Unfortunately there is no clear cut formula you can use. As with trying to value anything that is unique, such as a work of art, valuation ultimately comes down to a meeting of the minds of what the holder agrees to sell at and what the purchaser agrees to buy at.
Practices used to value mature companies generally do not work for start-up companies in their early stages. This is because there are too many unknowns if the company will be viable and how much revenue it will make. This makes using a discounted cash flow method of valuation very subjective as you can support a wide range in valuation by the assumption you make on the company’s terminal cash flow. Using a comparables method of valuation is also problematic as you will probably only have data on VC or IPO deals which deal with companies that are at a later stage of development. The value for these companies is going to be higher as they have proven they have a viable product/revenue stream.
In terms of practical guidance based on experience, a rule of thumb is to expect that if your company is looking for its first round of angel financing, then it will have pre-money valuation in the $1m to $3m range. This is based on the assumption that your company is pre-revenue or in the early stages of revenue, has a product that is close to going to market, has a partial management team assembled, etc.
The main advice I can give around valuation is to be reasonable and be flexible. As I discussed in the previous article, having a high valuation for the first round of financing makes it harder for investors to realize their ROI objectives. So unless there is something really special about your company, it is not a reasonable expectation to get an eight figure valuation. Since valuation is so subjective, your best strategy is to be flexible in the early stages of the pitch. You will not be able to convey the full value of your company during a 20 minute investment pitch. You should state your valuation expectations but say they are open to negotiation. During the more detailed due dilligence meetings, you will be able to spend more time with the interested investors and have the opportunity to have more serious discussions on valuation & the aspects of your company you feel support your valuation target (i.e. strengths in management, product, barriers to entry, IP, market potential). You will also get to know your potential investors better. Successful companies generally look for ‘smart money’, meaning investors that are willing to contribute money as well as their knowledge & expertise to help the business. You may find your investors can provide expertise to help fill out areas on the management team or can open doors for the company to potential clients. In this case, the value that the investors bring to the table is far more than just money so you may need to accommodate this via a lower valuation to entice them to get on board.
A final point of advice is to separate the valuation discussion from control. A lot of founders approach valuation along the lines of: I need to raise $X, I want to maintain 51% control of my company, therefore I’ll set my valuation to ensure that after I get the money, I will still have over 51% of the shares in the company. This is flawed logic as its fairly easy to structure a financing deal where investors get control of a company without owning 51% of the shares outstanding. If control is an important consideration, then as a founder your best option is to get the company as far as possible before requiring outside financing. As soon as you take on other financial stake-holders you will have other people’s money involved in your company so you will need to ensure they viewpoints & opinions are managed.