How to negotiate your valuation with investors? One of the biggest challenges startup founders will face during the process of building their business is raising investment. Getting funding is essential for startups out there because no startup can function or grow without enough funding to support its expenses.
However, when most new business owners approach an investor for funding, they are faced with a common debate and negotiations regarding the valuation of their startup. Valuation, as the name suggests, is the total worth of a startup. It is an important number for investors when they are about to invest in a new business.
Valuation is a big deal for investors. It determines how much of the company they will get in exchange for their capital. Which can also impact their control over that company, and other legal factors.
So, if you are a startup owner trying to raise funding, you should be ready to negotiate the valuation of your startup with potential investors. With that said, negotiating your company’s valuation can be complicated. Especially when it’s your first negotiation and funding round.
In order to help founders that might be seeking funding, this article offers some key tips on how to negotiate your valuation with investors.
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What exactly is the valuation of a startup?
A startup’s market value is what it’s worth is on the market. Which depends on many things. Valuing a startup is something that every entrepreneur has to do, especially when they are looking for money or an exit.
Valuation doesn’t just help estimate the current value of a startup, but it also tells what it will be worth in the future. In particular, there are pre-money and post-money valuations at each round of funding. Notable valuations can also suggest credibility, and attract great talent, business partnerships, and more.
There are many ways to figure out how much something is worth. However, when we look at valuation from an investor perspective, it helps them in figuring out whether the company fits into their investment criteria or not.
When evaluating a startup, investors look at things like how it is run, how its capital structure is set up, how likely it is to make money in the future, and the market value of its assets, among other things.
Every business, whether it’s a startup or not, needs a financial analysis and valuation to figure out how much its business is really worth, and whether it is actively seeking funding or not.
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Too often, new businesses avoid getting an official valuation and try to guess what their company is worth based on what they think it might be worth. You may end up selling yourself far short, or fail to be taken seriously because you are grossly overestimating your value.
Before you start reading up on the different ways to evaluate your new venture, you might want to check out this video on how to value your company. You’re sure to find it interesting and helpful.
What are the different methods of valuation for startup businesses?
Before you can start to negotiate your valuation with investors and investment terms, you need to know how to value your company to base the negotiations on. As mentioned above, having a vague guess of your startup’s value, without any data to back it up doesn’t send a good message to investors.
Businesses are frequently valued using the following methods.
Comparable company analysis is a form of relative valuation in which the current worth of a company is compared to the value of other comparable companies. This method of valuing a business is based on how many other businesses that are similar to it are worth right now. It is also one of the most common methods of valuing a business because it is easy to calculate and can be kept up to date. You can look at how other startups at the same stage as you have recently been valued in fundraising events.
When doing a precedent transactions analysis, you compare the company in question to other businesses in the same industry that has recently been sold or bought.
This shows how much a business is worth as a whole. This method is useful for mergers and acquisitions, but as time goes on, they can quickly become out of date and no longer reflect the market. This method is not used as often as the previous valuation method and is more commonly utilized in M&A transactions compared to investments.
DCF analyst predicts the business’s free cash flow into the future, and discounts it back to today at the firm’s WACC. A DCF analysis is done by making a financial model in Excel, and it requires a lot of analysis and attention to detail. It is the most detailed method and needs the most estimates and assumptions. But the work that goes into making a DCF model also usually leads to the most accurate valuation. A DCF model lets the investor make a value forecast based on different possible outcomes.
Market capitalization is the easiest way to figure out how much a business is worth. It is found by multiplying the price of a company’s shares by the number of shares that are still in circulation. However, since startups rarely have publicly traded shares, this method doesn’t apply to them.
The times’ revenue method
Under the “times revenue” method, a business’s stream of income over a certain amount of time is multiplied by a factor that depends on the industry and the economy. For example, a tech company might be worth 3 times its annual revenue, while a service company might be worth only 0.5 times its annual revenue.
Multiplier of earnings
Because profits are a better indicator of a company’s financial health than sales revenue, the multiplier technique may offer a more accurate picture of its genuine value. The earnings multiplier compares future revenue to the capital that might be invested over the same time period at the present interest rate.
Liquidation value is the amount of cash a business would have left over if all of its assets were sold and all of its debts were paid off right now. Investors are highly interested in the liquidation value of a business, and that is why this method of valuation is suitable for startups looking for investors.
If a company were to go out of business, the investors want to know that they can still recover the money they invested in it, and the liquidation value method provides them with this information. That’s why you should know how to negotiate your valuation with investors.
Tips for negotiating valuation with investors?
Now that you know what a valuation is, and some of the common ways it is calculated, it is time to jump into some tips that you can use during the valuation negotiation process.
Without further ado, here are some top tips for negotiating valuation with your potential investors:
Be careful not to set the bar too low
In any negotiation where the price isn’t already known, the parties negotiating can choose who mentions the price first, and the same goes when negotiating an evaluation. The first number that is mentioned or offered creates a bias that makes the other person put more weight on that first bit of information, and in most cases, the initially offered valuation is what ends up getting negotiated upon.
Should the buyer go first, they commonly offer a lower price than they are willing to pay. Should the seller start the conversation, they may offer a price that is higher than what they are willing to accept. Though you don’t want to sell yourself far short of your potential. Therefore, before you make your first offer, make sure you have a good idea of how much your business is worth, so you don’t sell it for less.
Make sure you have alternatives
Having options is the first and most important thing you can use in a startup valuation negotiation. So if you really want to negotiate your startup’s valuation, you need to leverage the fact that you have alternatives and there are other investors willing to invest in your startup. This gives you an edge in the negotiation process, and you don’t have to accept the first term sheet. Now keep in mind that it is also important to have other sources of funding before you can employ this tip during your negotiation process.
If you don’t have any other investors or financing sources, you’re really at the mercy of a single investor who offers a term sheet. As is the case if they know you are running out of money. This is why you should start raising while you still have plenty of financial runway.
Position your value well
Investors have other options as well. You may have a reasonable value for your business, but it’s a competitive market. Investors have many options; they may be thinking of other investments with the same potential as yours but at a lower investment.
A valuation is not looked at in a vacuum. Instead, it is compared to a list of other opportunities that the investor is thinking about. So, make sure you look at how other businesses like yours are valued so you can see how competitive the market is. Show how you are the superior option in relation to risk-adjusted returns.
Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
The Benefits Of Running Your Own Valuations
By now, you probably know that valuations are important for startups, so here are some real benefits of getting a valuation earlier on as a startup founder. In addition to compliance with some employee stock programs, running valuation methods on your startup before you go out fundraising.
Better knowledge of the assets of the company
Getting an accurate assessment of how much a business is worth is very important. Estimates are not good enough because they are too broad. Valuations need to give specific numbers so that business owners can get the right insurance, know how much more they need to invest into the business, and know how much of the share they should give to investors in return for investment.
Know the market value of the company
If you are thinking about selling your business, you need to know what it is really worth. This process should start a long time before the business is put up for sale on the open market. That way, you’ll have more time to increase the value of the business and get a higher price. As the owner of a business, you should know how much your company is worth if you want to make a decent profit by selling it.
You may have a general idea of how much your business is worth based on simple facts like the stock value, the total value of the business’s assets, and the amount of money in the company’s bank account. But valuing a business is about a lot more than just these simple things.
Helps in getting investment
Knowing the real value of your business is an influential factor when getting investment from investors. It also helps show how the company’s income and market value have grown over the past years. As well as showing that you know what you are doing in terms of running the business, not just building the product.
Leverage in negotiations
The biggest benefit of getting a valuation, as explained in the previous section, is the leverage you get in negotiations with the investor. Having an accurate valuation shows the investors that you know the true worth of your company and you aren’t going to have to settle for anything less.
Now, of course, the valuations are open for discussion, but the fact of the matter is that there is a lesser chance of getting a low valuation when you have already gotten your business valued.
Knowing the value of your startup is a key part of the negotiation process with your investors. The best way to get leverage in negotiations is by increasing your knowledge about the matter, so you don’t go to the negotiation table unprepared. Make sure you know these and learn how to negotiate your valuation with investors. Though remember that the terms of the investment can be even more important.
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