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Startup valuation methods don’t work. Here’s how to do it

Asking founders their startup valuation tell you nothing

Tl;DR: Startup valuation methods don’t work because founders aren’t generating revenue. The real way to figure out your valuation is to calculate how much you need to raise to get to your next round and what dilution you will accept.

“What’s your valuation?

Perhaps you:

That’s fine if you have well-defined logic, but I don’t think it makes sense:

You learn very little from that question. What you want to know is:

  1. How smart is this founder?
  2. Do they have strong logic abilities?
  3. Do they have a plan?

You can get the basic info and hell of a lot more if you ask probing questions.

The better question has two parts:

  1. How much do you need to raise to hit your milestones?
  2. What dilution are you targeting in this round?

Why startup valuation methods (at early stage) don’t make sense

When startups are at a later stage, sure there are metrics. Bessemer track public SaaS multiples which can be a benchmark (though need some adjustments). Here is an example of what that would look like:

5x their shite all revenue is shite all.

When founders are selling hope and rainbows, they don’t have meaningful numbers. Their valuation is based on their potential (and sales ability).

So you need to figure out how to value ‘potential.’ Let’s face it. You can’t.

How startup valuation really work

There is a formula for valuation. It’s this:

Valuation = Investment / Investor ownership (Dilution)

So if you agree on a valuation of $10m post, your investment is $2m and the dilution is 20%.

Only a dumb founder would give up 50% of their startup in one round, right? Yeah, fucked cap table.

But they should be ‘happy’ to give up maybe 20% for the right suitor. Maybe 15% is ok, 25% they can live with… but no more.

Now they need investment. They calculate around $2m, but could be more or less. That sort of depends on you ;).

So we can map this out and see a range of post-money valuations (in $000s):

On this basis, the valuation is between $4m and around $13m. That’s a big range. You may be price sensitive.

To tighten this up, you could argue they will achieve more with a larger raise, so you think they should take $2m. The range is, therefore, $8m to $13m post.

So startup valuation comes from how much you will invest and what dilution the founders will accept. It’s an output range rather than an input.

Learning more

What you want to hear is:

“According to our calculator, we need $2m. We are targeting a dilution of around 15%.”

You do some basic math and figure out the valuation range in your head.

Then you ask them to explain the logic.

If they have well-formed answer then you learn a lot about the founders. And if you are dealing with great founders then they get the opportunity to differentiate themselves.

Asking the valuation and them responding “$13m post” and gazing at you whilst trying not to flinch tells you nothing.

Founders have no clue why their valuation is $13m. There are also no benchmarks. All you learn is if they under or over value themselves.

Do you understand why startup valuation methods don’t make sense now?

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