There is a lot of confusion around what startup valuations are really based on.
To start off, let’s understand what they ARE NOT based on:
- Numbers taken from the sky, or unjustified projections
- Wishful thinking
- Desired percent of equity that you “think” you should give away
To drive the point home, you can’t just say: “I think I am going to generate $1M in Year 1, $5M in Year 2, $25M in Year 3, $50M in Year 4, and $100M in Year 5”, just because those numbers seem reasonable, and even if other startups have similar projections.
Why? Because those numbers are not justified by your strategy. You have not determined the capital required to achieve these goals and whether you can get access to this capital. And finally, you have no idea how long it will take you to meet those targets based on all the information available to you to date.
Instead, startup valuations MUST BE based on ASSUMPTIONS, which come from
industry norms and business strategy.
It is not easy to formulate those assumptions. The process requires a lot of research and an in-depth analysis of your business model, but in the end, you will have a proper quantitative representation of your business plan in a form of your financial model and valuation.
Examples of assumptions based on industry norms:
- Subscription conversion and renewal rates
- Conversion rates for different marketing strategies
- The length of a sales cycle for BTB products
Examples of assumptions based on business strategy:
- Product development timeline
- Product or service price
- Operating budget
- Marketing budget and allocation
- The number of and timing of revenue streams
The better assumptions you create, the more credible your valuation is going to be and the more accurate financial forecast you will have.
To learn how to formulate assumptions for various business models, we recommend you take Class # 2 - Business Models for Early Stage Software and Service Startups.