How to value your early stage startup

 By Aron Solomon

Meet Alan Yang.

When not expertly pouring wine in China, Alan is a Toronto-based VC, working for The Canada China Angels Alliance, one of the most active early-stage investors in Canada.  Alan and his colleagues have been wonderfully profiled in this Globe and Mail article.

So Alan and I were discussing early-stage investment last week, as we move from 120 discussions, to 60 meetings to 20 finalist interviews (mid-July) to 10 selected startups for the CAMP Program, in which we work together. And, as is the case almost daily in discussions Jason and I have at Law Made, the topic of early-stage valuation came up.
Before I go off and tell you that startup valuation shouldn’t be based upon the startup’s potential, here’s a fairly iconic image these days of exactly that from Funders and Founders.


From Funders and Founders

And this is actually an okay starting point (really no better or worse than most of what’s out there) for something that’s complex and startups tend to do very badly.

The reality is that where a company isn’t a publicly-traded one (startups aren’t) and information is incomplete (as is always the case with startups, who are constantly trying to prove new hypotheses) determining the valuation of a startup is very, very difficult, whether you’re in Toronto, Beijing, or anywhere in between, and particularly when the startup is pre-revenue, as the vast majority of early-stage ones are.

Our first piece of advice is not to use silly online calculators, such as this one.  They’ll hinder more than they’ll help.

Yet you should absolutely look at resources such as the superb ones over at Mattermark, who are great friends to startups. They have a range of helpful things on their site, including a really interesting case study on the pretty amazing coffee business Blue Bottle, one of the best in San Francisco, which is one of the best coffee cities in the world.

ming-chen-84613But these are heavy reads, especially for the novice entrepreneur, and much of the early-stage advice one finds through googling comes through very self-centered lenses (writ: see things our way so that we, probably not you, can benefit). Honestly, those of you who know me know that I don’t write pieces like that. And, if you know me or even know of me, you know that when I vouch for someone, it’s gold. And I vouch for Alan. I’ve known him for a while and he’s good people, concerned with the long view and helping founders building successful businesses.

So what we’re going to tell you today comes out of a lot of years of experience and zero self-interest. Ten points. Nice and simple.

(1) Stop looking for a perfect valuation formula because there isn’t one. There are several methods that people might use to calculate what they think your valuation is. Again, if you see early-stage startup valuation as a science, you’re totally wrong. One you have predictable revenue, that’s one thing. Otherwise, you can consider perspectives such as the Berkus Method, which, while it’s interesting, still provides nothing but a massive valuation range, is subjective in every way, and still doesn’t take into consideration that no matter what valuation it comes up with for the startup in issue, if investors aren’t willing to pay that price, it ain’t gonna happen.

(2) Timing is critical and it can really suck when you’re on the wrong end of it. Like when you’re seriously running out of cash. When you reek of desperation, investors can smell it. And the last honorable ones will squeeze all the juice out of this that they possibly can.

(3) Know exactly how much of your startup you’re willing to give up for the amount of money being discussed. This may seem really elementary, but if you’re trying to raise $200,000 and are willing to give up 20% of your startup in exchange for that investment, your pre-money valuation is $800,000 and your post-money is $1,000,000. If you go in with this in mind, and the conversations you’re having with investors show that they might be willing to invest that $200,000 for 40% of the company, there’s a fundamental disconnect in perspective and you need to quickly figure out why. Sorry, but more often than not it’s something like “they don’t get how much potential our team has!!”

(4) Your startup is almost certainly worth less than you think if you’re pre-revenue. Truly, revenue is the greatest favor you can do for your startup when it comes to raising money. Being able to show that people are using what you’ve build and that some of them are paying is an absolutely superb thing. Then, crafting a story around that as to how big this business will get can help you get investors on board at a valuation number that makes the most sense for you. More on this later.

(5) Most startups wildly overvalue their team. Again, sorry, but when your team slide has four founders fresh out of college with a narrative around how you’re all so damn smart, this may very well be true, but will and should hold little weight. Yes, investors want to invest in teams they like, including teams of very new founders. But unless your team slide includes founders who’ve already had massive exits, it doesn’t affect valuation and focusing too much on it makes you look like you’re brand new to the game.

(6) The vertical you’re in will absolutely affect your valuation. Fire is fire. When you’re in a very hot space and everyone wants to invest in that space, this is good. When you’re in an unproven startup vertical, or one that has long ago hit its peak and is saturated with more mature competition, this will also affect your valuation in a negative way. And, yes, in a hot space where there is FOMO, you can and should use this to your advantage.

(7) Compare others doing similar things. Your investors will. That means not only a cursory analysis of the competitive landscape, but some real digging on how much they’ve raised, terms, whatever else you can find out.

(8) Get yourself into the mind of the investor. Alan talks about aiming for the 20 bagger, which is a 20x return on investment. That doesn’t mean that the investor will always hit this rate of return (they extremely rarely will) but it’s a goal and it’s not one that you get to share in (meaning that while you might get the investment if the VC believes that you can get to 20x, you’re not going to do so on terms that even come close to approaching that potential exit).

(9) Look way ahead and craft a story around what you see. To the last point, above, the best way in the world for an investor to believe that investing in your business will yield a 20x return is for you to convince them that this is so. Period. Storytelling is critical. Learn how to do it.

(10) Understand that we’re all guessing. Alan often speaks about the strengths and weaknesses of the various valuations theories and models, just a few of which are addressed in this piece. It’s still gambling, in that a method that might have worked one or twice or even consistently can go cold. So insisting to your investor that you know the definitive way that a startup (yours) should be valued, really only works if it’s your money, and it’s not.

When you have a lot of time and want some extra reading, here’s a fine McKinsey piece on this issue and how it ties into why startups are staying private.

SAFE notes are somewhat in fashion in Silicon Valley. Here in Canada they tend to raise the hackles of investor. You don’t need to do the research on this – we’re telling you that this is the case. When, in Canada, a startup says that the investment vehicle is going to be a SAFE, many investors perceive that the real message is that the startup thinks they have more leverage than they do. Just sayin.

One article could never be enough — so watch for more on the topic of valuation — part art and part science.