When you decide to go ahead with your Startup, your initial investment may be from your pocket. Next stage may be asking your friends and relatives to invest. After that comes a stage when you need to approach Angel Investors who can provide incubation, support, and guidance along with investment.
Venture Capitalists (VC) provide the lowest valuation as the only moto behind investment is Return on Investment (ROI). They do ask for partnership/stake in the company. There are multiple rounds of discussions and projections and numbers need to be agreed by both parties to start the investment process. While looking for freelance jobs, you can also study the Startup culture to have your Startup one day.
Thumb Rules of VC Investment
There is a saying that for a Startup with no balance sheets, the valuation is what someone is ready to pay for it. So, at the initial stage, the valuation is only related to the market price. The market price can be related to the valuation of similar firms, the potential for growth, the uniqueness of idea/product, etc.
The Factors for Valuation
Competition between VCs: IF your idea/Startup is in demand and multiple investors are showing interest in investing; there are more chances of getting better funding. It is an influencing factor, where, because of competition, the VCs may like to fund your Startup
Innovative Idea: If the idea is innovative/unique along with practical and sellable, the idea is likely to get sold quickly. Whether it is a disruptive technology or a solution to a common problem, the innovative mind is a critical factor for new Startups to be successful
Revenue: If you have already started earning from selling your product/service, the revenue generated and potential to generate are good for calculations. The money flow immediately attracts investors, and there are figures which you can put on the paper to prove your predictions.
Profile of Founders: Startup relies entirely on the Founders and Co-Founders. Their knowledge and experience is key to the success of Startup, and that is a key factor which the investors will consider before investing. Remember, a freelance work often gets converted to a Startup if the freelancer aims for high growth.
Loans/Prior Investments: Anyone who is investing will check for your financial condition as on date. If you have already taken a lot of money from many other people or investors, they will be reluctant to invest in a Startup which is already in debt.
Forecasts/Growth: You need to spend a good amount of time to forecast the sales and revenue. The mature state or state after receiving the funds is important for the VC. In the current situation there may be multiple constraints but when you get the required funding, how the Startup will perform, operate and earn is the required forecast (as accurate as possible)
Valuation by VC (Berkus Method)
What market is willing to pay for your Startup is the first valuation. This method of comparing your Startup to a similar Startup in the market is also known as Berkus method.
An investor is always looking for a specific return on investment, let’s say 10x. Besides, according to industry standards, the investor thinks that your Startup could get sold for $50M in 7 years. Based on those two elements, the investor can easily determine the maximum price they willing to pay for investing in your Startup, after adjusting for dilution.
In the above example, $50 M / 10X = $ 5M, If you have invested $1M, The valuation is $5M-$1M = $4M. If you consider 25% dilution, the current valuation will be $3M
The cost of Duplicating/Risk Factor Method: If the cost of duplicating/cloning your company is too small, there may be several competitors quickly in the market as soon as you launch your Startup and the predictions can go for a toss. It is typical for a Software Startup, where anyone can design and develop similar Tool/Mobile App once you go live. After grouping all risks together, the valuation can be done using risk-factor summation method.
Discounted Cash Flow/DCF Method: For non-earning Startups, the valuation depends on future potential. DCF analysis shows how much your Startup can produce in future and then it is easy to calculate the returns on investment. A VC will apply high discount rate considering all possible risk factors. The DCF may vary from one analyst to another based on their knowledge of market potential and growth in the particular sector. The cash flow method is good for valuation at the current stage.
Valuation at Each Stage
As the Startup is evolving and growing every single day, it needs some time to come to mature operations stage. The VC will always be interested in commercial product development and mass sale, and by the time you reach that stage, the valuation and need of funds keep on changing. State by stage valuation method can be good for both investor and founders as it involves low risk and high success rate. Your valuation depended on the Startup stage when you approached a VC.
Milestone based Funding
At a particular stage, you just need funding for operational costs; then you may need more funds to complete research and create a prototype and few products for evaluation. Once this stage is successful, you may want to start production on a lower scale and then eventually on a high scale based on demand. At each state, you will expect the VC to put in more funds and valuation will keep on changing. This approach is also called Milestone based funding.
Once the Startup reaches mature operations and can sustain on its own, the valuation is again related to how much someone is ready to pay to buy the VC’s stake. The VC will typically like to exit after 3 to 5 years and gain maximum at the end of this investment period. Based on one of the above methods, they will do the valuation and invest in your Startup. Keep reading freelance tips on blogs like this for more information. The traditional method is book value method, but for an IT Startup, as there are hardly any assets, this method is not much useful.