Understanding Start-up Valuations
Start-up valuations are difficult as there is no specific rationale behind it. It is like measuring the intangible probable. What is the worth of a Start-up? The entrepreneurs have been a hard-charging, always optimistic, and full of emotions personalities. They are passionate about their company valuations. Valuations are important as it forms the basis of ROI. Hence arriving & agreeing at the magical number of valuation is a headache for angel investors.
Entrepreneurs & Angel Investors equally think about how much of the company they will own & at what cost. There is a big notion from entrepreneurs to ask or expect astronomical valuations. The seed investment cardinal rule for start-up space is based on its capital needs for the idea to reach its first milestone to ensure next round of funding. Overfunding & underfunding both are detrimental for the idea's success at seed stage. Cash flow positive start-ups will always be in a better position to understand & negotiate better valuations. There is a genuine concern on valuation for angel investors where start-ups have high burn rate models. Lavishly funded start-ups tend to see sentiment shift signals in subsequent rounds due to the perceived high cost equity in comparison to their performance. The decline in next round valuations offered by VCs to emerging technology start-ups is a fuelling concern. It is always advisable for entrepreneurs to accept realistic valuations.
Over valuation expectations from entrepreneur is the big obstacle difficult to overcome in most cases. Psychologically seed stage entrepreneurs tend to ask for very high valuations. They think more money raised is more success. It works otherwise for entrepreneurs in reality if they have fought for high valuation only basis of unrealistic performance milestones. The subsequent rounds will be down rounds with stigma of not meeting expectations. Entrepreneurs will have to offer major chunk of equity to raise capital & hence lose out eventually at exits. Entrepreneurs need to learn that more money is more problems. It takes up a lot of time and energy of angel investors to paint this real picture. Angels tend to rationalize the valuations to make the start-ups look attractive and perceived successful. If the level of desperation is not high, entrepreneurs tend to meet multiple angel investors to scout for better valuations. There is nothing wrong or right in it. Entrepreneurs have an ego which stops them from lowering their expectations on valuations & work with investors. When reality hits them unfair valuations automatically crumble. Valuation discussions makes the entrepreneurs forget to look at their real need of capital in company and map best investors accordingly.
Low valuations are also equally detrimental for an idea to be successful. When the valuations are low founders have to shell out more equity resulting in more dilution of ownership than required. Entrepreneurs should be eternally optimistic in executing their idea but realistic in financial numbers. Whenever the start-up gets unfair valuation they tend to fail. Many times entrepreneurs are not able to gauge the need of exact capital resulting in lower ask. Angels understand that underfunded businesses, due to low valuations, will run out of cash soon & wind up, so they offer entrepreneurs to recalibrate the plan.
Angels capital is a patient capital with no hurry for returns nor answerable, unlike VCs, hence they are a little averse to haggling on valuations. Their economics to value a start-up's worth is different than a VCs. Angel investors understand the entrepreneurs need of capital, for the company to reach the next milestone metrics, to the raise next round of funding. Valuation is driven by market sentiments, basis sector of investment, founder’s team, traction with customers & quantum of capital. It is also a fact that only a few entrepreneurs & angel investors get the valuations math right, hence this is an art and not a science.
Valuation of a seed stage start-up is an educated guess.