Nailing your pre-money valuation will have long-term effects on the success of your startup. For the health of your company giving up some equity to investors can be a wise investment. They will become vested partners in your company and will have your best interest in mind as you try to create a successful business.
Your new business could end up quickly failing or you might have the next Uber on your hands. The truth is probably somewhere in-between but if you want your company to be successful you need to believe that your startup is the next unicorn and every point of equity is something you will not give up without a fight. To have a business that an angel investor or VC wants to invest in you should worry about what they look for in a company.
How much are they willing to invest in your company? This is a function of fund size (if they have a $10 million fund they're unlikely to write a $2 million check because their fund will lack diversification). They also are looking at the risks in your company and their desired ownership.
What percentage of your business do they want to own? If they're a concentrated fund they're likely to want to own over 20 percent because they don’t do many investments. If they're a higher-volume fund that doesn’t want board seats and wants more diversification, they might only want 5-10 percent and they might prefer additional investors.
How much is in the option pool? If you have an option pool of only 6 percent and will need to hire a team of executives you're going to ask for more options to be created in the future, diluting the investors equity percentage. If you already have your executive team in place and it doesn't look like you'll need a larger team, they might accept an option pool of 8 percent unallocated. If you're a solo founder without a team or engineers they will likely want at least 15 percent.
Your startup valuation is essentially what investors think your company is worth, which has a huge impact on your company when you raise money. The higher your valuation, the less equity you have to give up for a particular dollar amount of investment.
Investors aren’t just backing your product; they’re also backing a team. What is your team’s track record? Do they have a history of launching successful startups with exits? If so, it will be much easier for your company to get money, and VCs will value your company more. In addition, VCs are looking for teams that have significant experience in your industry’s domain. If that experience is in a leadership position, even better. Although many VCs intend to be involved in steering your company, they are also looking to back entrepreneurs that they trust and will make the right decisions. Be sure to get a top-notch team in place before you begin raising money to get the best valuation for your startup.
While the best way to demonstrate traction is to show escalating revenues, not every startup is that far along in the process when they need to begin raising money. Your sales pipeline may be light as you build out your product, but do you have exceptionally low churn? This shows VCs that you’ve got a product that customers love; now you just need the money to get your sales and marketing to scale to reach a much larger market.
There is no single formula that can be used to precisely value every private business. The seller will want to drive the price up, and potential buyers will want the opposite. Businesses, where profits are growing rapidly, will also command a higher earnings multiple, than firms where profit growth is low. As a general guide, business advisers may suggest a valuation of between four and ten times the annual post-tax profit.