Startup valuations expert Bharat Kanodia breaks down what founders should know about maximizing their company’s value.
Why do valuations matter to startups? What goes into the whole process?
Valuations is a dark art in a dark room in a black box and it’s designed as job security. Now, evaluations are the new currency for startups. Startups don’t have much revenue they rarely have profitability yet, they need to attract talent, investors, and customers. Valuations as a term have become their currency over the last 15 years and that’s the term that’s used to describe how awesome they are if at all.
Many questions come when we talk about startups. Let’s discuss the below questions.
If we have a startup or we are a business owner how can we rely on the valuation being accurate?
So, there is no such thing as accurate valuation. Valuation is a perspective or advantage point and everybody can have a different perspective on the same thing. For example, a glass is filled with half water. You are seeing a half glass is filled with water and others seeing it half glass is empty. But everybody’s seeing a different perspective of it. So, a startup too because there are so many unknowns about startups. Everybody has a different perspective so they might be multiple valuations by multiple investors or different valuations for accounting or different valuations for investing or different valuations for tax purposes.
If we have a business and get a valuation from two or other people. Do they approach investors for assuming with the largest valuation because selling the business at the highest cost that someone is placing on your business is an accurate statement to some degree?
Let’s understand, for example, Clients or business owners have two offers or two-term sheets where one is from sequoia capital at 50 million and one is from the other. It’s not necessary if you have a 100 million dollar valuation that is better than the 50 million dollar valuation. You need to peel the onion and understand what goes into those term sheets because at every inflection point or every raise venture capitalists will be expecting you to at least double the valuation. So, if you start at 50 at the next inflection point you have to give them a hundred and if you start at 100 at the next inflection point you have to give them 200.
Also, it is not necessary that the 100 million dollar offer is better than the 50 million dollar offer.
Why are valuations so high for some startups valuations?
Valuation is dependent on three factors: Growth, Profit, and Risk in terms of when it comes to startups is valued high because the market, the investors, the customers, the founders, they’re all anticipating significant or high growth and that is why they’re valued so high. So, if there’s a large number placed on it’s because the company or the investors have faith that this particular startup will do well.
People start looking for venture capital and they expect that they would be looking for this or they’d be looking for these certain KPI’s but the fact is very different:
- Venture capitalists are looking to invest in a founder or a person. Money is always given to a person. So, the founder has to be likable relatable and that is most important because they have to hire people, retain people, find more investors, to work with people.
- Traction – Venture capitalists don’t like to invest in pre-revenue companies. They want to invest in companies that have proven proof of concept. For example: if you go to venture capital and say I have zero revenue vs. say I have revenue of 300,000. So which one would be looked upon favorably 300,000 because there their risk is less.
- At every inflection point, venture capitalists want to double their money so at every evaluation or every raise they want to at least double their money. So they’re always looking to do a back-of-the-envelope calculation which bet you will be going to double my money the fastest and in the shortest way.
Venture capitalists are not looking for any collateral, unlike the bank they don’t have a house as collateral so they’re just giving you money based on your credibility. Everybody comes up with a new idea every day and all the ideas are great. It’s not the idea, it’s the execution of that idea and to execute.
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How can a founder maximize their company’s valuation and their ability or the chances of having a favorable investment?
- You need to have a product or a service which has a market or a pre-existing demand. Many times in venture capital, founders have a solution and they’re looking for a problem which is putting the cart before the horse. Find a void and try to fill it.
- You want to invest in a company or venture capitalists or angels. They want to invest in a company that has a recurring revenue model like SAS companies. You’re getting paid on a monthly or a weekly or a daily or quarterly or a yearly basis. That money is going to keep making money and that company is going to keep making money, no matter what as long as they don’t screw things up.
- Most founders don’t realize that recruiting is very important. A founder can only do so much but if a good founder is great at attracting and retaining talent. If they can do that it helps because running a startup is an uphill battle and you want good people around you. The biggest secret is most founders don’t know that your venture capitalists or your investors as your partners they want to help you. So, at every inflection point, they want to double their money.
What questions should founders ask venture capital firms? When they’re trying to negotiate their term sheets?
Most of the time, founders are just thankful to be there or they’re just always playing defense but it’s a bad idea. They should be asking venture capitalists on the investment team just as many questions as the investment team is asking them so they should be asking questions like what experience do you have in scaling a company like this? How can your network or your other portfolio companies help my company grow? These are some very important questions that founders should be asking. There are many people in this town with a lot of money but you want to work with people who are going to stick by you because when things do go south and they always, do at some point or the other you want people who are going to stand by you.
Also, check the episode on “What’s a Startup Worth?” and read more about it on the What’s it Worth Youtube channel.