Start-up valuation

When you are dealing with potential investors, they will be able to do valuation, I hope, but again, they are looking after their own interests. I assume it is a good idea to have your own numbers in mind, especially if you are a single founder. Some companies are being valuated well even before they go to market with a product, So, how can you check if the numbers are inline? How does one go about getting an independent start-up valuation? How accurate are those valuations? Is it based on science of a gut feeling? Is there a formula to be used?

Thank you.

Valuation is more black art than science but there are generally 3 accepted methods

1. replacement cost basis ... basically what you've spent (or someone else would spend) to get to the same point
2. discounted cashflow
3. market peers

You can immediately see the problem(s)

1. in era where technology is moving so fast, new tools/frameworks make the next generation faster cheaper better so often the replacement cost is a fraction of the actual sunk costs
2. negative cashflow and no revenue means crystal-ball gazing is now a first order predictive tool
3. if you are a first mover or creating a completely new category, who are your peers?

So investors avoid the issue (along with the tedious yelling/name-calling) by issuing convertible notes which is basically a loan (at high interest rate) with debt-equity swap at discretion of investors. This gives them a chance to see your performance and leaves the tedious arguments about value to a more mature stage. The years of (painful) startup funding people have come up with rough rules of thumbs like $1M / engineer, or $X per unique visitor or $Y per conversion rate. However, this varies so much across domains that only detailed study might come up with a methodology which is acceptable accounting-wise. If you're fortunate enough to be at that stage to pay for such expertise, congratulate yourselves on a value-creation joy-ride.

The Valuation of an early stage startup is basically a totally made up numbers pulled out of thin air (they probably have formulas and Excel sheets designed by very smart people but all the inputs to those formulas are guesses and estimates).

You are giving up a part of the company in exchange for some money, the valuation is used to decide how much of the company you are giving them, they say "your company is worth $X therefor we get Y% for $Z" - but since X is a total made up number you actually have "I've selling Y% of the company for $Z", so you should derive the valuation you are willing to accept from the amount of money you get and the percentage of the company you are willing to sell.

It's just like selling or buying any item that doesn't have an agreed upon price (and it is, you are basically selling a part of your company):

1. First you decide what is the valuation (based on investment amount and ownership percentage) you want to get and what is the worst valuation you are willing to accept.
2. In the second step you let the investor do the "black magic" and get their valuation.
3. Than you negotiate like a crazy - remember their number is based on what they want to pay and what they want to get, not on reality (just like your numbers are based on how desperate you are for investment and not on subjective "worth").
4. In the end if you agree on a number you make the deal, if their offer isn't good enough you walk away.

Also, remember this deal isn't dependent on a single number, every clause in every contract and term sheet can (and should be) negotiated.