Valuation of Early-Stage Startups: The Mindset of Investors

The valuation of early-stage startups is a controversial topic. There is no widely agreed-upon valuation methodology that can be used to correctly value all early-stage start-ups. There are some valuation models which are more widely used as compared to the other models. However, there is no consensus and almost every investor has their own yardstick by which they value any startup.

It may not be possible to know the exact criteria which are used by investors to value any company. However, it is indeed possible for entrepreneurs to understand the mindset of early-stage investors. This is useful as entrepreneurs can pre-empt some of the concerns which are likely to be raised by investors. This helps them obtain funding on better terms.

In this article, we will try to explain the mindset which of investors as well as entrepreneurs when the topic of early-stage valuation is on the table.

Information Asymmetry

It is important to understand that in most cases, the discussion between the entrepreneur and the investors has an adversarial undertone. This means that both parties perceive the negotiation to be a zero-sum game and want to maximize their gains at the expense of the other party. The entrepreneurs want to maximize their valuation whereas the investors want to pay the minimum possible amount to buy an equity stake. The problem is that an adversarial mindset creates a lot more problems.

When investors find an information gap in the pitch for investment, they generally factor in the worst possible outcome. After factoring in the worst, they provide a reduced valuation to the entrepreneur which is often not acceptable to them.

Hence, entrepreneurs may hide information to increase the valuation of their startup but might end up decreasing the value of the same. The best way to solve this problem is to ensure that both parties disclose the relevant information on time. This will help create an atmosphere of trust which can be considered to be a precursor to arriving at a fair valuation.

Valuation Divergence

A lot of investors believe in the adage that profit is made when you buy not you sell. This is the reason that they try to buy at the lowest possible valuation. Also, many investors take the concept of valuation divergence into account and hence lower the price further.

Valuation divergence is defined as the difference between the valuation of the entire company and the valuation of the price of the shares owned by investors. This can be best understood with the help of an example:

If an investor invests in a company valued at $10 million and sells his or her shares when the company is valued at $150 million, they are unlikely to make 15× profit. This is despite the fact that the value of the firm has grown by 15×.

The investor is likely to have made a 5× return based on historical data. This generally happens because the stake of the investor gets watered down as the company goes on for further rounds of funding. This dilution of shares creates a disparity between the rate at which the company is growing and the rate at which the investor’s share is growing. This is called valuation divergence and it plays an important role in the thought process of the investors.

Target Rates of Return

Angel investors and venture capital firms have a target rate of return which they are trying to achieve. It is common for investors to target anywhere between 4× to 8× over a 5 year period. This can also be expressed as an internal rate of return between 25% and 75%! It is important for entrepreneurs to be aware of this target rate of return.

It is also important for the entrepreneur to validate whether they can realistically provide this rate of return to the investors. This is because if they fail to deliver the required rate of return, the investors might cut funding to the project in the middle of the investment even though it may be delivering a lower level of profit. The expectations of the investors need to be understood and carefully managed.

The fact of the matter is that different investors have different points of view. Some of them believe in the growth story of a certain sector whereas others believe in the growth story of a certain country. It is the entrepreneur’s job to gauge the mindset of the investor and model their investment pitch to align with their philosophy.