How Startup Valuation Works – Illustrated.
It is important to understand what the investor is thinking as you lay down on the table everything you have got.
- The first point they will think is the exit – how much can this company sell for, several years from now. I say sell because IPOs are very rare and it is nearly impossible to predict which companies will. Let’s be very optimistic and say that the investor thinks that, like Instagram, your company will sell for $1 Billion. (This is just an example. So do not get caught up in how unrealisict that is. This is still possible.)
- Next they will think how much total money it will take you to grow the company to the point that someone will buy it for $1 Billion. In Instagram’s case they received a total of 56 Million in funding. This helps us figure out how much the investor will make in the end. $1 Billion – $56= $ 940 million That is how much value the company created. Let’s assume that if there were any debts, they were already deducted, and the operational costs are taken out as well. So everyone involved in Instagram collectively made $940 Million on the day Facebook bought them.
- Next, the investor will figure out what percentage of that she owns. If she funded Instagram at the seed stage, let’s say 20%. (The complicated piece here is that she probably got preferred shares, which just means she gets the money before everyone else. Also, there might have been a convertible note as part of the funding, which gave her the option to buy shares later on at a set price, called “cap”.) Basically, all of these are just anti-dilution measures. The investor that funded you early on does not want to get diluted too much by the VCs who will come in later and buy 33% of your company. That’s all that is. Let’s assume in the end, like in How Startup Funding Works, the angel gets diluted to 4%. 4% of $940 million is $37.6 Million. Let’s say this was our best case scenario.
$37.6 Million is the most this investor thinks she can make on your startup. If you raised $3 Million in exchange for 4% – that would give the investor a 10X returns, ten times their money. Now we are talking. Only about a 3rd of companies in top-tier VC firms make that kind of a return.