Valuations and the Startup Gamble

TL;DR: A valuation tells us how much a startup is worth today. The calculation of a valuation is based on macroeconomic market conditions, and the strength of the startup’s management team, product, market size, and competition. It is always hotly negotiated. The valuation is critical because it tells investors the percentage of the startup that they will own after making their investment.

The Startup Gamble

Picture yourself in this moment: you are sitting beside a young Prince as he first picks up a guitar. Young Prince says to you ‘I am very poor, but I have a lot of ambition. If you give me $5,000 to help pay for guitar lessons, I will give you a percentage of all my future earnings.’ Would you take his proposal? 

Before you answer, imagine the same question being posed by Hillel Slovak, the Red Hot Chilli Pepper’s founding guitarist, who was the band’s guitar player for their first two (relatively unknown) albums. Or by Brian Jones, the founding guitarist of the Rolling Stones. Or by the countless other musicians who had a lot of potential and ambition but, for one reason or another, did not ‘make it’. 

Knowing what we know now, of course we would accept Prince’s proposal! But, the sad reality is that, for every Prince, there are thousands, if not millions, of musicians with equal amounts of ambition and skill that are unknown to the culture. How would you know that you are investing in Prince and not Slovak or Jones? 

This is similar to the decision that startup investors face. They know that there is an asymmetric likelihood that any given startup will fail. Despite this knowledge, they have to make a decision (a gamble, really) on whether to invest. 

The Valuation: A Number to Simplify the Gamble 

This is where the startup’s valuation comes in. The valuation is an estimate of how much the startup is worth today and is used as a proxy for the startup's potential. It is one of the key tools that an investor has in their toolkit when making an investment decision. 

Determining a valuation is an intricate process that is more art than science, particularly at the early stages of a company.

To simplify this guessing game, investors and finance-savvy individuals at startups use financial tools to help determine the valuation. A laundry list of these tools is beyond the scope of this post but, at the most basic level, the person preparing the calculation will make an estimate of the expected revenue and profit of the startup and ‘discount’ those projections to today’s date to determine today’s valuation. 

What factors influence this calculation? 

• Market conditions: fundraising in poor economic conditions (for instance, periods of significant volatility and uncertainty) will naturally drive valuations downwards.

• Management team expertise: more successful management teams - those that have had prior success at starting and growing businesses  - tend to drive valuations upwards.

• The product’s ability to generate revenue: products that are assessed as more unique (not easily replicable) drive higher valuation.

• Market size: startups targeting bigger markets are assumed to be able to generate more revenue than those targeting niche, smaller markets. (Although Peter Thiel disagrees)

• Competition: the existence of competitors tends to (but does not always) drive valuation downwards, particularly if those competitors are successful. 

Even if we are able to make a beautiful financial model that outputs a reasonable, defensible valuation, the final number frequently deviates from this calculation. This is because there is one final factor to consider: negotiation. The investors come to the table with their (generally lower) number, and startups with their (generally higher) number. The final valuation tends to land somewhere between these numbers. The caveat is that an early-stage startup with a short history has much less leverage than, say, OpenAI or Stripe or SpaceX in these discussions. The latter are more likely to be ‘valuation makers’ and the former, ‘valuation takers’.

We Have A Valuation - Now What? 

So, a valuation is how much the startup is worth today. So what? 

The main reason that valuations are critical is that they determine the percentage of the startup that the investor will own after making their investment.

All else being equal, investors want a larger stake in a company. But, they generally have limited ability or willingness to increase the size of their investment in any given funding round. For instance, if Investor A writes a check of $1 million, they will get 10% of a Company A valued at $10 million but only 1% of a Company B valued at $100 million. You can now see why this investor has an incentive to negotiate the Company B valuation downward: it means that they will own more of the company!