You see a talented team with a great plan, a slick presentation and a functional demo. You believe in their plan, you want to invest. But what is the company worth? There are no customers yet, only leads, there are no earnings, only costs. The company does not have any tangible assets. How do you put a price on that?
The most common way early stage startups measure the value of their company is based on how much money they need in order to build a product or to grow their company in a certain period of time. Then they decide how much equity they are willing to give away for that amount of money. A case of a startup raising 100K euros / dollars in exchange for 10% equity of a company with a valuation of 1 million euros / dollars, screams bullshit. It’s a clear warning sign that the startup didn’t do any research.
Investing in early stage startups always come with a great risk, but the risk is even greater when basing your investment decision on assumptions and valuing something that may or may not happen in the future. If you still decide to take that road, make sure the startup can defend their valuation by comparing earnings of their closest competitors in their target location. You can also try to analyse startup’s financial forecast, but the reality is that it’s all guesswork until the startup becomes profitable.
How to value a startup
Don’t! If you try to value an early stage startup you almost always get it wrong. Either it will be undervalued and the company sells too much shares, or it will be overvalued and the investor pays too much. Both ways the company runs into trouble in the next financing round. If the founders have sold a huge slice of their company in the first round they will be reluctant to dilute even more. If the company was valued too high there will be a down round which is bad for the earlier investors.
When using convertible notes, the whole valuation discussion is postponed. The startup is able to raise financing and grow. The valuation will be done is the future when the notes convert into stock and the startup is more mature. Valuation will be done either based on a qualifying event, usually a significant investment directly in the company. This event automatically give a valuation. Or conversion is done on a set date based on an independent valuation. Since the startup is more mature there are better indicators, such as number of customers, sales, market-share to base the valuation on.
Bundling multiple investors in one round and postponing the valuation through the use of convertible notes, also has one other major advantage. The valuation discussion is a very difficult one. The more parties involved the higher the chance that the discussion does not come to a conclusion and the round fails. No valuation discussion means a higher chance of a successful financing round.