Valuing an early-stage company can be a sensitive issue, for both entrepreneur and investor alike. For an early-stage entrepreneur, they might not have much in the way of revenue, traffic might have plateaued, and their website might not be much to look at right now.
But they were the ones that stayed up through the night when their database servers crashed, they were the ones that subsisted on ramen noodles for weeks on end so they could put more cash into marketing, and they were the ones that suffered the indignities of being rejected by yet another potential investor because they didn’t have enough traction.
Yes, valuing an early-stage company can be painful.
To an investor, determining an appropriate valuation is nearly always a financial decision, a calculation intended to maximise positive returns on their portfolio. To an entrepreneur, a valuation is the literal quantification of their hopes, fears, and their indomitable, unassailable stubbornness. The process of financially quantifying the unquantifiable can be tremendously difficult, even traumatic, for founders.
When fundraising, their immediate urge might be to place a large price tag on their company. This protects their financial interests by reducing their degree of dilution, while giving sufficient justice to the sheer number of sacrifices they’ve made to help grow their startup from 0 to 1. Often times, this price tag is beyond what others might consider reasonable or fair for the startup, especially investors.
While a large price tag might seem an indication of success, founders would be wise to remember that fundraising is a marathon, not a sprint. And sprinters can stumble long before they get to the finish line: Fab.com was once valued at $1 billion USD, and now it’s barely worth $15 million; Digg, the would-be rival to now ubiquitous Reddit, was once worth $164 million dollars before eventually being sold for $500,000; and who can forget Webvan’s famous implosion at the turn of the century?
But because it’s so easy to understand, and perhaps because it’s the simplest proxy of their time and effort, founders will often push that number as high as possible. This is misguided for the following reasons:
While it might seem perverse, an alternative method to value a company might be to not think about valuation at all. Entrepreneurs become fixated on a price tag,and then raise funds based off that figure. They should do the exact opposite:
- Calculate monthly burn, and how much you need to spend to get from point A to point B: to finalise the development of their prototype, to acquire 10,000 new users, to survive eighteen months based on current projections, so on and so forth.
- Determine what would be an appropriate level of dilution. This doesn’t mean giving away 50% of your company; this means giving enough to entice investors while giving you enough ownership of your company to keep you involved even after several more future rounds (and subsequent dilutions).
- Establish a valuation based on that number. For example, you need US$500,000 to survive eighteen months, at which point you’ll raise again. You believe a reasonable dilution given the stage of your company would be 20%. Hence, your pre-money valuation would be US$2,000,000.
- And don’t forget to understand what your local market can support. If you are raising a US$5,000,000 seed round in a region where a typical seed round is literally a tenth the size, then you simply will not raise.
Early-stage investing is more art than science, but it doesn’t necessarily need to be that way. Entrepreneurs can and often will change investors’ minds if they reasonably and precisely explain why their startup should be valued at a certain price. Establishing a trusting, working relationship with investors, especially at the outset, goes a long way in creating outcomes beneficial to all sides.
Valuing an early-stage company can be painful. But it doesn’t have to be.