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Understanding startup valuations
A startup’s “valuation” is how the price per share is determined. Here’s an oversimplified example: if a startup has a valuation of $1 million, and you invest $100,000, you are acquiring an interest of roughly 10% of the company.
Today we’re going to explore how startup valuations are determined. Unlike mature publicly traded companies, an early-stage company’s valuation usually isn’t determined by its earnings or dividend yield.
Young startups are valued according to their estimated potential. Here are a few of the most common factors used by venture capitalists to figure out a valuation.
• Traction (progress made)
• Growth rate
• Founders’ previous track record
• Team strength
• Industry growth rate
• Comparable deals
The stronger these factors are, the higher the startup’s valuation can be.
Valuations are a compromise
New startup investors often assume that the lower the valuation, the better. And new founder(s) often assume that the higher valuation they can raise money at, the better. But it’s not that simple. Setting a fair valuation is important for everyone involved.
Surprisingly, it’s often not in an investor’s best interest to invest at a “cheap” valuation. If the founders only own 5% of the company after a few rounds of funding, they may lose interest or motivation. Ideally the founder(s) should be strongly incentivized to grow the business, and the strongest incentive is owning a big chunk of it.
If the price is too low, the founders also may not have enough stock options to reward key employees with. At a startup, there are only so many stock options to go around. When investors own too much of a company, this can lead to a shortage of equity for founders and key employees. So as strange as it may seem, investing at too “cheap” of a valuation can actually be a bad thing.
On the flip side, it isn’t in a founder’s interest to have the valuation of their company set too high. If the price turns out to be too optimistic, this can be devastating to a startup. It sets the expectations very high. When it comes time to raise their next round of funding, they often won’t be able to do so. Their previous investors may feel like they got a raw deal.
And if they do manage to raise capital, the company may have to do a “down round” (a funding round where the price goes down from the previous one). Down rounds can hurt morale, so many investors avoid these situations. So setting the valuation of a company very high isn’t in the founder or the investor’s best interest.
Ultimately it’s in everyone’s best interest to find a price (valuation) that is fair. The goal is to find a price that incentivizes both investors and founders, and will allow the founders to reward stock options to their key hires in the future.
Here at Republic, we do our best to ensure that valuation caps are set fairly, and we’ve rejected many companies due to unrealistically high valuations.
Take a look at the 52 companies currently raising on our platform. You may see their valuations in a more nuanced way after reading this article.
Startup investing through an IRA
If you missed our newsletter last week, we explained how it’s now possible to invest in private startups through an IRA (individual retirement account).
We listed three companies who offer self-directed IRA services which can invest in startups. They are:
• New Direction Trust Company
You can read the full article, “Investing in startups through an IRA” on our blog.
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