The Valuation Myth – Part 2

The biggest driver of valuation is not the quality of the management team or the size of the market. There should influence the investment decision in a binary manner – if you don’t have a good team, or a big market, you don’t reduce the valuation – you just DON’T DO THE DEAL!

The biggest driver of valuation is Geography. Where is the company operating?

And specifically – how much it costs to do stuff in that location?

By ‘Stuff’ we mean something achieving a millstone that in the eye of the next round funder or exit partner adds real value. (The biggest value drivers are usually related to customer engagement / evidence that customers value the product – not tech ‘features’).

So valuations look higher in say San Francisco than Ohio simply because you have to put 4x the cash into the Valley company to do the same stuff that costs so much less to do in Ohio (salaries and rent are now almost prohibitively expensive for startups in the Valley now) – but you can’t take 4x the equity, or you would own more than 100%!

A resent analysis of valuations for Tech Coast Angels suggested they were 50% higher than the rest of the USA – due to geography.

Valuation of early stage companies is not really valuations at all. It’s not like valuing a house, or a picture, or even a traded stock market investment – all of which can be relatively easily turned into cash if you need to do so.

Early stage company valuation is really a way of expressing how the cake is being divided between the investors and the founders.

Angel investors, who are putting their time and reputations into deals, not just their cash, look for a sizable ownership percentage on an initial investment. This reflects both the perception of present risk – but also critically the level of future dilution they face as the company takes on more and more rounds of funding. It’s the ownership they have at Exit that is critical, not the ownership on initial investment.

The specific numbers will vary a bit from case to case, but for any meaningful amount of funding (say $200,000 or more), the early investor(s) will likely look for between 25% and 30% ownership.

10% – 15% will be put aside for share option incentives in the futures, leaving the founders with between 65% and 55%.

And the numbers don’t really change much whether it’s a $200,000 investment, or $500,000, or (for my groups most resent investment $800,000).

The valuation driver is the amount of cash going in – the size of the cake.

If the investment is $200,000 the valuation is likely based on the lower end of the ownership band – 25% – so a valuation of $600,000. If the cash going in is $800,000, then the higher end of the ownership range will be used – 30%, so a valuation of $1.8 million.

So quite different ‘valuations’ for the identical company. The difference driven by how much cash needs to be put in to achieve key millstones (what needs to be done to get the next round funding, or an exit).

Now benchmark that valuation against likely exit values (using exits in the location of your company) – a $1.8 million value today needs a credible likely exit value of $18 million – without the company taking on any more funding (the investors not suffering any dilution), to archive a potential 10x return – needed to get a potential 2.5x – 3x return at a portfolio level, when you account for the companies that will return zero.

Perhaps investors should be encouraged to study Geography, not Maths, to get an understudying of valuation.