A startup’s value is fluid and matters most upon exit

Here’s a fact that may surprise you: Most startup founders aren’t looking for a massive valuation and a quick, cash-laden exit. Dare we say most founders actually pursue a business idea because they want to solve a problem? That might be an idealistic view, but those who dive into startup land with a sense of greater purpose tend to be the ones who survive. Look at Bill Gates, Travis Kalanick, Matt Mullenweg, and Steve Jobs, for example.

The magic that is company valuation is not the result of waving a magic calculator and pulling a golden spreadsheet from a black silk hat. A company’s worth comes from an analysis of revenue, cash flow, and assets. But that’s exactly what stops startups dead in their valuation tracks. How does one go about valuing a company that has no revenue, few assets, and is swiftly running out of cash? That’s where the so-called magic comes in.

Tom Varga, founder of Bellevue-based CFO Selections, believes finding the value of a company is similar to finding the value of a home in the real estate market. One common method is to “pull comparables” for a company to create a baseline-valuation.

Startups don’t need a formal valuation for fundraising, even though there are plenty of local accounting firms, such as Kirkland-based Hersman Serles Almond, that offer such services. There also are a number of online resources, such as the Angel Resource Institute’s quarterly Hope Report, and AngelList and Equity Directory, which offer valuation guidelines and comparisons, including a plethora of blog posts and answers to frequently asked questions.

“At the end of the day, an early stage company has to raise enough money to get to the next milestone, and that milestone is either profitability with some form of an exit, or it’s another financing round,” said Josh Maher, a Seattle-based angel investor, startup mentor, and author of Startup Wealth: How the Best Angel Investors Make Money in Startups. “If the valuation is too high or too low, that next round of funding becomes impossible.”

Startup founders must have a good understanding of how much money they need, what they will do with it, and what milestone the money will enable the company to reach. When it comes to early-stage companies, investors are putting money into the company’s potential to earn a return, and not necessarily into the assets and revenue. “Depending on the amount of progress they’ve made between milestones really changes what the valuations look like.” Maher said.

“It’s always a negotiation to some extent,” Maher said. “It would be really difficult for an entrepreneur to say with no investor in the room, ‘This is what my company is worth,’ because they don’t know who’s going to pay that.”

When it comes to nailing down a round of financing, it’s the lead investor that helps figure out what a company is worth, and once that happens, entrepreneurs are able to say they are raising a certain about of money based on a certain valuation. But until an agreement is reached with an investor, the number is arbitrary.

As Dave Parker, serial entrepreneur and CEO of Seattle-based Code Fellows, recently wrote on his personal blog, the state of direct competitors can have an impact on valuation as well. “If one just raised cash or exited, your timing is likely good,” he wrote.

The topic of valuation hits headlines most frequently when a noteworthy startup begins looking for or receives investment. Otherwise we hear about how much a company is worth when it hits some sort of milestone, such as Uber’s unicorn status, or Snapchat’s drop in valuation at the end of 2015.

Being able to throw around a lofty valuation number can be splashy and lend a bit of swagger to founders. But unless you’re getting ready for an investment round or preparing to sell, better to focus on finding market fit for your product and seeking that hockey-stick growth rate.

A slew of factors go into valuation, including: 

  • Traction: Traction refers to the number of users an app or service has, and how fast that number was reached. If 100,000 users were acquired a handful of months after launch, the possibility of getting a high valuation, and therefore more funding, is high. The faster a company grows, the worthier it is for funding.
  • Reputation: It’s no secret that reputation is a big deal in startup land. Serial entrepreneurs have an easier time getting funding because they are well-known. But how does one overcome being a first-timer? Build that professional network of founders, mentors, and investors, and get people on your side who can speak to your drive, vision, and results. Meantime, follow through on your commitments, and soon your good reputation will precede you.
  • Revenue: This can be a double-edged sword for some companies. One school of thought believes revenue means users want the product, indicating good market fit. The other school of thought believes paying customers means a slower growth rate, which translates to less revenue down the road. So which road do you take? If you’re looking for angel or venture capital investment, take the road with high growth. If you’re bootstrapping, slow, steady, and sustainable revenue growth is the name of the game.
  • Distribution Channels: Where is your product available? If your app is available only for Windows phones, you’re missing the largest sections of the mobile market with iOS and Android. If a physical product is on the line, is it available in stores, on QVC, or online? The largest number of users needs to be able to come into contact with your product.
  • Potential Exit: Time to drop some truth: People invest to get more money in return. When it comes to valuation, the potential of a good return has an impact on the value of a business.
  • Option Pool: The option pool is how much company equity founders reserve for employees. The value of the option pool will be subtracted from the startup’s valuation, since the option pool is future employees’ value, something you don’t have yet.

This article originally appeared in the February 2016 issue of 425 Business.