First of all, there is no magic formula for valuation. It’s a negotiation based on the characteristics of your market, your company’s performance, and the quality of your team. Secondly, not all money is the same. Your company’s valuation matters, but it’s not the only thing that matters when you look to raise money. The quality of the funding source matters, too. Giving up a little more of your company to gain access to partners, future funding sources, top notch strategic thinking, and mentorship is often worth it.
By Peter S. Buchanan
Let’s say that, as the CEO, you believe your company is worth a $100 million, pre-money valuation. This number fits in your long term financial plan for yourself and your team, and you believe that investors should be thrilled to invest $10 million to participate at this valuation. Well, the truth is, despite your strongly held beliefs, there’s only so much you can do in establishing a valuation for your company. Lots of things come into play:
- The number of funds that are targeting your market and have the amount of money you need available to invest.
- The size and attractiveness of your market.
- The status of your product offerings.
- Your sales performance.
- The competitive landscape.
- The quality of the team you’ve put in place around you.
- Your ability to manage and project your finances.
Most of the time, it’s not about investors coming to you. It’s about you going to them and proving that your company has great answers to investor questions and great prospects for a future return. Usually, you’re the one selling, and investors are the ones being sold.
The Numbers and Metrics That Drive Valuation
Before you hit the funding trail, there’s a baseline set of questions to which you should absolutely have answers:
- How much capital do you really need to last you 18 months?
- Will this amount easily allow you to hit milestones to raise your Series A?
- What’s a fair valuation?
18 months is an important time horizon. Fundraising takes you away from operations. Your company will suffer if you’re not actively running things. Looking for funding again in six months is not the answer unless you are at the very earliest stages. Once you think you know that 18-month number, add 30% as buffer since, as an entrepreneur, you’re likely to be overly optimistic. There are always setbacks and delays. Finally, whether you have one investor or several, you need to consider objectively what a fair valuation really is. Consider these factors:
- Look at recent published funding events in markets that are similar to yours. There are a surprising number of articles that list the pre- and post-money valuation. Compare your company to those companies. Are you further along or behind those companies? Is your approach to the market better or worse? Are you in a geography where you can get a similar valuation? Right now, valuations in Silicon Valley are pretty frothy. Here in the Mid-Atlantic: Not so much.
- Look at the metrics of your market and your stage: If your product is ready for market and you want to fund a sales and marketing ramp, you’re likely to get a better valuation than if you need funds to build version one of the next, new thing.
- The competitive landscape is key: Let’s use eCommerce as an example. The market is brutal. Every eCommerce start-up seems to have a new model to get unique goods to consumers faster, or, if it’s a services business, wants to become the “Uber of something.” Unfortunately, virtually every segment has entrenched, successful competitors (and then there’s Amazon!), so you’re probably better off raising a modest amount of money at a modest valuation, proving your model, and then asking for the moon in your next round. That’s how next generation eCommerce leaders like GILT, which filed to go public last month, did. In the Mid-Atlantic, Optoro, which enables retailers to gain some revenue from returns and items that didn’t sell at full price, raised a small initial round, proved its model, and then went big – raising over $25 million from Revolution Growth, Grotech, and others.
The Right Amount of Money
For many entrepreneurs, money is a dangerous drug. Their reasoning is simple, yet flawed:
- You can never have too much funding.
- You need to spend money rapidly to grow your company.
- There will always be more funding.
In fact, too much funding can create big issues. You know you have too much funding when things like this happen:
- You’re wiling to spend insane amounts of money on gaining potential customers that won’t move the revenue needle or give you credibility in the market.
- You’re creating expensive marketing programs that make your company look really pretty but don’t drive leads, create thought leadership, or improve your competitive position.
- You’re making your products too complicated by overinvesting in product development just because you can afford it.
More than likely, you took in too much funding, because you thought the valuation was good. Well, guess what: You’ll always hit some significant speed bumps. That high valuation and large cash infusion cause big problems when you’ve spent all that money and you’re trying to raise the next round to keep things going long enough to execute a reset. Nobody likes a down round.
The flipside is that you might not raise enough money. A good rule is that you need enough out of the gate to build a version 1.0 product and get it in the hands of charter customers. Product development shouldn’t come in fits and starts based on funding. It should be consistent and working towards a market launch. Customers want this, too, because they want to invest in a supported product that can use for several years successfully. If you don’t think you can raise enough funding to get to launch, it’s better to find another better idea.
The Last Two Points
- Keep it simple.
- Align with smart investors.
Lots of entrepreneurs like to create complex financial instruments for potential investors. The typical pitch might be:
Invest now, because, in three months, the valuation will double.
Most of the time, “deals” like this backfire, because there is seldom a defining event that justifies a doubling in valuation in a short period of time. Good investors don’t fund hucksters and carnival barkers. Good investors like clean terms based on current market conditions, the progress of the company, and the quality of the management team doing the work.
Investors also like to be heard. Therefore, our last piece of advice is:
While all money is “green,” not all money is smart. Follow the smart investors.
“Less than smart” investors bring funding, but not much else. They express lots of opinions, but generally lack a detailed knowledge of your market, can’t connect your company to customers and influencers, deliver useless or bad advice, and won’t help you sell your company at a good price. They are a drag on your business, not a benefit.
Smart investors bring the four areas of goodness that generally drive a powerful exit:
- Consistently good business advice.
- Connections to customers, influencers, and future funding sources.
- The ability to read and view the market and competition in a sophisticated way.
- The ability to help drive a successful, lucrative exit.
Therefore, pursue smart investors even if the terms may be a little bit less advantageous. Your company will run much more smoothly, and, more importantly, the payback at the end is likely to be much, much better.