To Consider in Early-Stage Startup Valuations
For young and budding businesses to thrive, seeking support and securing funding is a crucial step for many entrepreneurs.
One of the critical factors for companies to secure funding is startup valuation, which involves determining the worth of a company in its early stages.
Looking through an investor’s lens, let’s dive into the intricacies that influence startup valuation and unpack the key elements of navigating the dynamic startup ecosystem with confidence:
Experience of Entrepreneur and Stage
Strength of the Business Model
Data-Driven Projections
Evidence of Traction
Comparables and Benchmarks
Investor Competition
Current Economic Climate
1. Experience of Entrepreneur and Stage
This clarity is essential right from the get-go: the valuation of an early-stage startup is considerably different from that of a mature business.
The earlier the investment stage, the more dependent the valuation will be on the experience and reputation of the entrepreneur, her team, and perceived size of the opportunity.
The experience and track record of the entrepreneur plays a significant role in the valuation process because seasoned entrepreneurs with a successful history are more likely to attract investors than first-time founders. Previous achievements often instill confidence regarding the founder's ability to execute the business plan and overcome challenges.
Some studies have found that the older you get, the more likely your chances of success are, but that doesn’t default to failure for younger or first-time founders. Successful founders will share the criteria of knowing their domain, showing success at their job before pursuing their entrepreneurial venture, and being intrinsically motivated.
Additionally, the startup's stage of development is crucial. Early-stage ventures might have higher risks but could also have higher growth potential. The stage determines the amount of funding needed and the percentage of equity investors may require in return.
2. Strength of the Business Model
Considering early-stage startups are typically based on an idea or concept, valuation works as a process to quantify the worth of that startup idea.
So it should be no surprise that a well-thought-out and sustainable business model is critical for startup valuation. Investors are looking for clarity on how the startup intends to generate revenue and attain profitability in the long run. Are customers actively seeking solutions? More importantly, are they willing to pay for it?
Because this clarity helps to de-risk their investment, investors may reward understandable business models with higher valuations—but not without estimates and projections.
3. Data-Driven Projections
Projections underpinned by defendable assumptions instill confidence that the founder understands the market.
Benefitting both founders and investors, well-supported and data-driven projections provide a roadmap for the company's growth potential and future profitability.
For founders, this ensures they're not flying blind and can make informed decisions around allocating resources, setting realistic goals, and measuring progress. On the investor side, this helps better estimate the return on their investment.
But how do you make projections in the pre-revenue stage, without any hard facts or figures as a base? There are five predefined, prominent methods that are commonly used in the valuation process: the Berkus method, scorecard method, risk factor summation method, venture capital method, and First Chicago method.
4. Evidence of Traction
Nothing shows value like customers telling the investor that the startup has value.
Evidence of genuine customer interest in the product (recall: the willingness to pay) and capital-efficient revenue growth will drive valuations higher.
Startups that can demonstrate evidence of traction are better positioned for favourable valuations and catch the eye of an investor willing to pay more for a company. Metrics like user engagement, customer acquisition, steady or accelerating revenue growth, and product adoption show that there is a demand for the product or service in the market.
Traction validates the startup's business model and provides tangible proof of potential success, reducing uncertainty for investors.
5. Comparables and Benchmarks
Comparables, or "comps," refer to the valuation of similar startups in the industry. Companies solving a similar problem at a similar stage with comparable traction metrics will serve as benchmarks in valuing a startup.
Because businesses are unique, selecting comparables and benchmarks is not an exact science but a matter of judgment and relevance. The objective is to choose companies or transactions that are as close as possible to a startup in terms of business model, target market, product, stage, size, and growth rate. By benchmarking a startup to comparable references, you can get a sense of how the market values the industry, niche, stage, and potential for growth and profitability.
For example, some common benchmarks for SaaS startups are monthly recurring revenue (MRR), customer acquisition cost (CAC), lifetime value (LTV), churn rate, and net promoter score (NPS).
6. Investor Competition
Three words: supply and demand.
The level of interest from multiple investors can have a significant impact on startup valuation. The more investors vying to finance a startup, the higher the valuation founders will command.
It can be incredibly challenging for founders to predict and plan their fundraising rounds, much less how well their product will turn out. So the goal for founders should be to create investor interest from multiple firms while generating the least amount of friction to quickly close the round—a balance between knowing their value, respecting what investors are looking for, and being flexible on valuation.
Along with a higher overall valuation, competitive pressure from investors can also secure more favourable terms for the founder, such as higher investment amounts or lower equity dilution.
7. Current Economic Climate
The macroeconomic environment concerns the broad economy as a whole and will affect the balance of power between founders and investors.
A strong, bullish economy favours founders, resulting in investors who may be more willing to take risks and offer lofty valuations. Conversely, slowdowns lean in favour of investors, resulting in cautious strategies from investors who demand more reasonable valuations and more stringent deal terms.
Because economies are often cyclic at the macroeconomic level, understanding the climate and its influence on investor sentiment is essential for both entrepreneurs and investors. As investors, the ability to balance growth versus pressure informs which actions to take regardless of how the environment plays out and what calibrated risks will determine a reasonable startup valuation.
Startup valuation is a complex process influenced by various interconnected factors.
By being equipped with insights that cover elements from entrepreneur experience to accurate financial projections and everything in between, entrepreneurs can present their startups confidently, and investors can make informed choices when doing their due diligence on startups.
If there's a main takeaway, it's this: startup valuation is not merely about a number. Valuation is an art, a science, and ultimately, a reflection of the startup's potential to succeed and change the world.
Looking to learn more about early-stage investing? Take a peek at a couple of our recommended reads to learn more:
And for more in-depth, immersive learning, registration for the Fall Cohort of our Financial Feminism Investing Lab (FFIL) is open!
Run in collaboration with the Haskayne School of Business, University of Calgary, FFIL introduces participants to the ins and outs of early-stage investing and teaches aspiring investors how their dollars can power the next generation of future-fit, feminist businesses.
*Please note that the information provided in this blog is for informational purposes only and should not be construed as investment or financial advice.
