All mothers think that their babies are beautiful. OK, if not really beautiful, then certainly much more special than all the others… There is something primal in humans that makes us seek to find endearing qualities in our offspring. How much would you be willing to sell your baby for?
I have had 3 different calls this week from entrepreneurs asking about how to value their startup companies with early investors. How do you put a “fair” value on your startup company?
Valuation is certainly one of the most difficult aspects and many deals die here. Ask for too much and the investor will turn and run. Ask for too little and you lose your motivation & end up with nothing. The saying is that the only suitable investors for early stage companies are the 3 F’s: Friends, Family and Fools. Early stage investing is risky. Very risky, but if you are going to pitch your business to early-stage Seed or Angel Investors, then you need to carefully consider the valuation that you will propose and remember that your baby may not be as special as you believe.
There are really two different objectives of an early-stage investment. The first objective is obviously the cash. You need enough to support your activities until the breakeven point where you will have enough sales revenues to pay for your growth plans. A second objective is that an early-stage investor will become one of your closest partners and have a direct effect on the success or failure of your business. Too many entrepreneurs only focus on getting the money and forget that choosing an early investor is just as important as hiring a key colleague or choosing a wife. Establishing a fair valuation will set the stage for fair treatment by your investors. Doing the opposite is a proven recipe for disaster and court battles that the entrepreneur seldom wins.
Ron Conway, a famous angel investor from Silicon Valley, was recently quoted as saying, “I will not talk to an entrepreneur about valuations for more than five minutes. If they want to talk more than five minutes, I probably do not want to invest.”
Conway’s logic is so simple and straightforward and built on so much commonsense it is difficult to dispute. The valuations for pre-seed startups, regardless of the ups and downs of the economy and venture marketplace are level and consistent… Oh, sure, there’s the exception, but if you’re a rational entrepreneur or investor, you wouldn’t want to bet on identifying it before investing.
Much more important, as Conway’s logic seems to run, is the capability of the management to grow the company to, say, $50 million. An entrepreneur who spends time focusing on pre-seed valuation probably doesn’t understand valuation, which probably means the entrepreneur does not have the vision and ability to put a company on the path to high growth.
From the article entitled: Is Valuation a Key Issue in Funding Startups?
by George Lipper, Editor, National Association of Seed and Venture Funds (NASVF)
A study in 2007 by the US National Venture Capital Association showed that the average pre-money valuations of early stage startups has been surprisingly consistent over the years. The values in 2009 are surely a bit lower, but the interesting thing to note is that the values increase dramatically depending on the development stage of the company. In 2006, the average pre-money valuation of a startup was $3.38 Million. Note that if a company was at the point where products were already developed and ready for market, that the average value was $15.50 Million. If a company has already started shipping products, but was not yet profitable, then the average value jumps to $22 Million. After breakeven the average valuation is $27.65 Million. The most interesting lesson here is for entrepreneurs to understand how important it is to wait as long as possible before seeking funding and setting valuation. What development stage is your startup company at? What can you do to move to the next development level (and thereby get a much higher valuation)?
How you actually determine the valuation (ROI, Future Cash Value, Risk assessments, etc.) is something for another and a more detailed article. In the meantime, get clear on your objectives with seeking funding and choose your investment partners carefully… And make your baby really special!