In my recent post on how an early-stage investor values a startup, I talk about how market comparables were the closest guide to how early-stage investors value a startup vs. any other methodology. However, I feel like I left one question unaddressed. Namely, why are there valuation discrepancies for comparable companies across the world (more specifically at investment stage rather than exit stage)?
The answer has to do with liquidity of deals, the localized risks for investors, and the supply of investors.
As I mentioned in my last post, there are various factors that can come into how an investor values a startup, but using market comparables from deals done in the USA doesn’t always incorporate all the risks that are prevalent in the specific geography where the company and investor in question operates. Furthermore, the availability of capital in any geography will also affect how an investor gauges his own risk/reward ratio when pricing deals.
I’m going to talk about this point abstractly and without incorporating the argument of the global nature of internet-based businesses (they do have some localization risk still, but less so). So, for example, startup exits for investors in certain developing economies will happen less often than say, in Silicon Valley. This has to do not only with the number of companies coming out of the country, but the universe of potential buyers for these companies in that geography.
This affects that risk an investor takes, as he is less likely to get that 10x that I mentioned in my previous post. Therefore an investor seeks a ‘discount’ to take on a deal in order to have a portfolio of deals where there is the possibility that one will be able to exit in spite of whatever market conditions exist locally. Add to that the fact that the investor may be one of very few investors, and therefore can command this discount more forcefully than if more competition existed (once enough investors exist, market pricing becomes more stable and in parity with other larger markets).
Think of it this way… If you’ve been on tourist holidays to resorts abroad, you’ll have noticed that things that are generally cheap(er) back home are notably more expensive at the resort store. This higher cost is due not only because of the transport cost to the resort, but also the cost of holding them there in inventory without knowing if anyone traveling to the resort will buy them. If the seller doesn’t include a higher premium on these items, he will not break even considering the high scrap-age risk he must take on inventory not-bought, and if there aren’t any other stores around, the store doesn’t have to compete on price either, but can continue to seek profit under the circumstances.
So, the point of this post is only to highlight why in certain parts of the world financing can be more difficult to get, but also why it can be priced differently than equivalent deals elsewhere.
One of the most frequently asked questions at any startup event or investor panel, is “how do investors value a startup?”. The unfortunate answer to the question is: it depends.
Startup valuation, as frustrating as this may be for anyone looking for a definitive answer, is, in fact, a relative science, and not an exact one.
For those of you that want to cut to the summary of this post (which is somewhat self-evident when you read it) here it is:
The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.
Whilst this statement may capture the bulk of how most early stage startups are valued, I appreciate that it lacks the specificity the reader would like to hear, and thus I will try and explore the details of valuation methods in the remainder of my post with the hopes of shedding some light on how you can try and value your startup.
As any newly minted MBA will tell you, there are many valuation tools & methods out there. They range in purpose for anything from the smallest of firms, all the way to large public companies, and they vary in the amount of assumptions you need to make about a company’s future relative to its past performance in order to get a ‘meaningful’ value for the company. For example, older and public companies are ‘easier’ to value, because there is historical data about them to ‘extrapolate’ their performance into the future. So knowing which ones are the best to use and for what circumstances (and their pitfalls) is just as important as knowing how to use them in the first place.
While going into the details of how these methods work is outside of the scope of my post, I’ve added some links that hopefully explain what they are. Rather, let’s start tackling the issue of valuation by investigating what an investor is looking for when valuing a company, and then see which methods provide the best proxy for current value when they make their choices.
A startup company’s value, as I mentioned earlier, is largely dictated by the market forces in the industry in which it operates. Specifically, the current value is dictated by the market forces in play TODAY and TODAY’S perception of what the future will bring.
Effectively this means, on the downside, that if your company is operating in a space where the market for your industry is depressed and the outlook for the future isn’t any good either (regardless of what you are doing), then clearly what an investor is willing to pay for the company’s equity is going to be substantially reduced in spite of whatever successes the company is currently having (or will have) UNLESS the investor is either privy to information about a potential market shift in the future, or is just willing to take the risk that the company will be able to shift the market. I will explore the latter point on what can influence you attaining a better (or worse) valuation in greater detail later. Obviously if your company is in a hot market, the inverse will be the case.
Therefore, when an early stage investor is trying to determine whether to make an investment in a company (and as a result what the appropriate valuation should be), what he basically does is gauge what the likely exit size will be for a company of your type and within the industry in which it plays, and then judges how much equity his fund should have in the company to reach his return on investment goal, relative to the amount of money he put into the company throughout the company’s lifetime.
This may sound quite hard to do, when you don’t know how long it will take the company to exit, how many rounds of cash it will need, and how much equity the founders will let you have in order to meet your goals. However, through the variety of deals that investors hear about and see in seed, series A and onwards, they have a mental picture of what constitutes and ‘average’ size round, and ‘average’ price, and the ‘average’ amount of money your company will do relative to other in the space in which it plays. Effectively, VCs, in addition to having a pulse of what is going on in the market, have financial models which, like any other financial analyst trying to predict the future within the context of a portfolio, have margins of error but also assumptions of what will likely happen to any company they are considering for investment. Based on these assumptions, investors will decide how much equity they effectively need now, knowing that they may have to invest along the way (if they can) so that when your company reaches its point of most likely going to an exit, they will hit their return on investment goal. If they can’t make the numbers work for an investment either relative to what a founder is asking for, or relative to what the markets are telling them via their assumptions, then an investor will either pass, or wait around to see what happens (if they can).
So, the next logical question is, how does an investor size the ‘likely’ maximum value (at exit) of my company in order to do their calculations?
Well, there are several methods, but mainly “instinctual” ones and quantitative ones. The instinctual ones are used more in the early-stage type of deals and as the maturity of the company grows, along with its financial information, quantitative methods are increasingly used. Instinctual ones are not entirely devoid of quantitative analysis, however, it is just that this “method” of valuation is driven mostly by an investor’s sector experience about what the average type of deal is priced at both at entry (when they invest) and at exit. The quantitative methods are not that different, but incorporate more figures (some from the valuation methods outlined) to extrapolate a series of potential exit scenarios for your company. For these types of calculations, the market and transaction comparables method is the favored approach. As I mentioned, it isn’t the intent of this post to show how to do these, but, in summary, comparables tell an investor how other companies in the market are being valued on some basis (be it as a multiple of Revenues or EBITDA, for example, but can be other things like user base, etc) which in turn can be applied to your company as a proxy for your value today. If you want to see what a professionally prepared comps table looks like (totally unrelated sector, but same idea), go here.
Going back to the valuation toolset for one moment… most of the tools on the list I’ve mentioned include a market influence factor , meaning they have a part of the calculation that is determined by how the market(s) are doing, be it the market/industry your company operates in, or the larger S&P 500 stock index (as a proxy of a large pool of companies). This makes it hard, for example to use tools (such as the DCF) that try and use the past performance of a startup (particularly when there is hardly a track record that is highly reliable as an indicator of future performance) as a means by which to extrapolate future performance. This is why comparables, particularly transaction comparables are favored for early stage startups as they are better indicators of what the market is willing to pay for the startups ‘most like’ the one an investor is considering.
But by knowing (within some degree of instinctual or calculated certainty) what the likely exit value of my company will be in the future, how does an investor then decide what my value should be now?
Again, knowing what the exit price will be, or having an idea of what it will be, means that an investor can calculate what their returns will be on any valuation relative to the amount of money they put in, or alternatively what their percentage will be in an exit (money they put in, divided by the post-money valuation of your company = their percentage). Before we proceed, just a quick glossary:
Pre-Money = the value of your company now
Post-Money = the value of your company after the investor put the money in
Cash on Cash Multiple = the multiple of money returned to an investor on exit divided by the amount they put in throughout the lifetime of the company
So, if an investor knows how much % they own after they put their money in, and they can guess the exit value of your company, they can divide the latter from the former and get a cash-on-cash multiple of what their investment will give them (some investors use IRR values as well of course, but most investors tend to think in terms of cash-on-cash returns because of the nature of how VC funds work). Assume a 10x multiple for cash-on-cash returns is what every investor wants from an early stage venture deal, but of course reality is more complex as different levels of risk (investors are happy with lower returns on lower risk and later stage deals, for example) will have different returns on expectations, but let’s use 10x as an example however, because it is easy, and because I have ten fingers. However, this is still incomplete, because investors know that it is a rare case where they put money in and there is no requirement for a follow-on investment. As such, investors need to incorporate assumptions about how much more money your company will require, and thus how much dilution they will (as well as you) take provided they do (or don’t ) follow their money up to a point (not every investor can follow-on in every round until the very end, as many times they reach a maximum amount of money invested in one company as is allowed by the structure of their fund).
Now, armed with assumptions about the value of your company at exit, how much money it may require along the way, and what the founding team (and their current investors) may be willing to accept in terms of dilution, they will determine a ‘range’ of acceptable valuations that will allow them, to some extent, to meet their returns expectations (or not, in which case they will pass on the investment for ‘economics’ reasons). This method is what I call the ‘top-down’ approach…
Naturally, if there is a ‘top-down’, there must be a ‘bottom-up’ approach, which although is based on the ‘top-down’ assumptions, basically just takes the average entry valuation for companies of a certain type and stage an investor typically sees and values a company relative to that entry average. The reason why I say this is based on the ‘top-down’ is because that entry average used by the bottom-up approach, if you back-track the calculations, is based on a figure that will likely give investors a meaningful return on an exit for the industry in question. Additionally, you wouldn’t, for example, use the bottom-up average from one industry for another as the results would end up being different. This bottom-up approach could yield an investor saying the following to you when offering you a termsheet:
“a company of your stage will probably require x millions to grow for the next 18 months, and therefore based on your current stage, you are worth (money to be raised divided by % ownership the investor wants – money to be raised) the following pre-money”.
One topic that I’m also skipping as part of this discussion, largely because it is a post of its own, is “how much money should I raise?”. I will only say that you will likely have a discussion with your potential investor on this amount when you discuss your business plan or financial model, and if you both agree on it, it will be part of the determinant of your valuation. Clearly a business where an investor agrees that 10m is needed and is willing to put it down right now, is one that has been de-risked to some point and thus will have a valuation that reflects that.
So being that we’ve now established how much the market and industry in which you company plays in can dictate the ultimate value of your company, lets look at what other factors can contribute to an investor asking for a discount in value or an investor being willing to pay a premium over the average entry price for your company’s stage and sector. In summary:
An investor is willing to pay more for your company if:
It is in a hot sector:investors that come late into a sector may also be willing to pay more as one sees in public stock markets of later entrants into a hot stock.
You have a functioning product (more for early stage companies)
You have traction: nothing shows value like customers telling the investor you have value.
An investor is less likely to pay a premium over the average for your company (or may even pass on the investment) if:
It is in a sector that has shown poor performance.
It is in a sector that is highly commoditized, with little margins to be made.
It is in a sector that has a large set of competitors and with little differentiation between them (picking a winner is hard in this case).
Your management team has no track record and/or may be missing key people for you to execute the plan (and you have no one lined up). Take a look at my post on ‘do I need a technical founder?‘.
Your product is not working and/or you have no customer validation.
You are going to shortly run out of cash
In conclusion, market forces right now greatly affect the value of your company. These market forces are both what similar deals are being priced at (bottom-up) and the amounts of recent exits (top-down) which can affect the value of a company in your specific sector. The best thing you can do to arm yourself with a feeling of what values are in the market before you speak to an investor is by speaking to other startups like yours (effectively making your own mental comparables table) that have raised money and see if they’ll share with you what they were valued and how much they raised when they were at your stage. Also, read the tech news as sometimes they’ll print information which can help you back track into the values. However, all is not lost. As I mentioned, there are factors you can influence to increase the value of your startup, and nothing increases your company’s value more than showing an investor that people out there want your product and are even willing to pay for it.
Hope this helped! Feel free to ask questions in the comments.
A startup’s management team is its lifeblood… no amount of awesome ideas will ever overcome a fundamentally flawed management team. In the early stages of any startup, it is all about the people.
But what makes up a good team? How do you know if you have a good team, if you are a good team member, and if an investor will perceive you the way you perceive yourself?
Perhaps it is best to then approach this question from a different point of view…
A startup is fraught with challenges from day one. These include commercial, HR, and technical hurdles of all sorts, to name a few. These generally require a certain attitude and personality attributes from the founders for the startup to have a chance at surviving.
These personality attributes include a combination of confidence, stubbornness, individuality and a sense of self without arrogance, curiosity, humility, energy, maturity, and an eagerness to learn. I have found that founders that share many of these characteristics tend to fare better over the long run than those that do not share these.
While the above are just personality attributes of a likely ‘good’ founder, the equation is in fact far more complex. In addition to the above, I also believe you need to include the following variables as well when doing an analysis:
1) The technical or commercial competency (depending on their focus) of the founding team. This can either mean the founder(s) have the relevant experience from either having done a startup before (or the relevant role) or they have developed the appropriate skills necessary to execute on the stated vision of the company.
2) The ability to resolve conflicts quickly and constructively within a team. As most teams will likely hit road blocks when they can least afford them, an ability to either insert humor at the right time, or to divide a problem into parts, or know when to take a break, can all be really important skills to demonstrate the longer term likelihood of a team staying together and working well in spite of the inevitable conflicts that will arise. Although I have heard of some investors doing an artificial ‘stress test’ during investment reviews, it isn’t standard practice for you can usually tell just from spending time with a team, when a team may have potential internal personality issues.
3) Intuitively know when to persevere and when to quit (on anything). Some people just quit too early, others keep on going too long beyond the point when a strategy is the right one to use. Although harder to evaluate when meeting a founder or their team, this is an important attribute to have internally so as to use an investors time and money most optimally.
4) The team understands the assumptions and metrics about the market they wish to operate in, or have at least an understanding on how to research this information (the Lean ‘Build Measure Learn’ loop is a good example of a framework that is applied). An airplane pilot can fly an airplane through the dark and through really bad weather because he understand where he was, where he is going, and what he needs to be keeping an eye on the dashboard during the flight. Every great team I’ve ever met always understood the dynamics of their market well enough, knew what they needed to find out as part of what their startup was attempting to do, and knew how to measure it so as to know if they were going down the right ‘flight path’.
5) The team or founder can articulate their thoughts and plans. Communication both internally and externally is the most important thing to get right within an organization. It makes absolutely no sense if you have an awesome coder who can put out some amazing things if they are wrong because he didn’t get specificity from management or didn’t understand what he was supposed to be working on. Also, it is pointless if the founders of a company are awesome at building product, but then are entirely unable to communicate their vision to the outside world to both interest others to join their business and also to raise more capital.
6) Although defined as ‘working together to achieve a common goal’, I believe you could argue that collaboration can be summarized as a combination of both conflict resolution skills and communication skills. A team’s ability to collaborate both internally (with team members) and externally (with biz partners, investors, and the media), I believe, greatly increases the chances that they will succeed.
7) The geographical spread of a team is also something to be considered. This has mostly to do with the dynamics of working as a team. Yes, Skype has done marvels to revolutionize the way we communicate, but for the necessary ‘collision’ of ideas (borrowing from Steven Johnson’s book on Where Good Ideas Come From) to occur repeatedly, close physical proximity is an asset for any new team.
8) The equity spread between founders. Although generally speaking most founding teams have an equal equity spread (50/50, 33/33/33, etc) an investor will take note if there is an equity imbalance that makes for a key hire or co-founder to feel unmotivated.
So, when I meet a startup’s management team… aside from looking at the attributes I’ve listed above, I generally ask myself three questions:
Does this team have the necessary experience it takes to deliver what they have set out to do? (Teams with technical founders are of particular interest to me).
Does this team have the insight to identify their own weaknesses and hire good people to complement them?
Can this team constructively deal with all the challenges that are and will occur during the life-cycle of a company?
Once I feel like I’ve been able to answer these questions while also keeping an eye out for the attributes I’ve listed above, then I feel comfortable in appending the arguably overly-simplified statement of “they have a good team” when speaking about a startup.
So, some parting thoughts and advice for anyone evaluating their own team in the context of forming a new startup or raising money:
Get a co-founder that complements your skills
Understand what skills you lack as a team and hire them
Research the hell out of your market & understand your customers
var stated_vision = (think_big) * 2; -> multiply your vision by two.
Rehearse your pitch A LOT
Don’t be arrogant, but also add some spice and humor to your presentation
In my experience, the more subjective a subject matter is, the better off you are by getting more opinions to ‘triangulate’ around a ‘right answer’. To that end, I asked some friends of mine what their thoughts were around this topic. I have included their thoughts below:
In my view, I look for three things:
(i) Leadership: a CEO who can articulate a vision that excites and imbues a sense of mission in his team is very important. This is often evidenced by the calibre of team he is able to recruit around him [when he has nothing else to offer].
(ii) Self Awareness:
a) Breadth: businesses need ‘flour to balance the yeast’. The great teams have a balanced breadth of expertise and experience, not just one hero.
b) Evolution: as a business grows, so the team must evolve. A willingness to embrace this change is critical.
(iii) Openness: We look for teams who are willing to consult and collaborate. We are not good passengers and we wish to work closely with and assist teams wherever possible.
“I look for founding teams with a balance of skills in the following three areas:
1) design / ux, 2) marketing / distribution and 3) tech.
However the skills are distributed amongst the founders, they need to be present. I don’t worry too much about traditonal management skills, other than the founder who is the CEO showing a desire to learn them.”
“When we look at very early start ups, there is not much to judge, but the story and how it is told. The delivery of the story is as important as its content. The founder(s) have to be credible. One of the issues is that technical founders are proud of their technical competence and tend to overdo it on tech and lose the perspective of the other side of the table, that is thinking “are these guys going to make me money?” That is the bottom line, but it is not a question you can ask directly. The first attempt to answer comes out of the observation of the team during the first hour of meeting (it then needs more time to confirm it, but if the first impression is negative, there is the end of the journey). Are they passionate? Competent? Ambitious? Do they come across as honest and dedicated? Is this “a project”, or is this the thing they will be doing 22 hours a day for the next years? how is the team dynamic? Do they complement each other or are their duplication of the same guy. Is there a decision making process, or is it one guy that decides. Do they argue against each other (bi no-no during the pitch) or they have built a good delivery of the pitch so that it shows maturity and collaboration. “
“Eden likes to invest in a team. That is NOT one founder who has hired a group of employees but still holds all the equity him/herself. To us, a team is a group of like-minded people who have come together to pursue a common vision. They are all ‘at risk’ in the opportunity and so are looking for significant wealth creation. They regard each other as ‘peers’ in the business and have comparable equity stakes.’
They have to be smart. And persistent. One good sign is where the team worked together before, it didn’t work out but here they are again on the next gig. Let’s call it ‘stickability’.
‘It’s easy to build a team once you have raised money. We often hear that ‘the team will come once the money is in’. This is not what we are looking for – we are looking for a team that has been built on a common vision through the tough times of starting a company. Where the founders have got behind the opportunity, as a team, before the cash came in.'”
“There are lots of “obvious” qualities which a founder/management team should have – they must know their market, they must me smart, they must be extremely dedicated etc. This has been said a million times already of course, but that doesn’t mean it’s wrong.
To pick one quality which is particularly important from our point of view, the founders need to be able to build a kick-ass product which solves a real problem. As early-stages investors we can and love to help in many areas like sales, marketing, hiring, financing etc., but the ability to create a great product with a clear product/market fit is something we believe needs to be in the founder team DNA.”
Going into any new legal agreement is scary. On the one hand, you’ve seen enough movies to know that legal documents can have all sorts of loopholes and/or subtleties that feed your paranoia about walking into a trap at some point in the future, but on the other hand, you know you need to get them done in order to move on with any deal.
Legal docs are just part of business life.
The thing is, though, that it doesn’t have to be something that is so scary that you need to be extremely paranoid about. This is particularly the case when you’ve been able to bring on a good legal firm on board. Good legal counsel can basically help you understand all the tools in the legal toolbox. What the tools are for, how they are used, when they are appropriate, and what they are protecting against, etc.
Now, when I mean good legal counsel, I don’t mean your cousin’s best friend who is a lawyer and can do it on the cheap or a favor. That is probably the single worst thing you can do in terms of starting off on the right foot with your investors, you’ll waste their time and yours. If you can’t find good legal counsel where you live or nearby, then go outside of your area or move your business (and the good thing is you may not have to do it physically either). One sure sign of a startup ecosystem being mature is the availability of top tier legal firms in the area. If you need to move the legal state of your company to get access to these… do so, you won’t regret it. If you don’t know where to start, cold-call a startup you admire and ask around.
A good anecdote always helps in illustrating the point…
A few years ago, I was working with company that had reached out to a local lawyer, but not one that specialized in venture law. After having provided the company with standard industry docs, a long, almost two week period followed where I didn’t hear back from either the company or their counsel. Then, once I did receive the documentation, it was red-lined so much that it took another week just to come up with the response. As you can imagine, every single conversation we had was tough and grueling, and the entrepreneurs, grew increasingly paranoid that we were trying to get the better of them, but it was mostly due to the lawyers providing poor advice on items that we standard across the industry. This carried on for a few weeks with volleys going back and forth and various stalemates being reached at different points. In the end, we did reach an agreement, but it was after much work and much education. The situation was salvaged in the end, but it didn’t have to start off like it had. And, as you can imagine, the legal fees were over budget.
1) Validates your company. The best Firms will be selective of whom they work with. Their time is valuable as is their reputation. Working with a top tier firm definitively says something about your company.
2) Saves you money. Yes, it sounds counter intuitive, but whilst you may pay higher in terms of fees, you’ll spend less on legal fees in the long run with the reduced issues that you’ll have during a negotiation as well as with any future issues that are the result of poor legal advice.
3) Saves you time. As mentioned in #2 above, the time an experienced lawyer takes going through documents they’ve seen time and time again is a huge savings over a lawyer who is getting acquainted with the docs on your time and money. Additionally, that time could be better spent on helping you think of what realistic scenarios you are trying to protect yourself against rather than making mountains out of molehill standard terms.
4) Helps you consider the future. As your company will go through many permutations throughout its life, a good and experienced lawyer will not only be able to help you with your current situation, but also in preparing you for situations to come, be they setting up your company in a specific way, to how you should try and negotiate with potential investors.
5) Good counsel knows the industry players. By the very nature of being a top tier legal firm, they will have worked and will know the top tier investors first hand. The firm will know what the investors tend to offer in their deals, what to expect as being standard in their terms, and what might be out of the norm.
After considering the above, however, you do have to manage your counsel. In the end, you are responsible for every item on your documents, and only you care as much about your document as well.. you do. So as much as great legal counsel can help you on not making mistakes, don’t slack off during the process. Stay engaged, you’ll learn a lot.