Valuing Your Early Stage Company

First, an unfortunate reality: your start-up is almost certainly worth less than you think it is, if for no other reason than it is your start-up and you are far more certain about the likelihood and scale of success than anyone looking at it from the outside. All the more if the outside viewer has been around the risk capital investing block and seen the reality that 90% of start-ups never achieve anything like the level of success their founders thought was all but inevitable. Unless you can find some gullible “dumb money” (See Part 5 below), you’re almost certainly going to sell more of your company than you think is fair to get the capital you think you need. 

How do you get the best price for your company? That is, how do you get a potential investor to put a higher “pre-money” valuation on your start-up? A good place to begin is the VC Method.

From an earlier question, we know that an early stage VC wants to figure that every $1 dollar invested will get $10 or more back if the investment is a winner. Which means you need to convince them that whatever they put in now, and factoring in future dilution and the “exit” proceeds when you sell the company (and the larger majority of exits are by sales, not IPOs) will give them at least a 10x return. You do the math, or find the equation in our blog. And when you have finished, you have more or less applied VC Method to the valuation problem.

Of course, the math is mostly hypothetical for most start-ups. How much capital you will need to “get all the way home” to the exit is hard to say, and almost always more than everyone thinks at the get go. What prices investors will pay in future round, another critical input for future dilution, is at least as problematic. And let’s not forget that exit metrics way out there in the future, things like revenue and EBITDA and growth multiples for deals, also fluctuate over time in ways that defy even the best educated guesses.

Building an exit model to the VC Method of valuation is something you should do, but as more of a “you see this could work” demonstration of plausibility for an investor than a prediction that it will happen just so.

As much as the VC Method is a good exercise in putting some bounds on your start-up’s valuation, do yourself a favor and think about valuation in terms of what the market price is for similar start-ups. How do you compare with more or less comparable deals on the big three variables (team, market, and technology) and the often-neglected fourth big variable, location - or, more specifically, whether you are in a VC mecca like Silicon Valley or a VC backwater like Green Bay, or somewhere in between?

In terms of where to get information on comparables, several of the larger Silicon Valley-based law firms put out quarterly reports on deal trends by stage and sector, with additional data on trends in specific deal terms that favor investors or companies. Very useful, free information. Very useful if you are located in Silicon Valley or another of the handful of major VC investing centers. Not nearly as much of you are not located in one of those centers (though in terms of trends – in pricing and terms – still quite useful). The fact is, all other things equal, early round valuations (and capital raises) are much, much higher in Silicon Valley than Silicon Prairie. No one ever said life is fair.

If the Silicon Valley–centric data isn’t particularly on point for you, check in with the local entrepreneurial community. This includes funded entrepreneurs (not so much unfunded entrepreneurs, who tend to be optimistic); local lawyers and other service folks who regularly practice in the start-up space; and the same kinds of folks in other “between the coasts” regions with limited venture capital pools. Note that location-based differences in valuation tend to be greatest in early stage deals, deals with newbie teams, and in smaller, later stage deals (usually, if for no other reason than the exit plan is not as grand as the typical Silicon Valley exit plan). 

So, how do you distinguish your deal on the big three valuation variables of team, market, and technology/unfair advantage? 

Most VCs think the quality of the team is the most important piece of the investment equation. The gold standard is a team that has made money for investors before by working together in a similar space. Of course, those kinds of teams usually have their pick of investors, too, so if your team falls short (most do) try to get as close to the gold standard as you can. There are a lot of funded bronze teams, so flashing even some silver can get you a step up the valuation ladder. One of the better angel deals Venture Best Counsel Paul Jones was involved with had, in his conclusion, a team that was at least somewhat proven by virtue of flying (more or less without incident) attack helicopters together during the first Gulf War. A 10x deal for him.

The next box to be checked for most investors is the market. Size matters, but if two markets are about the same size, if one of them is growing significantly faster, it will get a much higher valuation mark. Not just because it will be bigger sooner rather than later, but because growth means new customers with little or no loyalty to competitive offerings.

The last of the big three valuation boxes for most investors is the technology box, perhaps better thought of as the “secret sauce” box. What is your “unfair competitive advantage?” In the biopharmaceutical business, the secret sauce is often a patent, or more often a patent portfolio. In the web application space, it is often a teeny bit of intellectual property coupled with superior execution and some branding genius. Whatever it is, sell what you have, not what would be nice to have. And if you are going to talk about having valuable patents, make sure you have valuable patents (most patents never generate any value), and also have a value-maximizing strategy for extending and exploiting those patents. (Another pitch for finding a good start-up lawyer, in this case in the IP space.)

A few things not to spend any time on in terms of valuation discussions:

No one cares how much you or anyone else has invested in your company before their investment. If prior investors overpaid, or the team under-delivered, that’s your problem. Prospective new investors could care less whether the folks already in the deal overpaid or under-performed, except as it may suggest the team needs fixing.

At the end of the day, you can argue yourself until you are blue in the face. One inconvenient fact won’t yield: your deal is worth what someone will pay for it. No more, and maybe less. Which leads to the next point…

The only real leverage an entrepreneur has in any negotiation with a prospective investor is competition for the deal. Getting the price up is almost always a function of having multiple interested investors, so fiercely resist prospective investors who want you to sign “no-shop” agreements. As much as possible, do not stop actively pitching your deal until your new investors’ checks clear. 

A final thought on valuation. If someone offers to write you a check at a valuation that seems too good to be true, it probably is. You should think about it very carefully before you do a deal at too high a valuation.

What is too high? We’ll get to that. First, what’s wrong with taking an investor’s money at a price that you know is way above market? Maybe in a given case, nothing, but more likely, a couple of things.

Someone willing to pay you far more than what your deal is worth (and if it is more than you think it is worth, it is likely far more than the market thinks it is worth) is probably a pretty dim bulb, as investors go. And dumb investors are notoriously difficult to manage. They offer little in the way of value beyond their capital to compensate for that.

Sometimes, the biggest problem with letting an investor vastly overpay is the trouble it can cause when you go out to raise more money. Here’s a real world example: An entrepreneur raised about $1 million for his ecommerce start-up. The company had made some progress and was looking for another $4 million. A VC took a look and had some serious interest, and in fact floated a deal at $3-4 million pre-money. “Not nearly enough,” responded the entrepreneur, “I mean, my first investors came in at a $100 million valuation.”

Thus, a doable deal cratered, because even if the entrepreneur (and the earlier investors for that matter) could be persuaded to accept $4 million pre-money on the new round, the new investor, having learned of the earlier round’s $100 million valuation, was no longer interested in the deal at any price.

That may seem counter-intuitive to the average bear, but to anyone familiar with our legal system it makes all too much sense. If the new investor invests $4 million at $4 million pre-money, the prior investors will be “washed out.” That is, their interest will go down to next to less than ½ of one percent. If the deal works – say it ends up with an exit value of $80 million – the new investor will get a nice 10x return of $40 million, and the old investor will get less than $400,000. The other almost $40 million will go to the founders and any other holders of common stock.

The prior investors will likely sue the investor who made all the money (and maybe the founder, too), and why not? Because with the benefit of hindsight, which is something juries are known to have a good grasp of, it would sure look like the founder and the new investor sucker punched the first round investors. In any event, this is a risk very few VCs are willing to take.

So, when is a valuation too high? It’s hard to say. A good rule of thumb in our experience is to look skeptically at any valuation that feels like, say, 3x or more of a reasonable number. And look skeptically, too, at any investor clueless enough to offer that kind of valuation. Smart investors are difficult enough to manage. Dumb investors can be even worse.