Some Thoughts on Startup Valuation

How does someone value a startup?  It’s an excellent question.  The startup valuation math is a dark science.  It seems more like tarot card reading and crystal ball soothsaying than actual math.  There are a lot of ways to value a startup.  It’s not like an established company where you can look at a balance sheet, revenue, and do a discounted cash flow analysis to try and figure out a value.

Most of it is rules of thumb and from firm to firm, there are different rules.

The way I like to look at it is look at some general data.  The Angel Capital Association tells us that out of all the companies funded by angels in the past few years, the median  pre money valuation is $2.5M and the median raise is $600k for a post of $3.1M.  It’s important to note the median isn’t the mean or average.  It’s the number that is directly in the middle of the sample distribution.

Here is some math on the original funding.  3.1M/600K=19.35%.  The entrepreneur sells roughly 20% of their company to outside investors.  By the way, in almost every subsequent round the entrepreneur will sell another 20% to outside investors.   The game is to do it at higher and higher levels of valuation all the way until exit.

The other way to look at seed valuation is exits.  Where do companies exit?  Entrepreneurs will look at the best cases.  They will point to a company selling to another company at a very high valuation.  This whets the appetite for the investor.  But, the truth is most angel and venture backed companies exit for less than $60M.  As Brad Feld correctly pointed out in a blogpost you should read, Unicorns get all the press but most companies are not that way.  I had an Ohio angel ask me two questions.

  1.  How many Ohio startups have exited at over $100M in the last 10 years?
  2. How many Ohio large corporations have bought a startup from Ohio at over $100M valuation in the last 10 years?

The answer is 0.  If I was in Ohio investing in an Ohio startup I would be pretty prickly about valuations post money over $3M.  Knowing that helps temper the investor enthusiasm!  Other areas of the country are certainly different.

Then there is angel math.  If your goal is a 27% IRR and earning more than 3X on invested capital, you have to be very careful about the earliest stage valuations given all the data.  Jerry Neumann has an excellent series on angel investing.  You should read it.  Think in terms of probability.   I know that virtually 50% of my portfolio will return 0. I also know that I can’t tell you from the initial investment which company will be successful and which company will fail.  I wouldn’t write a check if I thought it was a loser.   It leads me to try and value all companies the same at initial valuation.  This is sort of a loose Bayesian probability calculation that early stage investors do in their heads.

In order to get my desired return, I need one company to return 30x.  That means if I invest at the Angel Capital Association median, I need that company to exit for more than $90M.  Yet, I know full well most companies sell for less than $60M.  That begs two questions.

  1.  Is this entrepreneur the one?
  2. How confident am I in my ability to pick a winner?

If the answer to both is yes, barring other capital constraints, the investor tries to write a check.

When people from the coast tell me that the new pre-money valuation for seed rounds is $6M plus, it makes me choke.   Knowing the data from the previous part of this post, it seems sort of silly to write a check unless there are other circumstances that would cause the valuation to get bumped up.

Here are some of those other circumstances:

  1.  Entrepreneur has successfully exited a company before.  Huge props for this.  The journey of entrepreneurship is really hard.
  2. The bootstrapped data the entrepreneur has shared has shown gigantic stickiness.  If it’s a social network, it’s adding people driving engagement without churn.  If it’s a SaaS, it’s adding customers and increasing monthly recurring revenue with low churn.  I’d also look at sales cycle to see how long or short it is.  If it’s a device, there is some IP that gives it a huge barrier to entry.
  3. There are industry specific things that increase startup costs because of regulatory barriers.  For example, want to start a futures exchange.  Minimum of $2M startup costs because of the CFTC.  That means the initial seed post money valuation has to be around $10M.  Medical devices and drugs can be that way too.

For me, that’s about it.  I am indifferent to the number of people that are interested in the deal.  The herd is often wrong and pigs get slaughtered.  As a matter of fact, if most people don’t like the deal for some stock reasons, that makes me more interested if I have an information edge.  I have learned a lot from the trading pits.  I saw people make some really stupid trades simply because everyone else was doing it.  I also saw people make dumb trades at dumb prices because they lost discipline.

To do a good deal, be prepared to walk away.  Don’t look back if the company is successful.  You can’t win them all.  Just be nice to the entrepreneur, help them and wish them well.

Software startup entrepreneurs need to be careful with valuation.  It’s like Goldilocks and the Three Bears.  Too low, and there isn’t enough equity for them to build a team and make money given the amount of headache and effort that goes into the journey.  Too high, and the risk/reward for investors gets out of whack.  Too high and not meeting expectations and the next rounds are down.  That’s tough on the business, tough on the team.

The other advice I have is don’t offer term sheets with a bunch of junk in them.  Clean terms.  The entrepreneur is taking risk too.  Don’t burden them with a bunch of things that are only going to be negotiated away in future rounds.  Make it easy on them and create a term sheet that protects future round investing rights, but also makes it easy to interface with the VC’s that will fund the company to exit.

What you are really looking in Goldilocks valuation for is “just right”.  That means a pre-money of $2M-$4M depending on how much money you are going to raise.