The Startup Checklist

24Understand Your Company's Valuation

The valuation of startup companies before they have generated any profits—and sometimes afterward, too—is a cross between black magic, hard math, market dynamics, investor return calculations, and entrepreneurial hubris. As a result, it is the most confusing, debated, and variable number in the world of investing.

As the entrepreneur, you want the investor to value your company based on its (potentially sky-high) future value. The investor wants to value it based on its (much more modest) current value. Neither approach is objectively right or wrong. In most cases, the valuation of a company still in the early days of its history, but one that the founders and the investors think should be able to grow very big, lies somewhere in between.

The number that is ultimately agreed upon will reflect not only the number of customers, the total revenues, the user and revenue growth curve (if any), the business model, the market niche, the intellectual property value, and much more, but also the relative bargaining power of those doing the negotiating. Which generally means—given the huge imbalance between the vast number of companies seeking investment funding and the relatively small number of investors with real money to invest—that, in the end, the valuation assigned to a company reflects the price that investors are willing to pay for it.

Ultimately, an investment in a startup is a market transaction in which both sides need to believe that ...