Choosing A Startups Initial Evaluation

Choosing an initial evaluation for your company is tricky and an extremely controversial subject. Valuing companies at an early stage is incredibly challenging. Early stage companies have little or no revenues and quantitative methods can’t be used to determine value.

Today, valuation discussions are pushed by using convertible notes to do the initial seed investment. Although convertible notes avoid the valuation discussion they have caps and conversions making the valuation come back into focus.

High Startup Valuations

What you read in the press is not normal. The media loves reporting on outliers. This is what makes sites like TechCrunch and VentureBeat fun to read. People envision raising at the same valuations they read. Just because you read companies are raising at $10m valuations for their seed rounds, does not mean you can too.

Having an initial high valuation seems promising, however, it can set your company up for failure. Raising at a high valuation from the onset sets a precedent and an expectation for your company. If anything other than what is expected is delivered, you and your company have failed.

Failure to execute on what was initially promised will not bode well for your later rounds. With all startups the road is hard. When the rubber meets the road and reality doesn’t meet with expectations things, become shaky. If you raise at a high initial evaluation, this shakiness can prevent you from raising a later round. Investors don’t like down rounds.

Art Not Science

Initial valuations of companies cannot be determined using standard industry methods. These methods are used to calculate later financing rounds, but the initial valuation includes the future opportunity and potential of the business. This makes initial valuation of a company an art. This gives founders leverage to raise on good terms if their investors believe in their visions. However, investors believing in your vision doesn’t guarantee a high valuation.

The truth is, the market will decide what the value of your company is. It is a supply and demand market. If there is a lot of demand for your startup, then you can demand higher valuations. Only increase what your valuation is, if you are getting a lot of demand from investors. Keep in mind, raising at a higher premium can set you up for problems in the future. You may also have to kick people out of your round who said they were in. This is business. Manage the relationship politely.

Valuations Are Not Negotiations

Early stage investors don’t negotiate. They have an investment thesis they are sticking too and it is up to you as the founder to tell them what the valuation of the company is. Once stated, the valuation cannot be retracted or discussed. This is a sales conversation and makes many founders uncomfortable.

Investors of any size want deals. It doesn’t matter if you are taking from angels or venture capital. The major difference is the size of their funds. Investors with smaller funds (angels and micro vc’s) are typically price sensitive while traditional venture capital are not. The valuation of your company at an early stage doesn’t matter to a large venture capital firm. So set, your valuation accordingly by who you are raising from.

I am a strong believer in smaller valuations at the early stage. Angels won’t invest in you if you are raising at higher than a $4m valuation. Some won’t invest in you unless you are raising at a $3m valuation. But Why? Angels won’t invest in follow on rounds and don’t execute their pro rata rights. They will be diluted just as the founders shares are. The returns they receive will not work for them if they are participating in larger company valuations.

Investors of any size want to see their investments growing. If investors see their initial investment taking a down round, it means there was no point in getting in early. You want to keep your shareholders happy. Don’t make your investors sad.

Capital is Critical

Capital is the most important thing to a business. Capital reduces your chances of failure, but doesn’t guarantee success.

Since raising money will reduce the risk of your business, optimizing your financing is not building a business. Financing is an incredibly small part of your business which founders spend way to much time on. Raise enough money to fund the next 18 - 24 months. This months should run on a skeleton crew, while you identify all the important aspects of your business and get your initial traction.

I am an advocate of keeping valuations low, at least initially. Realize that all startups have a 90% failure rate. This means you too. Keep it low initially. If you kill it, raise a HUGE series A that will make up for your low valued seed round.