Startup Valuation – How much is my Startup Worth?

July 21, 2009

By sinha

[Guest article by Sanjay Anandaram, entrepreneur-turned-investor. This is an interesting article on valuation conundrum that every entrepreneur faces.]

“How much will my stocks be worth in 5 years?” was the question the senior corporate executive asked the CEO of a startup. “I don’t think my stocks are worth anything now, so I want a big salaryraise considering the fact that I’ll be spending the next few very productive years of my working life with you” was the refrain from a senior manager of a young startup. “What will your exit valuation be” asked the junior VC partner to the entrepreneur as if anyone had the answer!

Startup Valuation & Valley of Death

All too often such scenarios play out in young companies. These questions are not easy to answer with any certainty given the state of the company. Yet, these questions need to be addressed. The trouble occurs when these perfectly legitimate questions consume the startup team such that enormous energy is expended in explanations and negotiations with employees and investors leaving the startup shaky before take-off.

It is important to keep some basics in mind.

First, in young early stage startups, valuation is almost entirely subjective. Qualitative issues such as quality of the team, the market size and growth, market opportunity, uniqueness of the offering, the business model, the amount of capital being raised and likely to be raised, the kind of exit, what valuation have comparable companies in similar circumstances received, the competitive pressures on the investor, investor’s investment model etc are factors that determine the valuation. Being subjective, the beauty lies in the eyes of the beholder.

However, professional, quality, and smart investors while negotiating hard generally do not squeeze the entrepreneur beyond a point knowing that the key to their success is a motivated and charged up entrepreneurial team. One cannot make money at the cost of the entrepreneur so while starting valuations might seem tough, investors are open to parting with equity if the team executes to the plan. Assuming one has researched the investor(s), there must be some faith in their judgement. At the same time, naivete should not be the cause of being handed a lemon of a deal. You too should be professional, smart and demonstrate understanding.

Second, the qualitative valuation starts becoming more objective over time. So while entrepreneurs fight tooth and nail to secure a “high” or “good” valuation in the early days of their company, what many don’t realise is that having secured this “high/good” valuation, the company needs to execute to justify this valuation. What this means is that the company must demonstrate growth in revenues, cash break even, profits and profitability, productivity and so on. The company therefore has to be aware of expectations and demonstrate its value in financial terms. Of course, there are businesses like Facebook that are valued very high in spite of not having any profits because they demonstrate enormous growth month-on-month and have a visible credible path to making serious money in the future. But these are the rare exceptions. In short, the more mature the company, the more objective will be the valuation methodology.

Third, if the company fails to execute and therefore justify its earlier “high/good” valuation, the value of the company will be re-set to a new lower number in the next financing round. This, while not being a happy moment for the team, is certainly an important reality check. If the company, however, executes to its plan or exceeds it, the valuation will be more than justified and will increase for the next round of capital infusion.

Fourth, at the end of the day, valuation is a number that’s a function of how the company is actually performing and how it is perceived by the outside world. It is the job of the CEO to deliver on both these aspects. Investors invest in the company based on this promise.

Fifth, money is only made when an exit occurs (typically, an IPO or an acquisition) so returns, while looking good on paper thanks to “good/high” valuations, mean something only when cash hits your bank account. Till then, valuations are like money in the mirror – look good, feel good but worthless.

Remember, a “good/high” valuation will only be obtained and realized in cash if a good or great company is built. That should be the focus rather than worrying about intermediate valuation points.

What do you think?

[The article first appeared in FE. Reproduced with author’s permission.]

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Tags: Entrepreneurship, how much is a startup worth, startup valuation

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Vijay Rayapati on July 21, 2009 at 12:56 pm

Excellent write-up for entrepreneurs and people planning to join startups , I think this is the much needed information for the community.

Ramesh on July 21, 2009 at 1:10 pm

Valuation in itself doesn’t mean much while raising capital.

Important things to consider (other than valuation) include liquidity preference, option pools, blocking rights, board control. It is important for founders to understand these in context of exit

VCs use these as levers to negotiate a better deal for themselves.

Sridhar Turaga (open2save.com) on July 21, 2009 at 2:04 pm

So nicely put by Sanjay, like all his writings.

In fact there is a case to be made that … barring boundry conditions (leaving out twitter and boo.com) … increasing valuations un-related to real financial worth … to get better terms or to get more money invested decreases the chances of any money for the founders and comapny in the event of an exit.

The gap between valuation and real financial worth eventually comes back to bite non-preference shareholders (and VCs too) in many cases.

So,as ironical and counter intuitive it may sound … there is a case to be made for not seeking unjustified valuations as a company !!

p.s. It’s in many ways like with movie stars … one big hit can easily be wiped out by a flop that followed … and then it can turn off producers for ever

Kasi on July 21, 2009 at 2:52 pm

Excellent article.
I like the questions for which no-one has the answer part.

@Sridhar Turaga … i actually read the same somewhere else as well… but could not understand how getting more money invested decreases money for the founders at the time of exit? It is understandable that the next round
will become tough if over-evaluated.

That would be very important info for founders (may be separate post will
help with some example numbers ).

Sridhar Turaga (open2save.com) on July 22, 2009 at 12:28 pm

I am not a financing expert, so some one better qualified can address your question with the right details.

What I observed in various start ups is this …

Investors protect themselves for the worst case scenarios better than the founders. Investors have tools and leverage like preferred shares, liquidation preference multiples, controlling stakes etc. So in many situations bottom for their investment is protected. Investors by nature are skeptical and factor in the worst case in their calculations better.

However, founders leave their worst case scenarios exposed – which get further aggravated when u raise too much money and financial worth is outrun by valuations in early rounds. Reasons include high adrenalin rush in early days / years of starting up, religious belief in your idea, momentary suspension of touch with reality from getting to such a high valuation (typically in MNs in Series A in just 12/18 months), planning for the best case, thinking of how YouTube or Hotmail exited etc. (Ironically … the positive thinking qualities that keep you going thru hell and fine in starting a business … are probably not the best ones to use in financial planning !)

None of this is a science … so advice like “raise as little money as possible” is easier to give then to execute.

One interesting thing a wise man once told me is … think of equity investment like you would look at raising a loan … put a notional interest rate of 20-25% p.a. typical expected VC rate of return) … and always remember you will need to pay it back … like with a loan. Then would u raise that money and invest in the business … is there an ROI?

p.s. Leave boundary conditions like Boo.com and Twitter