The Valuation Myth – Part 1

I was asked recently to provide some feedback on possible valuation benchmarks for a company raising its first external equity funding.

Of course the funder has been looking at valuations from Silicon Valley. Largely one suspects because they are larger than the local ones in Latvia.

The use of comparatives is a sensible way to benchmark valuations – what valuations have been achieved by similar companies?

But they are usually used badly – because the definition of what is ‘similar’ is too narrow.

Similar is not only (or indeed primarily) those in a similar industry or tech vertical.  

What is more critical are factors such as:

• Achievements to date – critically customer engagement and meaningful revenue generation.
• Levels of actual Intellectual property (patents applied for, granted and freedom to operate reports).
• Experience of the management team – have they previously successfully built and exited a company?

Comparatives ignore the most critical influencers of future value for early investors.  For investors the return on investment is driven by three factors:

• How much ownership of the company you have at initial investment (the outcome of the initial valuation).
• How much ownership you have at exit – a function of dilution – how much more money will the company need to get to an exit, and how much of that will the initial investors be able to provide?
• The actual exit value achieved.

Investors who only look at the first of these – the initial valuation, are likely to do badly in the end.

Providing $200,000 for 10% of the company (which gives a pre money valuation of $1.8 million, is meaningless, unless we know what future dilution we will suffer. Say the company needs $100 million of VC money to get to the exit – what ownership will you then have? And even if you have say 1%, if the VC’s have just a 1x preference, then unless the company sells for at least $100m, you will not get one penny back (did I mention that most successful exits are for around $25m – $35m?).

Valuation is not about what a company is worth today – or indeed what it is going to be worth on exit – but what ownership percentage you will have at the time of exit, and what the terms of that exit are. Those terms will not be set by you – but by the provider of the last round of funding.

Valuation therefore begins with a deep analysis of Comparatives – the comparative of EXIT values and the total funding that has been required to achieve them.