The Art and Science of Startup Valuation: A Definitive Guide for Investors and Founders

Valuation is not just about numbers. It is a fundamental aspect of building trust, aligning interests, exits, and forming lasting partnerships. Valuation is at the heart of every startup journey, dictating investor decisions and shaping a startup's path towards growth and success. Without it, founders and investors will be in the dark. As Chair of Keiretsu Forum Northwest and Managing Partner and CEO of Keiretsu Capital, Nathan McDonald has worked with hundreds of investors and startups, conducting deals worth millions of dollars. In this blog, we will explore essential concepts and methods from Nathan’s keynote to help you navigate the complex landscape of startup valuation. 

Detecting a Startup’s True Worth

Valuation is a critical factor in evaluating a company's potential and plays a pivotal role in raising funds. Deciding upon a valuation for a pre-sales, early-stage company is always tricky. That's because valuations aren't static; they're a dynamic concept that evolves as a startup progresses and reaches milestones. However, the real world is full of challenges, especially around funding, which can influence the valuation.

Every stakeholder in a startup has a unique perspective on valuation. Founders, advisory boards, early-stage and late-stage investors, and the broader market all bring different views. Understanding and harmonizing these diverse perspectives helps make the decision-making process easier. Often, disagreements arise among founders and investors regarding the former’s contributions. “Two-thirds of businesses fail because founders don’t have the mechanism to agree on what their contributions are worth,” says Nathan. To avoid this common pitfall, founders must accurately assess their contributions. This, in turn, enables advisory boards and investors to form their valuation perspectives based on the founders' input.

Early-stage and late-stage investors have varying focuses. Early investors place a strong emphasis on the team's capabilities, while later investors prioritize growth opportunities and financial metrics. Recognizing these differences is key to securing the right investors at the right stage of your startup's development. Founders may be the ones who drive a startup but they eventually need to bring in executive talent and management to chart new waters. Managing the cap table, ensuring transparency, and effectively explaining options to employees are essential aspects of creating long-term upside. Failing to value stock options adequately can lead to talent attrition.

Valuation varies based on the type of financing offered. Bankers and different types of buyers (financial, strategic, and emotional) assess valuation differently. Public markets also influence liquidity, but going public too early can have consequences. Convincing investors to buy into your startup is crucial. You must essentially convert “unwilling buyers” into willing buyers. To attract investors, offer a deal that is just right — neither too hot nor too cold. Finding the right balance in your valuation is essential for building trust and securing investors. Nathan adds, “Less than 3% of those with a high net worth enough to do angel investing make one $10,000 investment a year.” As the statistics show, convincing investors is hard! It is essential to set a realistic valuation because investors are competitive and astute. There may be a lot of capital out there, but investors are more careful than ever about where they put their money.

Getting to the Nitty Gritty

The Berkus Method, developed by seasoned angel investor and Keiretsu guest Dave Berkus, evaluates pre-seed startup risk across five key dimensions: Sound Idea, Quality Management Team, Prototype, Strategic Relationships, and Product Rollout or Sales. This method helps investors assess a startup's potential success and identify areas of concern. A Discounted Cash Flow DCF analysis involves projecting future cash flows, usually at a 10% discount rate, though a 50% discount rate may be more appropriate according to Nathan. Evaluating exit costs and ensuring alignment between the capital and business plans are critical. It's also essential to assess future funding requirements, a significant risk factor for angel investors. Maintaining the right balance between capital and efficiency is essential for momentum.

Valuing a startup based on specific criteria organized in a scorecard format is another effective approach. These criteria include: 

Scorecard Approach to Decide Valuation

  • Team Strength
  • Profit Potential
  • Competitive Advantages
  • Intellectual Property Portfolio
  • Investment terms
  • Composition of the Capitalization Table

Maintaining momentum by having 80% of the cap table allocated for future growth is crucial. On the other hand, a top-down valuation approach, keeping in mind public markets, suggests that valuations should double every 18 to 24 months to achieve a 10x return in five years. The magnitude of potential upside significantly influences startup valuations. However, it's essential to recognize and adjust valuations when only a modest exit is expected.



Valuation Practicalities

Pre-money is the sum of all the cash, sweat equity, and ideas that have gone into the company before the investment round. It is crucial to understand the pre-money value because it determines the price per share. Post-money value, on the other hand, includes all the new financing that has gone into the company plus all the newly issued shares. It is vital to understand the post-money value because it determines the investor's equity in the company. It is also essential to be aware of convertible instruments and options that may not be taken into account in the fully diluted valuation. 

Term sheets play a significant role in startup valuation. Different classes of stock have varying rights and preferences. Understanding these differences is crucial, particularly when it comes to preferred stock, which has liquidation preferences, preemptive rights, governance rights, and more. Maintaining integrity within the cap table is crucial. All classes of stock should align with the same principles, and there should be transparency in the ownership structure. The control features, such as the board composition, need to ensure fairness and alignment.

Convertible notes provide a flexible way to bridge valuation gaps. These notes offer a percentage discount based on future milestone events, helping investors get the value for their investment.

A key principle in follow-on investments is maintaining existing investor participation. A rule of thumb that Nathan advises is not to increase the valuation from one round to the next by more than 40%. Maintaining alignment and trust with existing investors is vital for long-term success. The goal is to incentivize early investors to enter the fray. To maintain alignment of interests among stakeholders, it's essential to consider valuation across your capital plan. Giving away chunks of stock without a clear rationale is not the way. Seek sound investor counsel and legal advice. Your legal counsel should be well-versed in structuring deals, and understanding restricted stock agreements, option plans, and convertible notes. Remember, lawyers don't determine your company's worth – the investors and the market do.

Cash is King

The amount of cash in your startup's bank account plays a pivotal role in valuation. In today's landscape, with fundraising becoming more challenging, investors sometimes want to see at least 18 months' worth of cash in the bank. However, just a year or two ago, six months of runway sufficed. Valuing your startup based on future cash that you haven't raised is a risky move. Your valuation should reflect your cash position, and it becomes more substantial once you secure the necessary funds. To put it bluntly, don't inflate your valuation without the cash to back it up. Existing investors are vital because they have in-depth knowledge of your company and should trust in its growth. If you overinflate the valuation, it can deter existing investors from participating. The goal is to keep it at a level where existing investors can reasonably increase their ownership and participation. Keep in mind that more informed investors are more likely to invest!

Startups may be notoriously hard to value, yet there are numerous ways to arrive at a number that both investors and founders can work with. Exploring diverse perspectives, growth opportunities, current talent, cash flow analysis, investment rounds, runway, and more are all valuable tools in the valuation arsenal. Once these tools have been utilized to make sure the price is right, the “unwilling buyer” may have no choice but to change their decision.


About the Speaker

Nathan McDonald is a Managing Partner and CEO of Keiretsu Capital and currently manages over $24M across four funds with over 200 investors and 165 investments to date.  Keiretsu Forum is a worldwide investment community of capital, resources, and deal flow with over 50 chapters on 3 continents comprised of accredited private equity angel investors, venture capitalists, and corporate/institutional investors. Keiretsu Forum members invest in high-quality, diverse investment opportunities. Keiretsu Forum and Keiretsu Capital (the exclusive worldwide fund partner of Keiretsu Forum) are ranked as the most active venture investors in the USA according to PitchBook.

To watch Nathan’s full keynote visit: 


 November 01, 2023