As venture capitalists, one question we get asked all the time is “How do you value a seed or early-stage company?” The truth is that there really aren’t many tools. Later-stage companies are often valued based upon metrics such as discounted cash flows and revenue or earnings multiples. The challenge is that many of the start-ups we invest in don’t even have revenue, never mind earnings!
Trying to establish the value of an early-stage company is complicated by many factors: there is very little operating history, forecasts are guesses at best, products are usually still in development stages and markets may not be developed, the investments are highly illiquid and lastly, first-time entrepreneurs tend to have an inflated sense of value.
When negotiation a price you’re willing to pay for the stock of someone’s company, the inclination is to point out all the risks, holes, and deficiencies in the business plan. The challenge in this exercise is that as soon as the negotiations are over, you’ll be partners in the business and you’ll want to make sure that everyone’s interests are aligned. That means that founders and management still own enough of the company to feel motivated to work hard and that the venture capitalist owns enough of the company to make it an important part of their portfolio. Importantly, room must be left in the capital structure to allow for future financings.
So how do we do it? At Highway 12 Ventures, we like to start at the end. What does that mean? Well, we subscribe to the notion that any negotiation in life is successful when both parties leave the table equally dissatisfied. An outcome where everyone is “mildly satisfied” and no one feels “ripped off” is a pretty good sign that a fair deal has been struck. This is usually the result of a tough but fair negotiation process where both parties have genuine respect for each other.
The fact is, valuing start-ups is far more art than science. Much like the US presidential election process, anyone who claims to be an expert is lying. Remember Supreme Court Justice Potter Stewart’s famous quote regarding obscenity “I can’t define it but I know it when I see it?” Well that’s closer to the truth than any quantitative methodology we’ve heard of.
There are many factors that influence valuations: How big is the market opportunity? What are the risks? How experienced is the founder and the team? How much money will be required to bring the company to profitability and perhaps most importantly, how many other investors want to invest? At the end of the day, the value of your company is largely driven by commodity-like factors, i.e., what are people willing to pay for it?
Of course there are some techniques that we use to try and establish a fair value. Like most VCs, we try to extract recent comparables of similar companies that have been funded. There are some rules of thumb with regard to stage and industry. However for the most part, these are just data points that help with a predominantly qualitative process.
At the end of the day, the most important job you have as the founder of a start-up is to make sure that your company is well capitalized to attack the opportunity you’ve identified and sustain the lean early days. Whether you’re taking investment dollars from friends, angel investors or venture capitalists, realize that the first money is the most expensive. If you have the chance to raise capital for your start-up and it’s not exactly the valuation you had hoped for, think twice before turning it down. Remember one thing when raising money for your start-up, drink when served…