What is my business worth: what drives a valuation?

Discussing funding with potential investors is usually a very good sign. It means a lot of things are probably going right for your business; a large market size, a great team, IP on track, milestones achieved, good exit potential, etc. If these things are not right or at least repairable, then it’s unlikely you’d be having the discussion.

When securing funding, the valuation is often the first topic any founder wants to discuss. This article will help get any founder up to speed on the drivers behind valuations by outlining some of the most common methods used to determine the value of any given company.

But, before diving into it, it is important to note that valuations are subjective and ultimately, your startup is worth whatever you and the investor agree it is worth.

Valuation perspective

More time spent on valuations means less time spent on your company, so don’t take your eye off what is important. Focus on your business, because a good business creates competitive tension and puts you in a position of strength when it comes to negotiations.

With that in mind, it is best to focus less on how much your company has been valued at, and more on who is invested. The right investors can, for example, empower you with mentoring, strategic advice and access to a network you couldn’t previously reach.

Let investors worry about the valuation, whilst you focus on the terms. Haggling for a slightly higher valuation is unlikely to make a material difference in the end (and may even be damaging), but agreeing to the wrong terms will. The key is to conclude quickly, yet justifiably, and get on with building your success.
So, to go through some of the simpler valuation methodologies, we’re going to use the example of Bob, first time entrepreneur and founder of Elacs Ltd. who are looking to raise funding in a Series A round.

Implied valuation

Bob is looking for $1.5m and willing to give away 15% in equity but is confused as to how much this means he is valuing his business at. Well, the maths is relatively simple. This means Bob is implicitly valuing his business at $10m.

To calculate the post-money valuation, we divide the investment amount by the equity percentage.

$1.5m/15% = $10m

Therefore, Elacs Ltd. would have a post-money valuation of $10m.

The pre-money valuation, therefore, is the post-money valuation minus the investment amount.

$10m - $1.5m = $8.5m

Many early stage businesses employ specialist firms to carry out extensive valuation exercises, often at great time and cost, only to arrive at a very similar figure to that indicated by the quick and easy implied valuation method.

However, Bob must realise that it is obviously extremely simplistic, doesn't take into account different capital structures and presumes a fixed amount of equity. Therefore, with this model, the more any company raises, the higher their valuation.

Perhaps the least scientific of all the valuation methodologies, the implied valuation method is a good starting point. The key question for Bob, though, is whether this is accurate and whether Elacs Ltd. has the contracts, KPIs and story to support it.

Reproduction cost approach, or floor valuation

Bob has also heard of the reproduction cost approach or floor valuation. These methods ask what it would take for an interested party to rebuild and replicate any given business, from the ground up, at today’s costs.

Bob estimates it has cost $2m to get Elacs Ltd. to where it is today, so he wouldn’t be willing to accept a valuation of anything less than that. He reflected back on how much his team has grown over the last two years and figured his key costs to date have been staff overheads, but has factored in all related costs to be sure.

The advantage of this method is that it is based on reliable information that Bob can look back on, and is generally useful to provide a ‘floor’ to the value of any business.

However, Bob still thinks there are many facets to Elacs Ltd. which aren’t easily quantifiable and haven’t been taken into consideration. For example, all the hypothesis testing of the business, Elacs Ltd’s loyal customer base and their strong predicted future growth. It is for such reasons that this method is used as a ‘floor’, more than anything else.

This is just the start

Both the implied and floor valuations are useful starting points to get an idea of the value of an early stage company. However, they are simplistic which has both its pros and cons. The next step is speaking to investors where your calculations will come under scrutiny. Whilst there are a number of challenges in the market today, there are also other methods of valuation you can consider to overcome them.

Just remember your startup is worth what you and the investor agree.

This article was written by the UK Scale team who’ve worked with hundreds of scale-ups from all over the world, across a range of sectors and technologies, to achieve commercial success.