Building a technology business can be tricky.
So, you started a tech business. You found a void that exists in a defined market segment that merited creating something awesome to solve the problem. You've organized a team of people who you believe can create, market, sell, and support your solution.
Unless you have a solid relationship with a rich uncle who has cash to hand out, in order to turn your wireframes and hobby into the next tech success story, you're going to need an external source of money. Almost as important as the cash you're after is choosing a funding partner that can help you navigate your industry, but that's a slightly different topic. ('Did you say 3.2 billion with a b?')
When you're in the process of raising funds for your tech startup, you'll want to know with as much certainty one particular piece of data (an aggregate of hundreds of other pieces of data) about your company: How much is it worth?
This can be a difficult question to answer, and there are lots of unknowns or hard-to-knows that factor into the valuation of a tech company. It can take some skill and a bit of creativity to come up with a specific valuation number, especially since, in the tech world, most of the data you're using to calculate that number is changing by the hour. However, at least knowing the factors that contribute to your company's valuation enables you to build a solid valuation case for your business and come up with a number that you can use as a starting point for negotiating a deal with investors.
The four factors that come together to create a valuation scenario for tech startups include:
- Market Size and Potential
- Competitive Landscape
- Product State
- Executive Team
Market Size and Potential
Determining market size can feel like spotting the Constellation Lynx from downtown. It can be done, but it requires focus. You have to know what it is you're looking for. To estimate the market size and potential for a technology product, you'll have to understand and use publicly available data points or estimates to serve as a framework for your product. For products that have the potential to interrupt existing markets and create new ones, you may even need to do some forecasting of where the existing markets are headed.
To determine the size of the market that exists for Nanobox, here is some of the data points we used.
- # of users of competing products - Heroku hosts an estimated 10M apps
- # of web developers - GitHub has 25 million registered users
- published revenue from support contracts - Red Hat has over $2B annual revenue
These are a few samples of the data points we use to create as complete a picture as possible of what potential exists for adoption of our development platform.
The competitive landscape naturally fits alongside the market size and potential factor for business valuation. Existing products that compete with yours, even if you believe yours will be interruptive and transform the market, currently define how your potential customers are solving the problem you expect your product to solve as you extract customers from your competitors.
You need to be able to articulate who your competitors are, what their products do, and how well your product will fare against theirs. That includes understanding how well funded competitors are, how well recognized their brands are, how they're marketing and driving demand for their products, and how their product and service offering is perceived by the market.
To articulate how Nanobox compares to some of our closest competitors, we created a graphic that highlights one of our greatest strengths: the fact that our platform spans the entire development to production workflow. This comparison helps us establish that we have a competitive advantage over the most popular existing alternatives.
Even when there is a substantial market for the product and lots of opportunity, if there is so much competition that your business will have severe difficulty carving out a segment of what's out there, your valuation will be negatively impacted by the over-saturation. The assertion of a high valuation for your business is dependent upon being confident that when your product launches, if it hasn't already, there will be users who will abandon competitors to use what you're selling.
Investors are pitched with opportunities ranging from hypothetical ideas to working prototypes to finished products already in use. How far along your product is in the completion process has a very high impact on how much value exists in your company. The amount of uncertainty for a particular product is greatly reduced as it moves from the idea stage to being battle tested.
Once a product is finished and in use, the hypotheticals about market size and potential start changing into tangible adoption data points that demonstrate a much more valuable, much more attractive opportunity for investors.
If your product is in its earliest stages - conceptual designs and wireframes - you'll find it much harder to bring on cash without giving up big chunks of ownership. That is, if you can get any at all. The less complete your code, the bigger risk you are to potential investors.
If you believe the concepts presented in the popular management book "Good to Great" (and most investment firms do believe them), you already know how important it is in regards to valuation and fundraising to have people in place who can execute your strategy. This typically includes having a strong CEO, an adept product development manager, a solid marketing engine, a strong branding person, and a finance expert. Some of these roles may overlap between people on the team, but they must be in place.
The members of your team, especially with their respective documented track records of success, serves as a validation that there is value in the company and the idea itself. Investors well know that attracting successful people to your executive team doesn't normally happen with a flimsy business model.
The management team also collectively represents the machinery that will execute the playbook that strategically places a legitimate product into a market in a way that will produce an acceptable ROI for investors. The extent to which you can demonstrate that the roles critical to your business' success have been matched well with people who are capable of filling those roles helps determine how much your company is worth.
Valuation May Differ Among Different Investors
Investor groups have varying motivations behind why they invest and what they expect. On the very conservative side, debt financing can be obtained from banks or similar institutions. Debt financing almost always comes strictly attached to collateral, something with well-defined value, like a house or other real estate.
Next to collateralized lenders on the risk spectrum are equity investors who are looking for deals that are relatively low risk but that have higher reward potential than most debt financed deals. Pitching to this spectrum will involve answering detailed questions about existing revenue, your marketing strategy, and sales projections based upon very quantifiable evidence. Their approach to valuation for your company will be much less based on its potential and much more based upon its historical performance. This part of the investor spectrum is not normally a fit for early stage tech startups who lack track records.
On the far other end of the spectrum are the risk-takers, the VCs known for funding the unicorns (also much less well-known for funding duds). Valuation of your company by this investor type will take more into consideration the market potential for your product, the track record of your founders and management team, the positioning of your product and your team's apparent ability to disrupt some part of the market or to aggressively attract market share.
Understanding the critical components that factor into your company's valuation will help you be better informed when presenting to investors to raise the money you need to succeed. Going through the valuation process will also help you understand better the metrics that affect your business.