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How is a startup valued or assigned a valuation by founders or investors?

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How is a startup valued or assigned a valuation by founders or investors?
posted Dec 15, 2017 by Sherlyn Mishra

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Deciding how to value pre-revenue companies is hard. There are many signals to process, and even after you've taken all of them into account, the final estimate is as much art as science. Deciding how much a startup should be worth is like deciding how much a one-of-a-kind painting should be worth: there are guidelines to move you in the right direction, but in the end you're basically making an educated guess. What's worse, you don't truly know if your guess was good until long after you've made the investment. Despite that bleak disclaimer, there are heuristics for calculating the value of a startup -- even one that has yet to make a dollar in revenue.

First, let's start with a few thought experiments. For each thought experiment, let's pretend you've been approached by a startup called ShopBetter, a company focused on improving shopping for buyers and for retailers, and you have the opportunity to acquire a 10% stake in the company. Your goal is to determine how much that 10% should be worth.

Thought Experiment #1: Founding Team

ShopBetter was founded last week and the founders know they want to improve shopping, but they haven't decided exactly how they'll do that. However, they are committing to work on something together for at least the next 5-10 years.
If the founders are your neighbors who don't know anything about technology or shopping, then 10% might be worth a few hundred or a few thousand dollars (if you happen to be a generous gambler).
If the founders are great engineers and salespeople that you've worked with, then 10% might be worth tens or thousands of dollars. Maybe even a million dollars.
If the founders are Jeff Bezos, Larry Page, and Jeff Dean, then 10% might be worth tens or even hundreds of millions of dollars.

Thought experiment #2: Traction and Expected Near-Term Revenues

ShopBetter recently released a service that lets retailers learn more about their customers. ShopBetter's businss proposition is that richer demographic info will help those retailers promote and target their products more effectively. If ShopBetter has 3 pilot customers who are nowhere near becoming paying customers, then 10% might be worth a few hundred thousands dollars (mainly because a finished product with potential is still worth something).
If there are 50 pilot customers, the plan is to charge each of them $1000 per month, and you believe (through surveying a few pilot customers) that about half of 50 will become paying users, then you might value 10% of ShopBetter at something like $500k or $1m. If the company has 1 pilot customer and plans to charge $50k/month, and you think the customer has a 50% chance of converting to paying, you might value a 10% stake at $300k - $500k. Even though a 50% chance of one customer at $50k/month has the same expected value as 25 customers at $1k/month, the proposition is more risky because it depends on a single client. As a result, the valuation take a hit.

Thought experiment #3: Growth and Engagement

The team at ShopBetter has been busy and launched a mobile app 3 months ago. Based on your research of similar shopping apps, you think a typical user's lifetime value (LTV) will be about $2.
If the app has 100k users and the user base is growing 15% per month, then 10% of ShopBetter might be worth $500k.
If the app has 100k users and the user base is growing 30% per month, then 10% of ShopBetter might be worth $1.25m.
If the app has 100k users and the user base is shrinking 10% per month, then 10% of ShopBetter might be worth $200k. There's still potential value in the company if they can figure out how to improve their app and get the user base to grow, but a shrinking user base is scary signal.
Additionally, user engagement is important. 100k users who log in monthly are not as valuable as 50k users who each use the app for 20 minutes per day.

Thought experiment #4: Market Size

You've analyzed the market for ShopBetter's consumer app -- the one where each new user is worth $2 in revenue -- and have come up with a realistic estimate of the max number of consumers ShopBetter can expect to acquire.
If there are 500k potential users, 10% of the company might be worth $50k.
If there are 10m potential users, 10% of the company might be worth $1m.
If there are 500m potential users and you think ShopBetter has a good chance of acquiring most of those users, then the value of a 10% stake is only limited by your optimism and your bank balance.

Thought experiment #5: Competition

You've take a good look at ShopBetter's founding team, its 100k app downloads so far, and its market potential, and now you turn your focus to the competitive landscape.
If ShopBetter has no competitors, you might value a 10% stake at $500k.
If it has two competitors which each have 25k users, you might value a 10% stake at $400k.
If ShopBetter has several competitors with millions of users each, and Amazon just announced a similar product, you might value the 10% stake at $200k.

answer Dec 19, 2017 by Deepak Jangid
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