How to (effectively) value for a funding round

Choosing valuation methods is one of the many confusing challenges of funding negotiations, and one the majority of founders will admit they have no idea about.
Valuing a mature company, while not simple, is a well-established practice with industry standards. For a quote company you simply look at the share price in the market, for non-listed companies might look at price-earnings multiples, EBITDA multiples, net asset values and discounted cashflows.
However, in the case of companies that growing rapidly but are yet to reach profitability, many of these methods simply won’t work. Below we look at some of the methods that can be used:
Discounted cashflows - where all the future cashflows of the business are discounted back to today to determine the present day value of that cash. This is one of the only traditional methods that has some utility as you can look at the projections of the business. Where this falls down is that many start-ups have 'hockey stick' projections, many of which are built on hope rather than defined metrics based on historical information. In these cases the risk attached to the future cashflows is simply too high to properly consider them.

Comparable transactions – where you look at similar companies transactions to infer value. For example, if you run a B2B SaaS business focussed on cyber security and a similar business raised £5m at a £20m valuation you could use that as a benchmark. The challenge is to know how your business compares in terms of current traction and future potential and to consider what sort of impact this might have.

Venture capital (VC) method - one of the best methods for valuing early stage businesses as it reflects the process investors will run through when deciding whether to invest in a company i.e. a work backward method of valuation. First an expected exit price for the investment is estimated. From there, one calculates back to the post-money valuation today by looking at the return on investment an investor would require for the level of risk attached. This explains why a number of VCs require companies with the potential for £100m + exits as the inherent risk in early stage businesses is so high that only these kind of exits offer the returns required to generate a return on investment for your investor.

Although each of these methods is only a guide, in the real world a business is worth what someone is willing to pay for it. That is why valuations at the early stage can be far more variable than mature companies and is also why overvaluation can happen. If a company is overvalued too early, investors will still be looking for a return on investment. This can make it very difficult when current investors will be pushing to avoid a ‘downround’ where the valuation decreases but the market does not value the business at that level.

In reality a host of methods should be used to define a valuation.
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