Early-stage startup valuations: More art than science Rob Douglas September 2, 2016 Columns, Featured, The Funder's Side It’s the inevitable and most pressing question when an early-stage startup pitches for investment. What is your company’s valuation? Angels agree this is not a number you can or should come up with on your own. To put it in perspective, the Golden Triangle Angel Network recently asked more than 200 angels to give the most likely reason they wouldn’t invest in a startup. Half of the angels who responded said, “Companies [who] have overstated their valuations.” To shed some light on valuations, I asked two experienced angels to offer their advice. Steve Gilpin is a well-known GTAN angel and sits on the board of directors. Even by angel standards, he has a robust investment portfolio. When asked about valuations, he says, “There is no perfect formula for valuing a startup, although some angels try to use a formula. The best one I have seen is from Dave Berkus. “In my case,” Gilpin says, “I am looking for founders who have a realistic expectation and are willing to negotiate if necessary to get to a point where all parties are happy, not just them. At the end of the day my rule of thumb is that new money ‘in’ should acquire 15 to 30 per cent of the company. So valuation pivots around that a bit as well.” Gilpin says it is helpful for startups to have a valuation for their pitch presentation so that investors can quickly decide whether the company is in their sweet spot or not (e.g. a $10M valuation on a pre-revenue company is regarded as unreasonably high). On the other hand, Gilpin says it’s not in a startup’s best interest to set an unrealistic valuation for the sake of having one, and that they should be willing to negotiate with investors. Randall Howard won the National Angel Capital Organization (NACO) Canadian Angel of the Year award and often speaks internationally about angel investing. Howard put together this handy little tip sheet for early-stage startups: SHARE THE PAIN: At a high level, a company should feel they have a good valuation when, in the negotiation, both the company and investors feel equal pain. Put another way, if either party (company or investor) emerges thinking they’ve “won” in the negotiation, then it’s probably not a great valuation. FOCUS ON GROWTH: Too low a valuation means too much dilution for the startup founders. However, founders should focus less on dilution (looking backwards) than on how big they can grow overall. The company metrics that drive valuations (revenue, etc.) should be growing faster than the dilution represented by the angel investment. BE REASONABLE: An excessive valuation might feel great for the company at first but can be even more problematic than a low valuation in the long term. The key concern is the prospect of a “down round” in which the next raise is at a lower valuation than the round before. Typically this happens when money invested doesn’t advance the company metrics enough to create a higher valuation. However, a “down round” is also possible if the company raises money at too high a valuation. DON’T EXPECT A SINGLE ANSWER: Valuations are typically arrived at through many ways – there is no one answer, and that’s why it’s a negotiation. If a company feels IT can find a formula for valuation on the Internet, that formula is almost certainly wrong. KNOW HOW YOUR INDUSTRY WORKS: Working backwards, if a company is going to IPO or be sold, investment bankers base their valuation on metrics (price/earnings or price/sales) specific to industry comparables. For example, SaaS multiples are likely different than those for a life sciences company. Sectors where high valuation multiples are common are typically those with high growth, reflecting a valuation based on high future earnings and free cash flow. High growth can be defined as approaching or increasing beyond 100 per cent year over year. It’s a good idea to find an EIR, mentor or angel who can help to explain the path from angel (seed) round multiples to the end-point valuation based on an acquisition or public market IPO. The key is to figure out the entire lifecycle of funding needs, from early “friends and family” through various seed rounds, venture capital rounds, and to an exit or IPO. KNOW YOUR STAGE OF VALIDATION: Looking the other way, Angels look at various points of validation to figure out funding. Does the company have a minimum viable product? If not, an angel is unlikely to invest. Does it have customers? If so, are they generating revenue? Is there more than one revenue-generating customer? Sometimes, the second “customers” are even more difficult than the first, so each of the preceding “validation steps” reduces risk and means that the capital is going more to market expansion than product or customer risk. BE WARY OF ALTERNATIVES: Some companies try to avoid the valuation exercise by proposing a convertible debenture or SAFE (simple agreement for future equity) approach. The latter was designed for accelerators in the U.S. and isn’t very investor-friendly. A large percentage of angels refuse to consider either, so tread carefully before proposing these approaches. In the end, startups going through the pitch selection process should engage with angels or Communitech EIRs to get solid advice on their company’s valuation. It is becoming standard for every pitch deck. GTAN will hold its first meeting of the new season Sept. 20. For more information check out their website at www.goldentriangleangelnet.ca. Photo: Value by J. Lightning is licensed under CC BY-SA 2.0.