The Evolving State Of Startup Valuations – And How To Ensure The Best Outcome For Your Business

By James McVeigh, CEO and Co-Founder, Cyndx

2022 hit startup valuations hard, and the first half of 2023 is shaping up to deliver much of the same. Tech companies were particularly vulnerable as they historically relied on the most forward-looking valuations during the relatively easy capital-raising periods with low interest rates. As a result, the ramping down of expectations across the market has had a more dramatic impact on tech valuations, and in turn, their ability to raise capital. 

With so much uncertainty, many startups are unsure of how much capital they will be able to raise, and at a more fundamental level, how to approach the task of valuing their company at all. So, with the new year in full swing, what should startups expect for valuations in the coming months? 

In my experience as an investment banker, as well as founder and CEO of Cyndx, I believe 2023 will see a clear shift in investment approach. With such unprecedented and unpredictable markets, investors will put a much greater emphasis on the DCF (Discounted Cash Flow) methodology. In other words, VC/PE firms will not invest in a company until they understand the longer-term prospects for the business and when that company will stop burning cash and become profitable.

Investors will move away from metric multiples and will start to rely on a more risk conscious method. The obvious cause of this is uncertainty is the increasingly challenging capital raising environment – gone are the days when investors will be comfortable assuming a company will be able to raise a subsequent round of capital. The risk of not making it to profitability has gone up dramatically, and investors are adapting in response.

In the intermediate term this puts a lot of pressure on founders to fine tune their financial models before engaging with investors. Previously, investors would look 2-3 years out when valuing a company. Now, they are looking much further out, and the projected performance of companies is likely to be lower. As a result, founders should expect that the valuations they achieve will be lower across the board.

So, what can founders do to ensure their valuations remain relatively attractive and their companies can secure the capital they need to grow - despite such an uncertain and risk-averse climate?

Get Your Valuation In Order… Now.

One of the most critical things a founder can do to set themselves up for success is have a clear and realistic valuation prepared before they approach an investor for funding. In such volatile times, having a real-time valuation is increasingly important. The markets are changing so dramatically that a valuation done months prior often is not relevant today.

For example, the multiples applied in April that produced a $100 million valuation are likely no longer relevant. For a founder starting a conversation with a potential investor, it’s crucial that they have realistic value expectations. If they approach investors expecting a sky-high valuation, investors will think the founder lacks knowledge, or if they go in too low, their equity will suffer. Going in with a realistic, real-time valuation significantly increases chances of success.

Having a current valuation also helps founder understand the potential dilutive effect of raising capital at a certain period. For some companies, it’s better to wait before accessing the market because the potential dilution to the existing investors would be too great given the existing market conditions. Capital raise processes are very time consuming and if the company is not willing to accept the current market valuations it’s better to not begin the process at all. 

Another benefit of having a real-time valuation is that it helps startups make better investment decisions in property, plant, and equipment. If a company is targeting a certain return, it will make certain operational decisions – whether that be purchasing new equipment or hiring new employees. If they are getting valued only on revenues and not on the cash in the immediate term, they are going to put more money into activities that will grow their bottom line. If they are being valued on cash generated however, they likely can’t afford to be as speculative. 

So How Can Entrepreneurs Determine A Real Time Valuation?

For most entrepreneurs, determining company valuations is not what they do for a living. Because they do not value companies every day, they are at a significant disadvantage when talking to people who do. Many founders rely on mentors or friends to help guide them through the valuation process – yet at the end of the day, the likelihood they can provide an appropriate valuation taking into consideration all the various market conditions or supporting documentation is very slim. 

Getting up to speed on the fundamentals of fundraising and investing is hugely important as it will enable founders to reflect current views in the market. But while reading all the books and doing all the research is beneficial, it would take years to become successful at it. Take WebMD for example, we can all self-diagnose a common cold with a quick browse, but conducting heart surgery is another thing altogether. 

There are tools and platforms out there designed specifically to help people who are not sophisticated in the nuances of valuation. But using these platforms often requires insights and assumptions to accurately value the company – and this is where most founders struggle.

Getting It Wrong Will Leave A Scar At A Minimum 

Remember, determining your company’s valuation is one of the most important decisions you’ll ever make as a business owner. If you get it wrong, the implications will last for a long time. If your valuation is too cheap, your shareholders will suffer irreversible dilution; if it is too expensive, you won’t get the funding you seek. 

That being said, there are actionable strategies and tactics that startups and founders can adopt to help identify the most appropriate valuation for their company and have the best chance of investment. 

My advice to startups looking to improve their valuations is to go to market as late as possible to investors, but not so late that you run out of money. It’s a chicken and egg game. A company with a fully completed product that has customers will have a very different valuation than a company who has a great deck and loads of ambition. On one hand, you want to delay it as much as possible to maximize your valuation, but the longer a company waits the higher the risk that the business will run out of capital. Yet the more capital a company has, the more opportunity it has to grow the business. Remember, once you issue stock to investors its often very expensive to get it back. It’s all about striking the right balance. 

Startups should also consider including strategic investors in their capital raise discussions. Don’t underestimate the value of what a strategic partner can bring to your company and how it can impact you valuation discussions. Strategics have the ability to impact your operations and they often appreciate the unique value of what you are bringing to the table. Having them in the mix can be valuable but they do bring potential risks. Introducing a strategic into your cap table can limit your future exit alternatives so be careful what rights they get as part of the investment.

On the whole, there’s significant value in having a real-time, accurate valuation. As with most situations in life, the more information you have and the more prepared you are, the better the outcome. And while the task of determining a valuation may seem daunting in such unpredictable times, there are tools and platforms that can do the heavy lifting for you. A real-time valuation can provide invaluable information on how your value will change over the coming years. This will not only allow you to seek much-needed capital, but also make immediate decisions on investments to help your business grow, and long-term decisions that enable you to keep more of your company.