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my 5 step framework for startup valuations
many founders ask me "how do i know what my startup's valuation should be?" when they're about to go fundraise
it's an important question, but almost all founders approach it the wrong way
what founders are asking tends to really be "how much is my startup worth?" but this is an impossible question to answer at the early stages. the right question is "what are the necessary conditions for my next round?"
vcs understand that startups are unlikely to succeed and that there's a good chance they'll never get their money back. you don't need to convince them your startup is worth anything. you just need to convince them you have a plan for getting to the next stage
here's my simple 5 step framework for determining your startup's valuation:
how to determine your startup's valuation for your fundraise
map out your milestones
understand your expected burn
calculate your round size
determine your valuation
double check the markets
map our your milestones
being able to raise capital from vcs is based on hitting milestones that believably expand the growth potential of your startup
at the later stages of a business these milestones are largely driven by your metrics (ARR, active users, retention, growth rate, etc) but at the pre-seed, seed, and even series a stages these milestones are driven by narratives
step 1 for planning your fundraise is understanding what milestones you'll need to hit between this raise and the next one. that will dictate the growth strategy you pitch to investors now
for my startup, we raised our first round by proving we could attract exciting founders to our coliving residencies. we, and our investors, knew that managing coliving residencies don't scale, but we knew we'd need to introduce recurring revenue and launch a broader membership product and we had a plan to get there
understand your expected burn
next, conservatively map out how much cash you'll need to burn in order to hit those milestones. and always assume you'll need more than you think you will (a safe assumption is 1.5x what you think, in case things go wrong)
this is a great forcing function for you to think through a full and honest growth strategy. work backwards from the milestones you've laid out:
what needs to happen for them to be true?
how long will those things take in an optimistic, realistic, and pessimistic scenario?
how much will you need to spend?
can you move faster or reduce risk by spending more?
critically, map this out in google sheets against your expected revenue over the same period, month by month
vcs aren't expecting you to be profitable, but knowing your expected revenue will show you approximately how much money you'll lose before your next raise (your total burn), and how much you'll be losing each month (your burn rate)
as an example, let's assume we have a SaaS business and we believe it will take us 10 months to hit our milestones for the next round. during that time, we expect we'll be consistently burning $50K per month that entire time
calculate your round size
now that you have your total burn and your burn rate, you can determine how much you need to raise. here's the formula:
fundraise size = expected total burn + (expected burn rate * 12) - current cash
vcs typically want you to have ~12 months of runway when you go out to raise, so you need to multiply your expected burn rate by 12 and add that onto the total amount you'll burn between this raise and the next one
your current cash figure is simply what you have in the bank right now, when you're going out to raise your current round
let's use our example from above. if we expect to burn $50K per month over the next 10 months before we'll hit your milestones for the next round and have $100K in the bank right now:
$500K + ($50K * 12) - $100K = $1,000,000 round size
4. determine your valuation
consider how much of the company you're willing to sell in this round of funding
this question deserves it's own deep dive, but a simple way to do it is to look at what others in your industry do. generally, you'll look to sell 10-20% of your company in each round
do an honest risk assessment of your business. if there are a lot of unknowns, you'll probably need to be on the higher end. if you don't NEED to raise right now but want to in order to move faster, you'll have more leverage in negotiations and can land at the bottom end of this range (or even lower)
in our example, let's assume we want to sell 15% of the company in exchange for the $1,000,000
that means our valuation should be approximately $6.7M (we can call it $7M to keep it simple)
5. double check the markets right now
this framework will make determining your valuation much easier, but don't blindly follow it
look at other deals that have been made in your industry recently and consider macro factors in the markets. tools like pitchbook and crunchbase can help with this
my suggestion: talk to a few vcs you're not necessarily looking to pitch to and ask them to share context on the markets right now. are valuations "high" or "low"?
if valuations are "high", you'll be able to be aggressive and rely on your storytelling ability to increase demand around your raise. if they're "low", you'll need to rely more on traction and metrics if you want to justify a more aggressive valuation, and may need to accept selling more of the company than you'd like to.
in our example, let's assume we're trying to raise right now (while the markets aren't hot and valuations are "low"). this means we might need to choose between accepting a $6M valuation or raising less capital than we want to
try this framework out during your next raise and let me know how it goes!