A Founder’s Guide to Startup Valuations in Colorado

Startup Valuations are an elusive dance where you learn a lot about founders and other investors. More often than not, the valuation conversation is a pretty straight forward one, but in the cases it’s not, it can easily create a lot of anxiety and headaches or even needlessly kill deals.

It tends to be just a little more science than art, and in the past four years operating in Rural Colorado, we’ve seen some incredible swings from each side of the table in how they approach valuations.

This includes investors paying way too much for companies (EG 20x revenue), or inversely, forcing exceptionally low valuations (buying X% of the company with a $Y check).

On the other side of table, we’ve had founders with little more than ideas try to convince us that they are worth 100X standard market norms.We’ve spoken with first time founders that think it’s normal to give up half their company because they see it happen on Shark Tank.

This post is for founders and investors alike. It’s a series of resources for understanding the economics, best practices and dynamics to expect when it comes time to determine the value of your company. Enjoy!

Know What You’re Signing Up For:

Valuations determine the growth path founders are committed to for the life of the company. We’ve seen founders get swept up with the napkin math of how much they are worth and believe that higher is always better. That is absolutely not the case.

“How Much Is Your Startup Worth?? Why Most Entrepreneurs Don’t Understand Valuation” by Riz Virk does a great job outlining this dynamic. This is a conversation we now force ourselves to have with any founder, which ironically, most investors neglect to do which leads to founders running into this wall after the fundraising honeymoon period.

“However, when it comes to valuations, the real rule of thumb should be:What is the highest valuation I can get, with expectations that I can reasonably exceed?”

Pricing Dynamics and Instruments:

Convertible note essentially punts on the valuation exercise; however, it can lead to some real issues down the road if you’re raising equity.dThis article unpacks why setting a valuation is important for companies and some of the pitfalls of using convertible notes with valuation caps by Mark Suster: “Bad notes on Venture Capital”

“I have never come across a sophisticated A, B or C round venture capitalist who thinks convertible notes are a smart move for entrepreneur or investor. They only people I have heard promoting them tend to be super early stage investors or accelerators and often when I talk to them about the structure they’ve never given much thought beyond “they’re easier,” “they’re cheaper” or “it’s faster to raise this way” none of which is actually true.”

Market Data

Market data for rural Colorado is non-existent, and companies need to understand that they are playing a different game in CO than Silicon Valley in terms of investment sizes, valuations, access to talent — most of which are driven by exit potentials. While not 100% applicable to our market most of the time, you can get a good sense of some regionalized data and market norms on angel and seed stage investments form the Halo Report. You can find the 2018 report here. Key points:

• Median Seed/Pre-Series A valuations across the country were $5M with median round size of $703k.

Know Your Alternatives

The Silicon Valley model of investing and startups isn’t great for a lot of companies. It is our fundamental belief that companies and their investors can still focus on goal posts like profitability and still build highly profitable and scalable businesses.

As you might guess, we’re not in the business of unicorn hunting. While we’d love to see companies like that get created, we know the statistics of creating one anywhere is very very low, and even lower in our market, so we choose to model our portfolio on much larger set of more modest exit potentials. This article from Aner Ben-Ami called “Don’t go Chasing Unicorns” outlines the Revenue Based Investment approach that we are very keen on for some ventures.

“Venture capital should never have become the standard way for us to fund new businesses. As an asset class, it’s uniquely designed to fund disruptive innovations. It does this by funding ventures that are likely to fail, but — if successful — can result in outsized outcomes. In other words, it’s a ‘home run’ based model. For a venture capitalist, seeing 6 or 7 out of 10 portfolio companies fail is part of the playbook.”

The Negotiation

One of the best pieces of advice I ever received when fundraising was to think of my investors like customers. That mentality forces you to predict and better navigate the entire process.

When investors work with entrepreneurs who have not done any self education on valuation, it can create unnecessary friction for both parties. We’ve seen several deals where we have to completely shelf a conversation about a specific valuation or investment in order to help educate a founder (or their investors) about standard terms, approaches, market norms, etc. The inverse is true as well. As an entrepreneur, it is worth preparing for valuation conversations. In another post from Mark Suster titled “How to Talk About Valuation When a VC Asks”, he breaks down the actual dynamics of the conversation and how entrepreneurs should think about positioning themselves.

“One of the hardest things about the fund-raising process for entrepreneurs is that you’re trying to raise money from people who have “asymmetric information.” VC firms see thousands of deals and have a refined sense of how the market is valuing deals because they get price signals across all of these deals. As an entrepreneur it can feel as intimidating as going to buy a car where the dealer knows the price of every make & model of a car and you’re guessing at how much to pay.”

But How do I Actually Come up with a Number?

The reality is that the real value of your company is what someone is willing to pay for it. That simple. That said, there are a handful of accepted approaches that may or may not make it into your VC conversations. Here is a great outline with examples titled “Valuation for Startups. Nine Methods Explained.” As with most VCs, we mostly are looking for method #4 — comparables. As stated:

“Keep in mind that the only methods really used by VCs are comparables and a rough estimate of how much dilution is acceptable by the founders”

How Much Do Valuations Actually Matter?

The last resource worth sharing is probably the most comprehensive outline of how valuations might be determined with the emphasis that if the company is successful, there are many strategies and different dynamics beyond just valuation. In “The Illusion of Startup Valuations,” David Odom provides a great example at the end as well as a great simplified framework. If you take one thing away from this series of resources here, it’s his framework:

“A valuation is book-ended by two strong constraints: 1) a floor that maintains equitable Founder returns to keep the team incented and allow for a valuable Stock Option Pool to attract employees; and 2) a ceiling that maintains Investor return multiples that support the investment fund’s target return rate, in the context of a weighted average risk profile of portfolio outcomes, and future company capital raises. By considering a transparent and comprehensive analysis of return outcomes and the capital lifecycle of a startup, there is room for a more reasoned valuation discussion between early stage Founders and Investors.”

IN CONCLUSION, we can’t promise you’ll know exactly what your startup is worth after reading the above, but you’ll be armed with a handful of different mental models and communication tools to make the process more objective and painless for all parties. If you have any other good articles to share on this topic, please post them in the comments below!