When I talk to new or aspiring founders one theme is always relevant: the magic behind setting valuations for early stage companies. My advice is, be careful what you wish for.
One of the best days in a founder’s life is the day he or she raises the first round of venture round. One of the scariest days of a founder’s life is the day after they raise their first venture round. The countdown to success or failure has begun.
Pre-money valuation is the “magic” number that everyone hypes because we’re led to believe that it validates the existence of early stage ventures. As a founder trying to raise capital, the more money you can bring in at the lowest possible dilution leaves you in the best possible position for both burn rate and high percentage ownership in your enterprise.
The media, however, puts a spotlight on inflated valuations. We’re surrounded by headlines about how “so and so mobile-social-local app raised $zillions at a staggering $bazillion valuation.” As a result, we assume that at such a major valuation, that specific business is destined for market domination.
What you must know is this: The buyouts you read about are inflated. In all actuality, these buyouts are completely unrelated to the valuation of the product and/or service itself.
When it comes to competitive buyout valuations, the sale price is very rarely influenced by the actual value of the business. Generally, these acquisitions are executed to prevent disruption in multi-billion dollar revenue streams.
An early stage company raising a venture round at a very high valuation means that VCs/Angels are willing to bet long on the business. This also means the investors are comfortable taking a small percentage of the business in exchange for the right to invest in its future if the company starts exploding with growth. In most cases, the investment makes up only a small portion of their overall portfolio.
In this case, the early-stage founder is able to retain a big percentage of his/her business and get a bunch of money with which to operate the business.
Seems like a good trade off, right? Wrong.
Let’s assume this isn’t the last round of funding the company is going to need, which is almost always the case. What the valuation really means is that the founder just set a crazy high bar for the business to reach before being able to raise more funds. As a result, the race is on to make that business worth much more than the post valuation of the previous round.
If the company isn’t “blowing up," when the founder goes out to raise more money and the original VCs/Angels who invested don’t lead or participate in the new round, it sends an very bad signal to other potential new investors.
Valuation does not equate to value or validation. Instead of how big, it’s important to think about what’s right:
- What is the right valuation so that over the course of the time you can operate your business on the funds being raised?
- What value do you think you can build with the business?
- What do you think the business could be worth – realistically – over the course of the next 18-24 months of operation?
Think about an early stage valuation like an ice cream sundae: The bigger they are, the more enticing they look to everyone at the table. But at some point, you’re the one who ends up vomiting in the bathroom instead of sitting back, patting your belly with satisfaction.
No one succeeds on a hype-based framework. Employing a reality-based framework when it comes to valuation is vital. Follow the above valuation evaluation process and you’ll be setting yourself, and your company up for success.