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Been talking to a lot of different startups in different industries at different stages about valuations.  I have a couple of portfolio companies going out to raise money, and one that just finished.  It’s an interesting conversation to have. I try to put myself in the shoes of the entrepreneur, and then I put my own shoes back on.  I also try to look at the over all market to get a feel.

There is no set formula for valuations in venture backed companies.  There isn’t a math equation that you can pump numbers into and spit out a value on the other end.  It’s not like Private Equity finance or M+A finance where you can calculate a WACC, estimate revenue, expenses and cash flows, discount them back and come up with a terminal value of the company.

The first thing that anyone should know about valuation of a startup is that this is not necessarily about the money.  Corporate finance when it comes to early stage investing is a strategic play-no different from a marketing plan or development plan.  If you screw up your valuation in the first round, you can screw up the company.

You might say that it’s best to follow the story of Goldilocks and the Three Bears.  Not too hot, not too cold, but just right.

If a company values itself too highly, two things will happen.

1. It will have trouble getting capital in the door because the market isn’t in equilibrium with their projected initial valuation
2. If they raise at the high valuation (too hot), they will have to hit their growth targets or exceed them to raise the next round at a higher valuation.  The risk for a down round increases, and dilution.
3. If you happen to raise a round at this valuation, many times it’s because the investors have a lack of sophistication.  That has different implications for an early stage company.

If a company values itself too cheaply( too cold), other aftershocks happen

1. Too much equity is given away to investors too soon.  That makes it difficult to hire quality employees-and takes economic incentive away from founders.
2. Not having enough equity might make future rounds harder to raise

The just right achieves a balance between founders and investors and allows the company to grow.  It also allows the company to absorb the bumps and bruises of early stage growth without it being a danger to future rounds of financing.  Having the right balance (and the right investors) gives peace of mind to the management team-allowing them to concentrate on building a blow out business without worrying about equity, exits and meaningless stuff that have no bearing on the company in the present.

This is even true at later stages of financing.   Snapchat raised a big round at a projected $19B valuation.   What’s their exit strategy?  If it’s an IPO, how does Wall Street value a company with lots of users and engagement that is really cool, but has virtually no revenue?  Alternatively, who is a potential buyer of Snapchat with cash that will pay a multiple of $19B that will make later stage investors money? VC Bill Gurley has repeatedly warned against over valuing companies-especially in later stages.

Get your valuation right.  Raise enough capital to give yourself a nice big runway. Then put your head down and build.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.