Nov 3, 2023 4 min read

EGD News #193 — How are startup valuations decided

A founder recently asked me to share my thoughts on calculating startup valuations. Both founders and investors might have their own view of how much a company is worth. It makes sense to break down the math, comparisons, and guesswork that goes into making a fair valuation assessment for your company.

Let’s set the stage. This piece will only cover pre-seed companies that often lack revenue or users. Pre-seed often means only the co-founders and their pitch deck, with maybe a working prototype.

During my years as a founder and investing in startups for the last fifteen years, the pre-seed valuations ranged from 1 million to 20 million. So, it’s a big ballpark, but this piece will explain how you can estimate the correct number for your company.

What follows is how I calculate a valuation for your startup based on the variables that matter.

First, the variables that are outside of the company but matter when evaluating a company. I call these the outside variables.

State of the economy and macro. During COVID, startup valuations increased drastically by 2-5x, depending on the market. Then, after the pandemic, we had headwinds in the market, which caused valuations to go back down again. At the same time, inflation and interest rate hikes have caused pressure to increase startup salaries, which gives pressure for startup investors to understand the dynamics of valuations, possibly staying higher, as companies will need to pay higher salaries than pre-COVID.

Geography. Historically, US-based companies have had much bigger valuations than European ones, mainly because the cost structure, incl. salaries, to run a US-based company is higher. I remember one VC telling me in 2014, after the massive success of Supercell, that a Helsinki gaming startup would get a bump in valuation, a Helsinki premium. Geography matters.

Industry “hotness.” Regarding gaming, you might be in a sought-after part of the industry, i.e., capable US PC/console game teams can get a much higher valuation than a mobile game team in the UK. The reasons are caused by more investors being interested in a particular gaming area. Note that this might change over time, when the part of the industry is more “hot” than other parts because of mergers and acquisitions happening right now, new technologies, consumer appetite, how likely a new funding round is to happen in 12-18 months, etc.

Second, the variables that relate to the company. The inside variables.

Strength of the founder(s). The founders and their team's strength and effectiveness lie in a combination of factors, including their resume, expertise, attitude, adaptability, and the “read” investors can get on how well they “gel” of the team. Of course, a more experienced founder will get a higher valuation on the individual level. However, the newcomer might still get a higher valuation if they can give a great impression to the investors.

The opportunity: the market size for the company’s product or service, the timeline to growth and revenues, and risks regarding execution and technology. How competitive is the market for what the company is working on; is it a blue ocean or a red ocean?

The product: When evaluating the product to understand valuation, the quality of the product matters a lot. Then comes the product/market fit that the company has achieved, the road to one, and the possible moats that can be built.

The big question is the quality of the go-to-market plan: How will the company get more users? What are the sales channels, and what has been proven so far about user adoption?

The founder’s expectations: The investor will want to hear about the founder’s perception of the size of the investment round, but especially about the need for financing. What kind of salaries will the founders be taking, how much are they willing to give equity to early hires, etc?

The third point is comparables.

Investors are constantly looking at deals done by themselves and other VCs. They collect comparable numbers and become knowledgeable on what kind of investments are being made.

As an angel investor, I constantly got deal flow, where I would see things collect data on raised amounts and the valuation being set. Post-money 5-7m was common pre-pandemic; it went to 10-12, then 15-20. And now we are back to the 5-10 range.

In a way, using these comparable numbers to set valuations is fair for the whole market. Founders aren’t easily getting cheated by investors to accept less favorable terms than the market. For founders who might wonder how they can ensure they are getting a fair valuation, they should ask around. Other founders and investors will know comparable numbers and can tell you if it’s fair or not.

Often, a startup valuation is decided by how competitive the round gets. At the end of the day, the better job the founder does at creating FOMO with investors, the higher the valuation will be. But this might not always make sense when it comes to future rounds needing to happen.

Which brings us to the final point. A VC will examine the possible journey to a new round in 12-18 months.

If the startup raises at a higher valuation than what makes sense in the market, there is a high risk that a new round with a 2X to 3X valuation will be much harder to achieve. If the valuation is low, they will wonder if the money being raised will be enough to get enough proof of things working to raise a new round in 12-18 months. It's a balancing act, where the VC wants the startup to raise enough but not at too high of a valuation, which could hamper the prospects of a new round happening at a higher valuation.

More reading

I’ve previously touched on these valuation topics in these articles:

(Photo by Israel Andrade on Unsplash)