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The quick rule of thumb for valuing a startup

By on June 7, 2011
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Valuing a start-up is more art than science. You can argue at length about the team, the product and the market. You can point to comparable companies in the space or if you have an MBA and misunderstood what your professors were telling you, look at discounted cash flow.

Some dollars, yesterday

In the end, like all negotiations, the value of a start-up is the amount you can persuade somebody to pay for it.

I loved the following approach, taken by a venture capitalist I knew at the start of the millennium. He started with the following premises:

  • I want a meaningful stake; the founders don’t want to give me too much equity. Therefore my range of equity is 25 to 40%
  • I want to put meaningful money to work; the founders don’t want to have to raise further equity for a while. The likely amount I will invest in a Series A will be £500,00 to £1.5 million.*
  • Meaningful valuation of a start-up is impossible. There are too many unknowns.

He concluded what he cared about was whether he wanted to work with the entrepreneur, believed in the team, and was excited about the product or market or both. Rather than wasting time on valuation discussions, he had the following conversation with entrepreneurs after the first or second meeting:

“Right, I’m interested. My terms are that I will invest £1 million in return for a third of the company. That is non-negotiable. Now that’s out of the way, let’s try to work out whether we want to work with each other.”

I like this approach because it avoids all the nonsense around valuation and allowing both sides to focus on the most important issue: Can we work with each other for the long term? Do we believe there is a big, sustainable market here? Can we win?

I think you could do worse than going into a valuation with this approach in mind. It might save you a lot of time.

 

* Note that capital efficiency, particularly of Internet-related startups, has increased massively in the last ten years. Productivity tools, open-source software, close-to-free online distribution – these have all reduced the amount needed for an early stage investor.

About Nicholas Lovell

Nicholas is the founder of Gamesbrief, a blog dedicated to the business of games. It aims to be informative, authoritative and above all helpful to developers grappling with business strategy. He is the author of a growing list of books about making money in the games industry and other digital media, including How to Publish a Game and Design Rules for Free-to-Play Games, and Penguin-published title The Curve: thecurveonline.com
  • The terms are negotiable. This is just one investor’s approach. I liked it because at such an early stage, valuation is very much an art not a science (though see the blog post linked to above for an alternative opinion)

    In short, this investing you he didn’t want to go higher valuation, he knew where his sweet spot for investment was (very early stage) and he didn’t want to waste anybody’s time.

    So he stated it was nonnegotiable. This won’t apply to all investors. It’s just a specific example of a single approach.

  • nicolasgb

    Nicholas, can you explain why the terms are non-negotiable ? Can’t a negociation be a different discussion from a valuation ?

  • For a more sophisticated approach to Series A valuation, I recommend this blog post (although the method is still very subjective).

    http://reactionwheel.blogspot.com/2011/06/valuation-for-investors.html