How Should Entrepreneurs Approach The Valuation Question?

First, remember that valuation is subjective.

It depends on variety of factors, the three basic ones are:

a) Who you are and what are your past accomplishments?

b) Who are the investors (eg: friends and family, angels, venture capitalists)?

c) What is the nature of the opportunity?

Let’s talk about the first factor – who you are and your entrepreneurial accomplishments to date.

The rules are different for someone who has returned hundreds of millions of dollars to investors versus a first- time entrepreneur.

It is not uncommon for one startup to be valued at $2M and another similar-stage startup to be valued at $500M – the difference being the former was led by a first-time entrepreneur and the latter was led by an extremely successful serial entrepreneur.

Entrepreneurship is a risky game and the odds of a first- time entrepreneur winning this game are very low. Super successful serial entrepreneurs provide the social proof that they have better odds of winning the game. Hence they command a premium in valuation.

Let’s look at the second factor – who are the investors?

Friends and family members invest mainly to support you and seldom do a full-blown due diligence on the opportunity at hand.

Angel investors are more sophisticated than friends and family. They are excited about you and the opportunity you present.

However, they are less demanding when it comes to valuation.

On the other hand, venture capitalists (VCs), have mandates about how to deploy their capital and under what terms. They have to answer to the limited partners and get the returns promised to them or else risk losing their ability to raise the next fund.

For instance, VCs generally want to own a certain percentage of the company in which they are investing. They are more concerned with their ownership stake than the capital invested.

In this case, the valuation is based on the ownership stake the VC is aiming for in the venture.

The last factor that might change the valuation equation is the nature of the opportunity.

Imagine that you bootstrapped a venture that resonated with the market brilliantly. Your venture is growing rapidly through word-of-mouth and your cost of acquiring new customers is very low.

Irrespective of who you are, it is clear that this opportunity is very compelling for investors. Multiple investors start wooing you creating a healthy competition for a share of your business and ultimately boosting your valuation.

In summary, the analogy I like to give is that of selling a home. The price you can ask for a home is what the market is willing to pay. A startup valuation is no different.

Focus on building a startup that is valuable and the valuation will automatically take care of itself.