Startup valuation — how to find a proper balance
By: Wojciech Fedorowicz
Tags: VC, Startup Lessons, Fundraising, Entrepreneurship, Startup

It takes two to tango

It all starts with some initial interaction — be it an email intro from a common friend or a forwarded pitchdeck. Next comes a call, a meeting, and discussions — about business, future, but also life and personal choices. You seem to be getting along very well, and both sides like the other’s value proposition. This startups is perfect for this VC, and this VC is perfect for this startup. Then you start talking about round parameters and things are starting to look less rosy…

Sounds familiar?

It goes without saying, that a personal chemistry is a must in a startup-VC relationship. But, at the end of the day, it is a business arrangement for both sides. There is a number of important elements to pay attention to (and we will talk about them in some of our future newsletter editions), but in our “Greed is shortsighted” newsletter [read it here] we focus on valuations.

Company valuation is one of three elements of what I call a “triangle”. The other two are round size and also company development stage. All three elements are in sync, and there must be a coherence between them. Otherwise we are off-balance.

Let’s put aside the “objective” company value, and focus for a moment on the above interrelated elements.

If the round size is too large as compared to the valuation — founders will be giving up too much equity

If the valuation is too high as compared to the development stage — there will be a challenge growing value before the next round of financing

If the round is too small as compared to the development stage — it may be not enough to achieve meaningful results

… and so on and so forth.

Company valuation cannot be seen as an absolute number “per se” — it should be put into context of the above “triangle”, considering that the startup will need to raise follow-on rounds, preferably at increasing valuation.

Of course VC’s have various tools at their disposal in regard to the valuation of the company, should the future progress not be as high as expected — like antidilution clauses or ratchet provisions. But personally I prefer a plain-vanilla approach, where everyone is in full agreement and well aligned from the beginning.

THE BILL COMES DUE

Quoting after our newsletter:

“Over-inflated valuations, especially early on, can lead to a whole host of unwelcome consequences, which will in the long term negatively affect your relations with existing investors, while also scaring off new partners, which in effect can limit the chances of you securing financing for further project development.”

This is very much true and I believe it does not get enough attention. Let’s use an example:

Company X is still pre-revenue, finishing its amazing AI product for enterprises. The founders are raising a round, and they believe their technology is a game-changer (as confirmed by some high-caliber pilots). The financial forecast looks very impressive and the founders request a steep valuation Y. Looking at the comparable transactions and the “market consensus” the valuation Y is justifiable if revenues are growing rapidly and at the level, let’s assume, of $100k MRR. But no worries — the financial plan shows $150k MRR before the next financing round! So we are on the safe side, right?

So let’s fast-forward. We invested in this company X, and the company ended up delivering a fifth of planned revenues. Not because they are not good, but because it takes more time to close deals. The money is running out and the company needs to fundraise with $30k MRR. The insiders are pushing for an increase in valuation as compared to their round, but the MRR is actually pointing into a much lower valuation. We have a discrepancy.

Of course it is not impossible to raise money, and there can be a good story to justify an even higher valuation. But will the insiders participate? If not — it is a very red flag for new investors. And if the market demands a much lower valuation, the insiders will be very unhappy, taking a so called “impairment” in their books and vis-à-vis their investors.

This is, of course, a very simplistic example, but the point still holds. If at any point the valuation is too high, the bill will come due eventually and someone will have to pay it. The more distant the valuation from the market consensus, the higher the bill will be.

THINKING LONGTERM

If you are a marathon runner, you will know, that it does not really matter how fast you start, but what is your pace throughout the run. It is the same with company funding — one should optimize for the long run and not try to get “quick wins” and “cut corners”. It applies to founders, who usually are quite allergic to giving up on equity, but it also applies to VC’s, who sometimes want to show progress in their portfolios from one round to another (or simply they are out of money for the follow on rounds and they are incentivized to push the valuations up).

In any case, the valuation (and the two other elements of the triangle) must be an outcome of a reasonable consensus taking into consideration what’s best for ALL involved: the founders, the VC’s and the company.