Posted On March 7, 2012
Most early stage valuation is voodoo. I have made financial models for early stage companies and I have had them pitched to me. They are mostly fiction. If you read David Einhorn’s book, “Fooling Some of the People All of the Time,” he has a long section on competing theories of valuation of current, investment-grade corporate debt that result in drastically different valuations. If a bond–a contract with a healthy (or not-so-healthy) operating company–is so difficult to value, imagine the complexity of valuing a pre-revenue company. Yes, there are ways people do this and even algorithms that people will claim work, but they are voodoo. There are people who can come up with reasonable valuations for companies with algorithms they swear by and have a good track record with using, but it’s an art, not a science. people who come up with reasonable valuations for start-up companies in a repeatable way mostly just have a good gut.
An early-stage company is valued on a bunch of things:
- Assets such as protectable intellectual property. These are a backstop against total loss and a sweetener in an acquisition — patent revenue takes years to develop, and most people can ignore your patents with impunity for years if management is focused on operating rather than suing competitors. Another asset could be some sort of exclusivity or barriers to entry. Few people will consider partially finished software (for example) developed by you–or worse, your contractor–to contribute much to valuation.
- Opportunity: is there something special that makes now the right time to do what you are doing? Is there something special that makes you the right person in the right place? Do you have your first 3 customers ready to place an order before your product is complete? Is there some first-mover advantage and you have good knowledge that you are, in fact, the first mover? Will some company need to acquire you in 3 years because they don’t know but you do that something will change in the marketplace?
- Your team: Do the principals seem like people who work together well? Do they believe in what they are doing? Do they listen to each other? If one jumps in with an idea, are the others pleased or annoyed? How will they hold together when things get hard? Many investors invest in teams and there are many cases of a great company rising out of a great team despite the failure of their initial idea. Remember, Gates and Allen started out counting traffic.
- Your business plan: Have you thought it through? Does it show insight and judgement? Are you enthusiastic for your opportunity but don’t live in fantasy land? Dwight Eisenhower once said that plans are nothing, planning is everything.
- You: Have you started a company before? Was it successful? Do you know how to recognize success? Have you overcome set-backs? Are you a crash-and-burn person if things go wrong?
There are many VC’s who don’t want to co-invest with managers. They’d rather management not have their own money in the business because they don’t trust what will happen if you lose it. They’d rather you make rational decisions to preserve capital and cut losses than take your last $100k to Las Vegas because then at least there’s a chance.
If you are reading this, you probably are making a tech company. Since 50% of corporate tech projects fail (still), your business could sell for more than double what it would cost for a big company to hire someone to do it for them. Kaiser Permanente spent $1.1B on a failed health record project. This is why there is often a disconnect between the discounted present value of your free cash flow and the enterprise value at sale of a tech company: big companies value an opportunity based on their cost (not yours) to replicate, and their cost (not yours) of being out of the market. Of course, unless you have a strong position, they’ll make a bid based on the lowest amount you are likely to take.
The most important thing for you to get right in your business plan is to understand when you will need capital to stay in business, and raise that capital well before zero hour. In any capital raise, you are much better off if you can say, “I need this money to accelerate my growth,” not “I need this money to stay in business.” No matter what your business plan says about your prospects, if you need the money to survive, your valuation goes down. If you need it to grow faster, your valuation goes up.