There are many ways to come up with a valuation when raising angel or venture capital and none of them rely on current financial statements.
It may seem ridiculous that when raising hundreds of thousands or even millions of dollars the value of a start-up has nothing to do with the current operating financials of the business but that’s exactly how it works.
Instead, the valuation is determined by balancing the money being invested with keeping the incentives of all parties aligned. This usually means that whether you are raising $300,000, $750,000 or $2 million, the business is issuing 20-25% of the equity of the company to investors.
The chief point to ponder for both the investor and the founders is what amount of money going into the company makes sense for where it is currently in its life.
A general rule of a fifth or quarter per investment round is so the founders of the company still have a great motivation to succeed and still feel like owners, while investors have a meaningful enough percentage that they feel like a partner. Raising money also takes a lot longer than you think, so you don’t want to always be raising money.
Why on earth would this be the case? Firstly, there are so many unknowns in a start-up and the current financial picture will in no way represent the picture in the future (hopefully).
Profit is a horrible metric in a young growing business because if there is any revenue, it’s being plowed straight back into the business to try and explore how big a market is actually out there for the new product or service.
The most meaningful financial metrics will be a per unit per transaction basis where an investor can see the possibility of profits as those units scale up. If, as a start-up, you get questions around those aspects then take that as a good sign. If on the other hand, investors are asking more about how the valuation relates to current profits then it’s probably a sign they shouldn’t invest (even if they wanted to).
Valuation is also driven by market timing. If you ever hear someone say it’s easy to raise money, take that as a sign that they have never raised money before. It is never easy but the degree of difficulty does vary year to year.
Currently, the market is “less difficult” but that will mean you have a chance of raising slightly more money with less proof than in years past. Ultimately getting a small sample of transactions and happy customers will speak the loudest to investors, so concentrate on those and then financing will surely follow, rather than vice versa.