There’s a few companies out there offering automatic valuations for startups. While it seems like a good option for all those companies who can’t figure out how valuation works and what value to communicate to investors, using an automated model completely fails the scope of the valuation.
There are three main reasons for this:
- Your financial projections are almost certainly wrong
- The software does not take into account most market-related information
- You cannot explain it to the investor
Your financial projections are almost certainly wrong.
I have worked with many companies of all sizes, and I have rarely seen companies build their projections based on the number of customers in their target group, the number of units bought by each type of customer, the price changes, precise timing introduction of new products and expansion into new countries. I see so many companies estimate random revenue numbers, use simple revenue growth rate, as if customers could grow forever. It can be suitable for established companies with recurring revenue, but not for early-stage startups. Producing a realistic financial plan takes a lot of market research and tackling the right issues and strategy with the founders. Costs also have to grow in line with revenue for many startups, you need to plan what each cost depends on. Also very importantly, planning your revenue on a per unit basis helps you monitor your progress and highlights where you’re falling short in your sales performance.
The software does not take into account most market-related information.
Aside from the calculation of market size and number of customers in your target group, there are many inputs in your valuation that depend on the specific market you are in. Mostly, you need to compare your company to those with a similar business model, not all companies in your sector will be relevant or provide you with useful data. There may be only 2 or 3 companies that can really be compared to yours in some cases. You will need to observe market trends, comparable fundraising rounds, relevant exit sizes, timing – and what your best exit strategy is (if any). At early stage, this strongly affects your valuation, and it also helps you understand the funding strategy of your competitors.
You cannot explain it to the investor.
Having a figure that you don’t understand does not help much. Many investors will ask you how you arrived at that number, and not being able to explain does not play in your favour – they might think your projections are just as reliable as your valuation. It will be very easy for investors to criticise your valuation when they know you won’t be able to answer their questions. Having a third-party do the valuation without providing you with a written explanation/report or by being present for investors’ questions, is also just as good as not doing it.
No one expects you to be an expert, it could be better to have a very simple explanation (e.g. the funds raised and stake you want to give away is typical for fundraising rounds in your industry/stage), and be confident about your strengths.
By oversimplifying the valuation however, many companies at the same stage end up with similar valuations, sometimes it means that they are undervalued and sometimes overvalued.