Valuation 101: Understanding Pre-Money Valuation for Early-Stage Startups
You have a brilliant idea that you are convinced will change the world, you team up with someone that shares the vision. Armed with passion, necessary skills and insights derived from thorough market research, you begin developing your product. Months and a few users down the line, you and your co-founder believe it’s time to raise your pre-seed round and take your product to the next level. You excitedly get on a call with a prospective investor and after walking through your building journey and the offerings of your product, the investor asks, “What valuation are you raising at?” Your response could potentially dictate the outcome of that conversation.
Now let’s get into it, shall we?
If there was an A-Z glossary of terms in the tech ecosystem, V would most likely stand for Valuation. Like in the above scenario, valuation is a common concern during investor calls because it is one of the important components that determines the economics of a venture capital deal. The valuation agreed upon by the founder(s) and the VC largely affects what each party leaves the negotiation table with.
Why is pre-money valuation so important?
Pre-money valuation helps to make informed decisions on raising external funding, equity distribution, and future partnerships. Moreover, it gives investors an idea of your company’s potential return on investment, which plays a role in securing funding. If the valuation is set too high, investors may not be willing to invest. Conversely, undervaluing your startup may result in a significant loss of equity for less funding or an underestimation of the progress you have made thus far.
Pre-money Vs Post Money Valuation
There are two sides of the coin when it comes to valuation: the pre-money valuation on one side and the post-money valuation on the other. As the name implies, pre-money valuation is the value of the company before the investor makes an investment in a round of financing while the latter is the total value of the company after such investment has been made.
Here’s a simple example to illustrate:
Let’s say your startup has a pre-money valuation of $1 million, and it receives a $500,000 investment. The post-money valuation would be calculated by adding the pre-money valuation to the investment, which will be $1.5 million in this case.
While post-money valuation is relatively easy to calculate, the pre-money valuation takes several factors into account and that is the main subject of this article.
Post-Money Valuation = Pre-Money Valuation + Total Investment Amount
Take a peek into the unicorn club
The trend of roof-shattering valuations for tech startups is quite commonplace in the global climate. In fact, CB insights reports that as of March 2023, there are over 1,200 unicorns around the world with companies like ByteDance, SpaceX and Shein topping the list (valued at $225B, $137B, and $100B respectively). In recent years, African startups have also shown significant presence in the list of unicorns. As at February, 2022, African payment company Flutterwave, had a post-money valuation of over $3B after their $250M SeriesD round. Wave’s $200 million Series A round of funding in September 2021 catapulted it to unicorn status, with a valuation of $1.7 billion. This made it the first unicorn in Francophone Africa.
Unlike early stage startups, billion dollar valuations are typically arrived at after considering concrete data such as financials and revenue for late stage startups. Take a look at Moniepoint, formerly known as TeamApt, one of Africa’s fastest growing fintech startups. According to its 2022 performance review report, 1.7 billion transactions worth over $100 billion were processed and $1.4 billion was disbursed in loans. Based on this data, it will not be a surprise to see the company valued at millions of dollars. The proof is in the pudding!
This is not to say that there is one straight-jacket formula as companies employ different valuation models to arrive at these sky-high numbers. However, for early stage startups, it’s an entirely different ball game.
How can you then value your startup at an early stage?
Early stage startups often face hurdles in setting a valuation when it’s time to raise. This is because at this stage, there is barely any clear cut data that can inform the valuation of the company. It is not advisable to slap on a random figure based on the perceived potential of your startup. Remember, if you set it too high you are mounting unrealistic pressure on your startup that is yet to take flight. In the same vein, investors want you and your team to stay motivated so that everyone gets attractive returns years down the line. This may not be the case if you give up too much equity.
That being said, before you respond to that almighty question about valuation when you are raising your pre-seed round, here are few factors to take into account;
- Size of the market: What is the size of the addressable market for your startup? Is it a niche market, or is there a large addressable market? The larger the market you are playing in is, the higher the valuation your startup can command.
- Traction: For early stage startups that are in the pre-revenue phase, there are alternative ways to demonstrate traction asides revenue. For example, if you have built an MVP, you have a waitlist or have signed contracts with clients, investors might be more inclined to fund your company. Your startup could then command a higher valuation when you have demonstrated that it can be profitable and scalable.
- Capital efficiency: How well have you managed cash in the bank? The more capital efficient the business is, the higher the chance the company has to attain profitability which could have a positive impact on the valuation.
- Team: Does your leadership team have the necessary skills and expertise to effectively execute the idea? What is the prior experience of your team members? Have you successfully launched and scaled a startup before? Investors tend to perceive lower risk and possibly assign higher valuation to a business whose founders have domain expertise in the sector the startup is operating in.
- Competitive advantage: What is your business moat? Who are the competitors in the market, and how does the company’s product or service compare to yours? How defensible is your business? Identifying and honing your competitive advantage would enable you to stand out in the marketplace and this could influence your valuation.
- Macro economic factors/Current economic conditions: Though this is not within your control, macroeconomic factors such as interest rates and inflation, could have an impact on startup valuations. With the recent global economic downturn amidst other factors, valuations of some African startups have taken a hit.
It is a popular and correct notion that valuing your early-stage startup is both an art and a science. Nonetheless, as a founder seeking to raise pre-seed or seed funding, if you can demonstrate or show potential for fast growth with healthy margins in a large market, you just might be on your way to achieving unicorn status.