Startup Valuation Made Simple(r) – Working Backwards

Anyone who tells you valuation is a precise science is lying. This is especially the case with growing companies and verges on pure art for startups.​​

Every young person entering finance or banking quickly learns that you can do rather absurd things to enterprise valuations just by changing the discount rate.​​

What do you do when, on top of all that, the value of current revenues is—as it is for any venture-backed/backable startup—worth next to nothing, and the projected future revenues are basically the entire determinant of the company’s value?​​

I’ve had a lot of cases where people say, “How the hell did they get to that ridiculous valuation with so little traction?” Some of it, of course, is often hype and sales ability (Theranos or Juicero anyone?).​​

Still, there is a method to (some of) the madness. And there’s an easier way to understand what you can get beyond the traditional, “Well, what are we worth at this stage/traction?”

Work Backwards

How much do you need to get to your next funding round? Take that number, multiply by about 5 (between 4-6, adjusting for the strength of your team/traction/etc.).​​

Of course, people know that this is often how rounds get priced, but they’re not sure why it works that way—or why it doesn’t work sometimes​.

The key is the next funding round part. ​​

Find milestones that look attractive relative to the amount you need to achieve those milestones, and the implied valuation from that. If it doesn’t work—as in, you can’t raise with that valuation—there are two possible reasons for that:

  1. ​It’s not an attractive enough milestone
  2. The milestone isn’t credible

Credibility is easy (at least to understand)

​The second point above is easy to understand: it’s your credibility on being able to reach the milestone you’re saying you’re trying to get to.​​

If you’re a startup that says, “I just need a billion dollars and I’ll immediately become Google/Uber/Bytedance,” and are walking in with the clothes on your back and an idea, you’re almost certainly not going to get funded. If you’re a serial founder who has built a previous Google/Uber/Bytedance, you might not get a billion off the bat, but you could potentially get a few tens of millions (or even hundreds) with just that.​​ If you aren’t… well, you likely aren’t getting anything except a swift end to the meeting.

This is usually the problem everyone knows about and tries to “get more traction/revenue/etc.” to deal with—or advisors, or LOIs (letters of intent), or whatever.​​

It isn’t a groundbreaking insight to most, but I do find it useful to make it explicit for first-time founders, who often only grasp this concept implicitly.​​

“What do these investors need to see to believe us?” is a useful framing question for a founding team. (Yes, I know the answer to that isn’t necessarily clear to first-time founders, but at least thinking about it will let them continue to build their case more directly).​​

Personally, I have mixed feelings about asking investors directly. They usually won’t specifically know ahead of time; it’s often an “I’ll know it when I see it” kind of thing, similar to how asking consumers directly, “what do you want to buy,” is often a fruitless exercise. You can certainly ask, but take the answers with a grain of salt.

Milestone “Hacking”

​First-time founders almost never consider the attractiveness of a milestone. If they do, it’s often in the context of despairing how much equity they’ll need to sell or that that they’ll never get anyone to invest.​ ​

And it’s quite understandable why.​

From a logical perspective, it seems quite stupid that the mere act of promising more will increase your valuation.​​

However, most of your value is future growth. Promising more of that growth faster and more upfront is inherently more valuable, even from a financial modeling perspective.​​

To be clear, you still have to be credible. Talking a big game alone is not going to help, unless you’re really persuasive. However, credibility can often come with a better articulated and clearer vision of how you’ll grow quickly from here—no extra traction required, just a better vision for the next 18 months.

“Not Thinking Big Enough”

In the real world, this concept is usually conveyed with extraordinarily vague and unhelpful feedback that a founder is “not thinking big enough.” This often encourages inflating the TAM (total addressable market) or adding on a smorgasbord of “expansion areas” that the startup can also address with its technology.​​

Neither solves the real problem at all.​ If anything, those tactics make a founder look less credible.

You’re still likely looking at similar milestones (unless your TAM/expansion inflation accidentally dragged up your milestone as well), and a similar issue of, “not attractive enough milestone” when you’re fundraising.​​

Instead, if you’re finding that you aren’t promising something exciting enough for investors, remember that you might not just need more credibility (earned either through traction/employees/advisors/whatever). You may need to go find a new milestoneeven if that milestone requires a LOT more money.

It’s just an easier way to get to a number

​It’s important to remember that this isn’t actually that different from traditional valuation with comps, etc. In most cases, you’ll find that you land roughly in a very similar spot as “asking around” for what the valuation should be at your stage. There’s nothing magic about it: you still can’t raise a billion dollars off-the-bat with a napkin sketch outlining world domination. Credibility constrains the milestone promise.​ ​

This just tends to be an easier way of thinking about it versus a vague financial modeling or Pitchbook/Crunchbase/etc. searching exercise.​​

The more important thing this allows you to do is adjust. You may have an innovative milestone that you could raise more money on with a higher valuation. In many cases, I’ve seen exactly that. A company has difficulty raising a small amount but is able to quickly fill its round with a bigger fundraise, even if the valuation is higher.​​

This isn’t just irrational exuberance of the VC market (though there is some of that). It’s also fitting the demand of your customer—in this case, VCs who want to see a pathway to even higher valuations and growth.​​

No one is going to be terribly impressed by your frugality if it results in very slow growth or a business that doesn’t look attractive enough in 18 months.​

With the dynamics of valuation often being counterintuitive, working backward should help founders approach the topic better—at least broadly speaking.​

(Originally posted on James’s Substack, Weighty Thoughts)

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