How do startup valuations work?

Putting a price tag on a young startup is a peculiar practice. While valuation models exist, many agree that it’s more of an art than a science, especially in the absence of revenue — if you’ve ever wondered how Instagram reached a billion dollar valuation without literally ever having made a cent, you’re not alone.

When a company is producing a profit or revenue, valuations can be based on thumb-suck math like five to ten times annual profit, or three to four times revenue. Great, but what if you were a VC in the early days of Twitter, Facebook, Pinterest, or Instagram?

A savvy investor will look at a bunch of stuff like the founding team’s track record, for example. The market the startup plays in is important — similar startups are templates for valuations, revenues or exit potential — and illustrating traction (growth), is a positive signal.

Instagram is a fascinating example of where little to none of the above applied. Its founding team was solid — Kevin Systrom worked at Google and Odeo, the company that spawned Twitter — and yet, neither Systrom nor his co-founding partner, Mike Krieger, had any notable commercial successes prior to creating the world’s favourite picture sharing service.

What’s even more interesting is how Instagram was funded. By chatting up some investors at a networking event, Systrom raised US$500 000 for Burbn, a Foursquare-like check-in service that would eventually be stripped down to focus only on uploading pictures. It was renamed to Instagram. At this point, without any traction and what must have looked to investors like a version of Facebook or Foursquare that lost most of its features, investors had to call on something else to calculate Instagram’s worth. Intuition.

Burbn investors, Baseline Ventures and Andreessen Horowitz stuck it out and as the traction came, so did further successful fundraising rounds. With user numbers surging, Instagram secured US$7-million in 2011 (valuation $25 million) and US$50-million in 2012 (valuation US$500-million). Andreessen Horowitz revealed that it made US$78-million off its US$250 000 seed investment.

Looking at the valuations, in the absence of profit investors were either betting on a future revenue model, or more likely, a big exit, which eventually came when Facebook paid US$1-billion in cash and stock for Instagram, its 13-member team and millions upon millions of users which it could potentially convert into dollars.

Pinterest had a similar trajectory. With a relatively unknown team and little traction, Ben Silbermann and his team managed to sell their idea to seemingly gut-feel investors who would eventually hold equity in a company worth US$2.5-billion. Like Twitter, Pinterest is now experimenting with business models. Only time will tell whether it will be profits, a sale or an IPO that eventually injects cash into its investors’ bank accounts.

Closer to home

Stepping out of the US and peering into Africa’s emerging economy, with its investment challenges, some would consider intuition a luxury. Instead, VCs seem to favour sustainable, profit-driven businesses.

Whether it’s a consequence of emerging market challenges or culture, its a rarity to come across startup valuations. Perhaps it’s not surprising given the continent’s tradition of not disclosing funding rounds. In the US disclosing funding amounts is a necessity towards startup valuations. Sand Hill Econometrics based in Palo Alto, California, use funding round amounts to calculate how much a company is worth. In fact, a company’s valuation decreases the longer it goes without raising and reporting follow-on financing. The Wall Street Journal reports that Sand Hill Econometric takes into account that companies that don’t report their valuations tend to be less valuable than those that do.

What does it say about African startup culture and its ability to attract international investment?

On the plus side, it does allow startups to bootstrap without being seen as less valuable. In the US, companies that go out on their own, run the risk of being sidelined.

In the end, a universal truth that emerges from all of this, is that investing is a tough job — investments from VC firms are reported to be down in 2012 — and that beyond valuation models and regression analysis calls for experience and most importantly intuition.

Thankfully angel investing is picking up in parts of the world and with more funding sources, startups can keep searching for a suitable funding partner. If there is anything that Instagram and Pinterest has taught us, it’s that it’s important to find the right financier. Even if your company doesn’t look good on paper, somewhere there’s someone that shares your vision. Don’t lose faith.