In the startup world, one concept that is often front and center for any entrepreneur is valuation. This term refers to how much your company is worth at any point in time. In many ways, there is a lot of financial alchemy that goes into valuing a startup business – especially one that may not have any products, any paying customers, or any source of cash flow. That's why it's essential to have a firm grasp of different approaches to valuation when traditional financial metrics might not be useful.
In a best-case scenario, a startup company already has a minimum viable product (MVP), a growing number of paying customers, and a clear path to profitability. That makes the job of valuation much easier because you can apply traditional financial models that take into account revenue, profitability, and future cash flows. But what if you're still in the pre-revenue stage, and have no financial metrics for investors to use?
That's when you'll have to rely on proxy metrics. For example, one proxy parameter for paying customers is Monthly Active Users (or, even better, Daily Active Users). Presumably, at some point, you will be able to convert a good portion of these Monthly Active Users into paying customers. If people are using your product or service every month, there's a good chance that they like what they see, and need a little persuasion to upgrade from a "free" product to a "paid" product.
Many types of similar measures can be used to help value a company. For example, if you've recently launched a new app, then "Total Downloads" might be one useful way to showcase just how popular your new startup is becoming. If you have a big presence on social media, then you might want to showcase "Total Fans and Followers." Again, the idea here is that if you have a rabid base of very active supporters on social media, then there is a strong likelihood that some of them will be inspired to start buying your products when you finally emerge from stealth mode, or when you eventually transform a working prototype into an actual commercial product.
One important point to keep in mind here is that valuation is not just what your company is worth right now – it is also a function of what your company might be worth in the future. Venture capitalists typically are looking to exit any investment in five years or less, and thus, they have one eye on the present and one eye on the future. When it's time to exit an investment, what will your company look like then?
As you might have guessed by now, valuation is a game of market perceptions. During a particularly frothy and speculative market, for example, valuations tend to be much higher than during much more bearish periods. And valuations also tend to be much higher in industries or sectors that are "hot" at any point in time. That's why valuations tend to fluctuate significantly, depending on where the overall VC market is headed. So the more certainty and precision you can provide a potential VC investor, the better. Instead of making wild guesses about the future, they can focus on valuing your company using real financial numbers and metrics.