How should you value your startup or scale-up's early equity rounds?

From time to time I’m asked by an early stage startup or scale-up if I can help them figure out the valuation they should seek, particularly in a seed round.

Although I try to help, the honest answer to that question is “no,” for several reasons. 

First, lawyers aren’t valuation experts. 

Second, and perhaps more to the point, the valuation of a startup or, indeed, many scale-ups, does not involve the use of classical valuation methods. As a result, there can be large differences in view between different potential investors and, even more, between different markets. Consequently, much of the analysis is based on local “rules of thumb” (influenced by stage, vertical, and the like, as well as company-specific factors).

Classical Valuation

Classical valuation methods include (i) earnings/cash flow value approaches (e.g., a multiple of historical or projected earnings or discounted cash flow), (ii) asset value approaches (a view of the value of assets net of liabilities), or (iii) comparisons with comparable established businesses. In a mergers and acquisitions context, potential cost savings and synergies in combining the businesses are also relevant. Customarily, valuation professionals use a combination of these methods.

The problem is that these methods are not relevant to startups or many scale-ups. These businesses may be pre-revenue, may in any case have negative cash flow, and are unlikely to have much by way of assets.

So, by these standards, most startups and many scale-ups would be considered worthless or worth very little.

Venture Capital Valuation

Early stage venture capitalists and business angels obviously take a different view, and value startups and scale-ups based on a view of their prospects. Effectively, the early stage VC is betting that (i) this founder team (ii) executing this business concept (iii) against actual and expected competition (iv) in the context of this addressable market and (v) with the capital investment provided by the VC (and by it or others in successive financing rounds) can reasonably be expected to achieve a 10X return on investment by the early stage VC. Needless to say, this is a highly subjective exercise.

If one looks on the web, one finds a number of blogs and articles on how to value startups. I think some are well-written, such as this one by Stéphane Nasser, “Valuation for Startups – 9 Methods Explained.” http://bit.ly/2HvhVbV A number of the methods discussed do take into account the subjectivity inherent in startup valuations.

However, I think the honest answer is that, as with many hard-to-value assets, valuation of startups and scale-ups is largely a matter of market demand. Consequently, the answers in different markets can be very different. Perhaps a bit of this difference may reflect a real difference in risk – for example, it may be harder to build a successful global business from a starting point in market A as compared with market B. Most of it, however, relates to the depth of the local investor community and investor competition for investments.

This difference in valuations in different markets is particularly important because early stage venture finance is, generally, very local. In my experience, the substantial majority of early stage VC’s are only willing to invest in a company if there is a founder being nearby (no later than the time of the investment) with a business plan based on a market that the VC thinks it understands. 

Founders of non-US businesses sometimes say to me – “If I was in the Silicon Valley I would be able to get a significantly higher valuation.” That may well be true, although one needs to take into account that the costs of operating in the Valley are much higher than most other places.  However, for the most part this is a sterile discussion unless a founder is willing to move to the Valley and develop the business based on an US-focused business plan.

Entrepreneur standpoint – factors other than valuation

In any case, I think that a high valuation, in and of itself, is not a sensible objective for entrepreneurs. 

Long-term Dilution

Founders should instead aim to secure the least dilution possible over time in the context of building a successful business. If only a single raise is required, securing the highest valuation possible may be the best way to achieve that. However, if multiple raises are going to be required, too high a valuation at an early stage may result in a subsequent flat or down round that complicates (and may prevent) the securing of further financing. 

Consequently, early overvaluation may kill the business or, in any case, result in greater dilution in the aggregate than if the earlier round had been done at a lower valuation or if more had been raised in that earlier round.

A sensible starting point for entrepreneurs is to think about how much they will need to raise over time to achieve their milestones and build a business that no longer relies on venture capital finance, and to consider how much dilution they will suffer as a result. Valuation is a key part of this puzzle, of course, but another key piece is how much money you are going to need, and how many raises you are going to need to do. What you can achieve through bootstrapping is also part of this exercise. Of course, you also need to consider the impact of competing against companies that have raised more or otherwise are better capitalized than you are.

Sophisticated early stage VC’s and angel investors understand the risks associated with taking too big a share of the equity too early. While they are focused on their ability to secure a 10X return at the end of the day, they know that founders incur a significant opportunity cost in working on a startup. Consequently, excessive dilution of founders at an early stage may dull their motivation to continue to build the business over time. 

I know of good businesses that effectively became uninvestable at Series A because seed investors had taken too large a share of the business. This is particularly an issue in countries that do not have an established early stage venture capital market. The only solution to this, which can be hard for investors to accept, is for those seed investors to permit the dilution of their equity in favor of founders.

Burn rate and runway

Entrepreneurs also need to take into account their burn rate and runway, and how long it will take to show demonstrable progress in the business. The process of raising venture capital is a distraction for the senior management team, particularly at early stage. Additionally, the business is likely to fail if it runs out of money before achieving positive cash flow, and achieving success always takes longer than you expect. Consequently, if at all possible, founders should seek to raise for at least an 18 month runway, with a view to completing the next raise (if required) no later than six months before the expiration of that runway.

Risk

More generally, entrepreneurs must consider their overall risk appetite. As discussed above, some of this risk relates to burn rate and runway, including, for example, product development risk and sales risk. 

However, some of it is a matter of finance market risk – the robustness of the venture capital market is affected by external economic considerations and by changes in the venture capital market itself. Entrepreneurs cannot assume that the next round of venture capital finance will necessarily be available when they need it, or available on terms that they find acceptable. For example, the emerging companies that survived the dot-com crash in 2001 were those that were well-capitalized when it happened. Consequently, the decision as to how much to raise at any particular time is influenced by the entrepreneur’s risk appetite.

Investor Quality

Last (but by no means least), founders should assess the quality of their potential investors, and what they bring to the table. For example, investors can play a critical role in helping companies secure their next raise, assisting them to meet and hire the right talent, and otherwise supporting the founders and the business. These elements are part of the overall value of the investment, and money is only one aspect.

Conclusion

In short, the valuation of early stage businesses is very much in the eye of the beholder, and that is heavily influenced by the market in which the business is based.  Valuation is only one factor that founders should consider, along with anticipated dilution (over time), capital needs, runway, risk and potential non-monetary investor contributions to the business.

* * *

This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact [email protected].

You will find a listing of Bob’s startup and scale-up blogs on US and international expansion and other startup and scale-up matters here: http://bit.ly/StartupGuidesIndex