The Startup
Published in

The Startup

How Much Is Your Startup Worth?? Why Most Entrepreneurs Don’t Understand Valuation

They are Asking Themselves the Wrong Question

I remember one entrepreneur who, a year and a half after his seed round, needed to raise more money and he explained to me why his company should be worth “twice as much”.

Let’s say that his startup had received a $3 million pre-money valuation in his seed round. At that time, he had:

  • no patents filed,
  • no MVP (minimum viable product),
  • no revenue or beta customers.

In the intervening time, he now had at least one patent, an MVP, and at least one sorta-customer, plus a pipeline of many big enterprises.

What’s a “sorta” customer? You know the one — the kind that is a friend of a friend, who is trying out your product as a favor, and who may or may not actually pay for it.

“Look at all the progress we’ve made!” he said, triumphantly, justifying a doubling of valuation.

Was he right?

Most entrepreneurs think t a valuation in a financing round implies “what the company is worth” at that moment in time and how much of the company they are “giving up”.

Therefore, if the company has made progress with “more xxxx” (i.e. more product, more customers, more prospects, more users) at another moment in time, then the company should naturally be worth “more” than it was in the previous round.

Unfortunately, a valuation is not just what a company is worth.

Rather a valuation in a financing round is really a set of expectations about how the company will do in the future, based on its current state and trajectory.

In this particular case, the expectation was that he would get the product built in the first year and have at least 5–10 paying customers before the next round.

Where did this set of expectations come from? Because he pitched investors on that. Also, the expectation was that by the time he had to raise his next round, the business model and product would’ve proven themselves out, thus de-risking the venture and making it easy to bring in lots more money.

In this case, his company hadn’t met expectations. The product, technology, and business model still had many open questions. The risks were still there, from an investors perspective. So what should the company be valued at?

The answer is not so simple.

Entrepreneurs Think: How Much of the Current Pie Do I Want to Give Up?

It’s possible, for example, in Silicon Valley and the tech world, to get a $2m or $4m or $7m valuation for the same company based on just a business plan. For example:

  • If you are raising $1m in a seed round, it’s possible that VC’s might value you at $2m ($2m + $1m = $3m post-money, so investors will get 33% of the company).
  • On the other hand, if you are raising $2 m, it’s possible the same company will be valued at $4m pre-money (or $4m + $2m = $6m post-money, so investors would also own 33%)
  • On the other hand (yes, I know this implies a three-handed alien!), if you have a very experienced management team and sold your last company for good money, it’s possible that you might get valued at $6m pre-money and raise $3m ($9m post-money — and the investors still own, you guessed it, one third of the company!).

Assuming that the objective state of the company is the same (a business plan with no product or customers or revenue), how is it possible that the same company could be worth $2m, $4m, or $6m, and investors got 1/3 of the company, no matter if they put up $1m, $2m, or $3m??

The answer is that the valuation isn’t what the company is worth, but rather what investors expect it can be worth. If you raise more money, the expectation is that the company can grow faster and this alone may justify a higher valuation. If it’s an experienced team, again, the idea is that the company can grow bigger more quickly, and avoid some of the rookie mistakes, getting to a higher valuation more quickly.

The truth is that most VCs are chasing percentages of the company, and don’t really care what the actual valuation is in the early stage (in most cases). They begin to care if the valuation gets too high and they are getting a smaller percentage than they typically get (typical ranges are 20%-40% per round, for seed, series A, and series B).

To see how price is tied to expectations, let’s look at how public companies work.

Let’s say public company Hooligiggle has stock that is priced at $20.

Now, let’s suppose that the company does an announcement about a big deal that they have just signed (let’s say with Microsoft). You can reasonably expect (if it’s a good deal) that investors might push up the stock price, maybe even up to $30 on the day of the announcement.

Did the company’s underlying worth really just jump by 50% in a day? In the case of public markets, you could argue that it has, because the stock is liquid and you can sell it that day. However, the real cause of the jump was expectations about future earnings.

Now, what happens if the deal with Microsoft falls apart or has no impact on earnings? When expectations aren’t met, stock prices for public companies can come down. For public companies, of course, valuations are typically expectations based on earnings for shares which is why you always see “Oracle beat expectations of $.12 per share by 2 cents, etc.”

For private companies and startups, the expectations are not so clear cut since there are often no quarterly earnings reports.

The expectations for startups have to do with the market and what milestones (revenue, customers, etc.) the company can reasonably expect accomplish in the next 1–2 years (i.e. before the next round of financing).

But one big difference is that private companies are typically illiquid, and entrepreneurs have common stock, so you can’t just say that because VC’s bought in with preferred stock at a $6 million valuation, that your stock worth is the same.

For example, I had a company once where we got a convertible note with a 20% discount off of the next round, with a valuation cap of $12 million. Since the total raised was ~$3 million, this meant that the post-money would be $15 million (or so I thought), or so we thought.

A $12 million pre-money for seed is very high, and it came with a very high set of expectations, which we promptly didn’t meet. After much negotiation, the VC’s converted their notes at a $9 million pre-money, much less than we were counting on!

Down Rounds Are No Fun

Any entrepreneur who has experienced a down round in their startup will tell you that it’s not fun.

Technically, you could say this last example wasn’t a down-round because the previous round was a convertible note and not a priced round per se. In our minds, though, it definitely felt like a down-round because we were giving up more of the company than we thought we were.

A down round is the startup equivalent of your stock falling. It basically means that the valuation is less than it was in the previous round, often triggering anti-dilution and other unpleasant clauses. More importantly, it usually indicates a lack of confidence in the management team and is usually accompanied by replacing the CEO and starting with a fresh set of expectations for the company.

But what most entrepreneurs won’t admit, even to themselves, is that a down-round is the very concrete danger of having set valuations too high in a previous round. As I said before, a valuation is a set of expectations, and if you don’t meet those expectations, just as there are with public companies, there are consequences for startups.

In my own example above, the difference in ownership wasn’t that big (20% vs. 25% ownership by the investors). However, in some cases, the investors will ask for a re-cap, which is a down round with a vengeance. I remember one case where investors took all of the common stock (which was say 60% of the company) and re-capped it so that all the existing common shareholders got 8% of the company, while the new CEO and management got another 10–20% and the preferred stockholders (who already had preference) got the rest.

Why would the founders agree to this? It’s usually a case where they company has spent its money and there are no outside investors willing to come in. There is usually no choice but to let the company go under or accept a re-cap.

Most entrepreneurs think the rule of thumb when raising money is:

Take the Highest Valuation You can get.

Why? Because you’ll give up the least amount of stock and retain ownership of more of the company.

But this is not the best way to think about valuation.

How High Do You Want to Jump?

Another way to think about a valuation is that it is a bar that you have to jump over. Now, if I asked you, how high do you want this bar to be that you have to jump over in the next year or two? How will you react?

Most likely, you’ll want the bar to be as low as possible so that you’ll be able to jump over it without any issues. The problem with it being too low, of course, is that you look like you’re not capable of achieving much.

But when asked what valuation do you want for your company, most entrepreneurs think: I want the highest valuation possible. I’d rather have a $10 m valuation than a $5m valuation, because it means my stock is worth twice as much and I give up half as much. What they don’t realize is that they are setting the bar twice as high for themselves to jump over!

There are of course many different reasons to take particular valuations that have to do with the investors you are dealing with: personal chemistry, value beyond money, strategic partnerships.

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?

When this is the question you ask yourselves in VC rounds, your chances of having your next round be an up-round, rather than a down-round, are much higher.

A down-round can trigger a destructive cycle in the company. Founders end up with less stock, they get less motivated, more outside managers are brought in to “fix” the company, existing investors don’t talk about the company much to their colleagues, it’s started to be seen as a failure. Startups are notoriously un-fixable, so there is no guarantee that bringing in even a more experienced CEO or management team will actually increase the chances of success of the company. As a result, most startups that have a down round end up failing or being sold in a fire-sale.

An up-round, on the other hand, can start a virtuous cycle for the startup. Up-rounds happen when startups meet or even exceed expectations. Investors talk to their friends about how well the company’s doing, generating additional investor interest in the next round. Recruiting is much easier when people can see that the stock price is going up, so they want to get in as early as possible, etc. Whether it’s true or not, at least in Silicon Valley, people see that the company is “healthy”.

So, the next time you are negotiating a valuation for your company, be sure to ask the right question:

How High Do I Want to Jump?