The only way to find the right number is to get inside the head of investors
Working with pre-revenue startups, I meet two kinds of founders — those who think they know their startup’s valuation and those with no idea what valuation is appropriate.
The first group are full of confidence and seem like great founders. But until they realize their valuation is completely out of whack, there’s nothing to do but say, “Sorry, too early.”
Founders in the second group, who ask me as an investor what valuation I’d find appropriate, are the ones who actually understand what valuation means. It’s not a metric from a spreadsheet, or an analysis by a valuation consultant. The valuation is the amount investors are willing to pay.
However, that’s a challenge for founders. There’s no analysis which gives the “right answer.” The only way to find a suitable valuation is to ask lots of investors.
Auctioning Off Shares in the Startup
The best way to think of company valuation, especially through Series A, is more like an auction than the sale of a product or even the purchase of public stock like Apple or Tesla.
How much is a Picasso painting worth? Like a startup, each one is unique. An expert appraiser can make a good guess based on the prices paid for other Picassos, as well as recent sales of other famous Cubists and trends in the art market in general, then attempt to apply that to the specific work. But that’s just an educated guess. In the end, the valuation is whatever buyers are willing to pay.
Determining a fair valuation for a startup is somewhat similar, and very different from the metric-based models taught to MBAs.
It’s not unusual for a founder to tell me his startup has a valuation of $53.7 million and show me his spreadsheet to prove it. The discounted cash flow analysis shows the company generating $10M per year in profits starting in a few years. It’s simple math to work out the net present value of the profit stream.
That is indeed how big companies make decisions. And it’s what they teach in MBA school. It’s how private equity firms value established companies. It doesn’t work for startups.
This model doesn’t factor in the 90% failure rate. Nor the fact that no startup in the history of startups has ever made a profit. In fact, for startups, a discounted cash flow should show a valuation of $0. Any profits are invested back into growing the business faster.
The model doesn’t work because the value of a startup isn’t the profits. It’s the exit, and how likely the company is to get there.
The Palter Uncertainty Principal
For an early-stage startup, where the risk of failure is high, an analytical approach to valuation looks like this:
Valuation = Probability of Success * Exit Valuation
In other words, if the company has a 10% chance of being acquired for $1B, the company should be worth $100M. Of course, there isn’t really one exit but a range of possibilities and probabilities.
This simple equation also needs to be adjusted for how long it’ll take to get to the acquisition. An acquisition within 1 year is worth far more than an acquisition in 10 years.
How much better depends on investors’ expectations for internal rate of return. The math is a little messy. And completely irrelevant. There are too many variables with too many unknowns to do an actual calculation. Let’s call this the Palter Uncertainty Principal.
While we can’t use the equation for calculating a valuation, it gives us important clues to how investors think. It’s all about the exit valuation and how likely we think the company will get there. In other words — risk vs reward.
Inside the Messy Mind of the Investor
No early-stage investor I know does a quantitative analysis of valuation. Instead, the process is more like that Picasso auction.
A VC fund has a fixed amount of money to invest over the life of the fund. Angel investors may not have rigid constraints, but we’ve allocated a certain amount of money towards startup investing each year. And we invest in the best deals we can find that meet our minimum viability.
We hear pitches. Lots of pitches. I probably see 100 pitch decks each month, and for me, investing is only a side gig. VCs who do this full-time probably see a thousand decks each month.
We start by eliminating the obvious bogons and the ones that are too early or too late for us. If we specialize in a sector or a geography, we can eliminate those that don’t fit.
That still leaves a lot of good potential investments. And we can’t invest in them all. So how do we choose? We pick the ones that have the best chance of the biggest return in the shortest amount of time. In other words, we pick the ones we think offer the best reward for the risk profile.
Last week, a friend asked me how that works in practice. So I had him sit in on a pitch session where 3 companies pitched their investments.
The first offered a valuation of $5M for a new consumer product. The second was at $10M for an IT product that already had a few customers. The third wanted $20M and though they had relationships with big partners, didn’t have any sales yet nor a coherent plan.
At the end of the pitches, I asked my friend, “Which one would you invest in?”
Given the choices, he came to the same decision as everyone else in the room — the second was the most interesting. With customer traction, a strong team of experts, and an easy exit once they achieved scale, the second felt like a bargain compared to the other two.
Now multiply this process by a 100 companies, or 1000. We simply pick the one that looks the best given the risk and reward.
After a few years of hearing pitches, the process becomes instinctive. At the beginning, it’s as bewildering for investors as for founders, but at some point we have enough experience to hear a pitch and say, “At this valuation, I’m interested in investing. At a higher valuation, I have better alternatives.”
How to Set the Valuation
That’s how investors decide what to invest in, but it doesn’t help founders pick an appropriate valuation.
Founders who haven’t spent years listening to pitches have no way to know what the market will bear. The only way a founder can set an appropriate valuation is by talking to investors.
Of course, what one investor finds a bargain, another will think is outrageous. So founders need to talk to a bunch of investors to try to find a consensus.
Once a proposed valuation is set, the founder can start pitching. Rather than coming in with a fixed number, remember: it’s a negotiation. I recommend starting a little high, but making it clear the number is negotiable.
Instead of specifying a valuation of $6M, for example, say “targeting $7M.” It might turn out $7M is fine, or you might get beaten down to $5M, but so long as the number is close, interested investors will negotiate.
Once a lead investor has signed a term sheet with a valuation, other investors can only join at that valuation or pass on investing.
Unlike that Picasso auction where only the highest bidder comes home with the painting, a startup usually needs multiple investors, so the highest valuation may not be the best one to get the round filled.
Even if the lead investor agrees to $7M, if other investors won’t come onboard, the startup may need to reduce the valuation.
In fact, it can be better to underprice the valuation instead of taking the highest valuation on offer. At a lower valuation, investors will be begging you to take their money. You can fill the round far quicker and choose the investors you want to spend the next 5–10 years working with instead of accepting the highest offer.
In the end, setting a valuation is not so different from setting the price of your product. You’re selling stock in your business. If the price is too high, we’ll invest in something else. If the price is low, you’re leaving money on the table. The only way to find out the best price is to talk to investors.
Note: early round investments are usually done with a SAFE or convertible note rather than equity. Technically, those include valuation caps rather than valuations. Legally they are completely different. However, investors think of them the same way, so for this article I’ve not made any distinction. And no, I don’t invest in startups without a valuation or valuation cap.
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