Returns for angel investors are determined by three things – the value of a company when an investment is made; the company valuation when an investor makes an exit; and the timescales it takes for the exit to happen.
Realistic valuations are therefore one of the most important aspects when it comes to making investor returns and consequently, are a key consideration for investors.
Arriving at the right valuation from the very beginning is equally important for all stakeholders of the company, as your valuation sets the tone and aligns the objectives and incentives of the founders and early investors.
Investors taking a majority of shareholding in the seed stage can dis-incentivise founders to be fully committed to the venture. On the other hand, an unjustifiably high valuation can lead to a down-round or rights issue at a later date; or worse still, provide investors with a reason to hinder a founder’s exit plans, as they wish to see higher returns.
And as there are so few performance indicators to judge what a company is worth at the seed or early stages, coming to the right valuation for everyone becomes tricky.
Another consideration is that investors have choice, and you are selling your company up against many others, which means you will have to meet the market in terms of your valuation.
As a general rule, most pre-revenue start-ups need to give away more equity at the start of their journey. So it is therefore quite wise to raise a smaller amount of funding in the beginning, at a lower valuation, in order to gain some traction and then raise your next round at a higher valuation.
Lower valuations will entice early investors and any perceived loss of equity in the first round, can be made up once you have more traction and you go for further funding in later rounds, at higher valuations.
At the beginning of your journey, you also need to consider things from an investor’s perspective. You might think your business is worth several million pounds, but if the shoe were on the other foot and someone was asking you to invest into them, what would you value your company at?
In the early stages, valuations can never be about revenue potential. They can only be about the quality of your team, any intellectual property the business owns, strategic relationships, your roadmap to product rollout and revenue, the strength of your product and the size of the opportunity.
The other key factor that most founders fail to take into consideration is the potential exit value of the business. As a rule, angel investors are looking for a minimum 10x return on their investment, which means that you will need to sell your business for at least 10x the valuation they are investing at. In other words, if you are valuing the business at £5m, will you be able to sell it for £50m?
Finally, exogenous factors such as economic climate, industry sentiment, and global socio-political events can tilt a valuation either way. The coronavirus pandemic for example, stagnated the global economy and the investment climate. As a result, many companies found it necessary to discount their valuations by between 20-50%.
As a rule of thumb, aim for 12-18 months’ runway with respect your funding target and keep it as low as possible; but give a little more equity away at the start by offering investors a lower, more realistic valuation.
In this way, you can attract that vital early investment, use those funds to gain traction, and come back to your (happy) investors for more funds and at a justifiably higher valuation, down the track.
Remember, you are actually in a beauty parade and there are a lot of start-ups and growth companies vying for investment; so be realistic with your valuation and look after your investors from the start, so that they look after you in your subsequent funding rounds.