Startup Valuation 101: Understanding the Basics

By: Alex McElfish July 29, 2022 8:46 pm

Startup Valuation 101: Understanding the Basics
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For anyone looking to start their own business, it goes without saying: it takes money to make money. In the early stages of any startup, founders are still in the process of solidifying their product, target market, and financials. These are just some of the factors that investors are likely to be interested in when deciding whether or not to invest in a startup.

Understanding startup valuation is necessary for the success of any startup. Founders must understand the importance of valuation, especially at an early stage, as establishing (And defending) early valuations can have a dramatic impact on the dilution faced by the founders and the attractiveness of the company to potential investors.

In this article, you will learn how early-stage startup valuation and traction work, and how you can use them to attract investors.

What is Startup Valuation?

A startup’s valuation is an estimate of its market value at a given point in time. It reflects how much founders and investors believe the startup is worth and is sometimes a major point of negotiation in the investment process. This valuation is what is used to determine what percent of the company an investor will receive based on how much money they put in.

A fair and defendable valuation is necessary whenever founders are looking to raise money. Overvaluing the company will lead to heavy pushback and low interest from investors, whereas undervaluing it will mean giving up a greater amount of equity for less capital and diluting other investors more than is necessary. Because these companies are so new and lack solid historical financials, their value depends on many different factors including developmental stage of the product, proof-of-concept in the market, founder, team, scalability of the company, projected financials, and sales. Although established businesses rely on vetted and established valuation methods and tools, they often aren’t relevant for startups.

Why Standard Valuation Methods Do Not Work for Startups

Early-stage startups do not have an established track record of financial data and have a lot of risk involved in their operation and growth. They often have aggressive plans for expansion and scale that create uncertainty and make them difficult to manage and grow successfully. This makes the traditional methods of business valuation not relevant and creates a need for alternative valuation processes that can help to determine a fair market price for these companies.

The Importance of Traction

Because there is so much uncertainty and risk involved in startups, investors often turn to a company’s traction to evaluate how successful it currently is and could be in the future. At its very core, traction is defined as any data or information that shows there is market demand for the solution being provided. This comes in many forms, but is most often identified by revenue generated, customers acquired, number of downloads, LOI’s signed, etc. In the end, these metrics are all data points that indicate your product is delivering value to your target audience and is a viable solution for the problem you are solving.

Traction is key to convincing an investor to invest in a startup. It validates your business model and proves there is demand for your product. This information is often coupled with a financial model to justify a valuation based on the projected return to an investor over a certain investment horizon (Normally 7-10 years for most venture capitalists and angel investors). Utilizing these tools and pieces of information will help you to raise the capital you need at a fair price for both you and your investors.

Key Takeaways

Now that you know how valuations are established for startups and how traction plays into that equation, you might have questions about different valuation methods and how a financial model plays into the process. Argent Strategies consists of a team of business and finance advisors that help founders build financial models and understand the role they play (in conjunction with traction) in reaching a fair and realistic startup valuation. If you have any questions, we are always happy to help founders navigate the fundraising process. If you or a founder you know would like to learn more, book a free 30-minute consultation today!

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