Fundraising

Startup Valuations: Why They Don’t Seem to Make Sense + How To Increase Yours

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Startup valuations don’t seem to make sense. Here’s why — and how simply having a better plan can improve your valuations and help you build a better company.

I’ve been working with startups to fundraise and grow for over 10 years.

Startup founders, entrepreneurs, and tech investors are among the smartest people I’ve ever met. They’re often brilliant mathematicians, engineers, or business minds.

These exceptional people enter private tech and often come to a quick conclusion: startup valuations don’t make sense.

I’m going to explain:

    • Why startup valuations are non-intuitive.
    • . . . but why it doesn’t matter.
    • How to understand and turn these nuances to your advantage.

Startup valuations are based on elements that aren’t seen in other markets. It’s what makes the world of startups both incredibly volatile, and world changing.

Why Startup Valuations Don’t Seem to Make Sense

Forget the fact that startups should be valued using objective, rational criteria. When you apply the linear logic of markets to startups, it simply breaks down.

There are many ways to express the apparent lack of rhyme or reason, but here are two examples.

Example 1: Comparing companies

  1. Startup A has two founders and no product and no revenue. They raise money on a $10M valuation.
  2. Startup B with a product, traction, and $1M revenue. They raise money on a $5M valuation.

This sounds like BS. What could it possibly be based on?

Example 2: Equity

Another example.

Mathematically, you only need two things to determine valuation:

  • Amount of money you’re taking in
  • Amount of equity you’re giving away

One may therefore assume: if you double the amount you’re taking in, you should double the amount you’re giving up, right?

Wrong.

The rhyme and reason behind startup valuations

There are several things you need to understand about both the opportunity of startups, and the investors who fund them, for these mind-bending examples to start making sense.

1. Startups are based on a “secret”

The entire private tech startup market is premised on opportunities that people don’t fully appreciate. These “secrets” are impossible to measure at the Series A stage.

Normal questions to determine a company’s value:

  • What market are they in?
  • What’s their revenue?
  • What are comparable companies trading at?
  • How can we estimate and extrapolate a company’s potential based on the above factors?

None of those are relevant to startups because a private tech company is based on a secret.

As popularized by Peter Thiel, these “secrets” are thusly named because the only people that see it are the founder, the founder’s employees, their customers, and an investor who gets it — or at least, trusts them.

The rest of the world doesn’t get it.

2. Opportunities are more valuable to some than others

Opportunities are not created equal and do not have a static value. It’s a foundational premise of this industry that many people miss when they scoff at acquisition prices.

Take, for instance, Whatsapp.

Facebook bought Whatsapp for $17B when they had no revenue. On the surface, this is insanity.

For perspective, look at the value to three parties:

  1. To me, personally, Whatsapp wouldn’t be worth very much. What could I do with a messaging that doesn’t generate revenue?
  2. To a retiree who wants to get a dividend on a revenue, it would be damn near worthless.
  3. If McDonalds bought Whatsapp, they could at least do something. Maybe make a french fry branded version that sends out messages to everyone when the burgers are ready. If they’re lucky, it drives 0.5 – 1% uptick in sales. It’s not worth very much to them.

Facebook, however, can do a lot more with Whatsapp. Facebook is expanding messaging capabilities and trying to drive usage among younger generations. They have 10-digit users, and a sophisticated ad network that could be deployed at any time.

Facebook has a future to protect, and that future requires a continued ownership of communication channels. Those channels don’t have value to someone who hasn’t built an ecosystem, which Facebook has.

For another example, Twitch wouldn’t be useful to a lot of companies — but Amazon ended up rolling the streaming company into a cross-sell of its Prime offering.

In tech, there are opportunities to solve problems that are really valuable to certain people.

I have a friend who sold her company to Mastercard. Someone at the acquirer gave her some of the best, most candid advice I’ve ever heard once she came aboard: get involved with as much as you can, learn about our problems, think about a problem . . . then leave, start a company and we’ll buy you.

What he was essentially saying: we need startups to learn about our problems and go solve them.

You could build a solution that may not have revenue or users, and solves a very technical problem. But Mastercard has revenue, users, and technical problems, so your solution is quite valuable to them.

Remember, secrets may only be visible to a small number of people who have been exposed to it. Don’t mistake that for lack of value.

3. Any company worth venture capital will likely raise a lot of $$

Companies that are on to a special opportunity almost always need cash in order to capture that opportunity.

For a non-tech example, let’s say I open a shop with a breakthrough sandwich that no one has ever seen. Everyone loves it.

  • I open my shop and sell out instantly. I’m talking sandwiches gone in 10 minutes! This is well and good, but I feel constrained. I can only sell 100 sandwiches.
  • I make $100 net profit, which I plow back into the business. If I continue to scale this way, I can grow without funding, but it’s slow and incremental growth.
  • The problem is that maybe I can sell sandwiches all day long: not just 100 in 10 minutes, but thousands in a few hours.

Knowing this, I’m not going to wait to get that cash. I want it upfront, to grow all at once. Let’s buy the next month’s worth of sandwich materials and grow this thing!

That is the situation of every successful tech company: Facebook, Uber, Tesla, SpaceX.  If you’ve found a truly great opportunity, it’s so hot — and demand is so high — that you can barely keep up. Those are the companies investors want.

If you can grow a startup from your own profits, you probably either:

  1. Don’t have a venture capital-scale opportunity, or
  2. Are leaving serious opportunity on the table by limiting your growth, and exposing yourself to competitors who can grab early market share.

The investor mix — and model

An investor might say to a startup, “I’ll give you $1M for 25% of your business.”  To break it down, this means:

  • 25% of the business is worth $1M
  • $1M x 4 = $4M post-money valuation
  • $4M – $1M = $3M pre-money valuation

But if you want that investor to double their investment, the formula collapses. Maybe they really like you and want to invest $2M – $3M. Not only will they not ask for 50% or 75% of your company — they shouldn’t even accept it.

There are two variables in startup investing:

  • Investment capital
  • Equity

And there are two broad categorizations of investors: angels and venture capitalists.

Angel Investors

Angel investors are using their own money to write smaller checks. If you’re raising $1M, an angel may or may not have it. Their capital is limited, so that’s not an area where they can be overly flexible.

But the other side of the coin, equity, is where they can be flexible. They might only have $50K or $100K, but they can be flexible in the amount of equity they take because they’re not accountable to anyone.

If they believe in you and it makes sense to them, you may be able to negotiate it down. Granted, some angels are committed to a specific equity strategy and won’t budge. But it’s worth finding out.

Takeaway: Angel investors can be flexible on equity, but have limited capital.

VCs

VCs are investing other people’s money — that of their limited partners, or LPs. Those could be insurance companies, endowments, retirement plans — much more.

VCs are responsible and accountable to their LPs. They have a business model they must stick to; if they deviate, LPs won’t trust them and the fund dries up.

Because of this, VCs are not generally as flexible on equity. In a Series A round, they will usually ask for 15% – 30% (which I’ll explain in a moment). You will not get them to budge too far outside this range . . . but you can ask for more money.

Takeaway: VCs aren’t very flexible on equity, but they can give you a lot more money.

Why VCs ask for 15% – 30%

VCs are searching for those great opportunities that will skyrocket. Knowing that, there are a few underlying assumptions that drive their business model.

They need you to grow fast

The term “venture model” means “grow crazy fast”. If you don’t have a formula that you can pour money on to grow rapidly, you’re not a venture-backable company.

Since the “secrets” of startups are hard to interpret, VCs place a lot of bets — and most fail. The power laws of startup investment mean that they don’t want you to grow solidly, or even really well.

It needs to be explosive growth, and anything less is a failure.

They know they’ll get diluted

Since high-growth companies need capital to scale, this round won’t be the last. You might raise one, two, three or more times.

That means dilution for investors. For this opportunity to be worth their time, projecting for dilution, it’s often hard for them to accept less than about 15%. They have LPs to please.

They need you to stay motivated

For a startup to overcome the competition, successfully iterate their product, and grow, you need a motivated founder.

Most successful founders are driven by an internal fire and the passion to solve a problem . . . but VCs want to ensure that founders also have sufficient financial light at the end of the proverbial tunnel.

They don’t want to make a significant investment in a company where the founder gets diluted out of being motivated.

What to do about it? Dream bigger.

To summarize the narrative to this point:

  • Valuations are based on opportunities no one else sees, which are more valuable to some than others
  • A startup’s value is not linear, nor is the investment-to-equity ratio.
  • Angels are constrained by cash, VCs are constrained by equity requirements

What do you do with all this?

My answer is quite simple: have a bigger plan.

There’s one other thing you need to know about VCs. Anyone who can write a $5M check can write a $10M check. $10M can be $20M. You get the picture.

When you’re networking and talking to investors about what you’d do with $1M, also have a plan of what you’d do with $10M.

Not only can VCs write a bigger check — they want to.

Think about it from their perspective. It’s really hard for VCs to find a company that can take $5M and turn it into $100M. When a VC does find it, it’s hard for them to get in on the action —  because a lot of VCs are competing to make the investment.

As a VC, once you do find that company with the ideal growth potential, you want to deploy as much capital as possible.

Your LPs are expecting you to take $X and turn it into $Y. The last thing you want to do is write a small check and start that process all over again.

Increase valuation by thinking more ambitiously

If the investor’s already talking to you about cutting a $5M check, keep in mind that they are more than capable of giving you $10M.  That difference almost doubles your valuation.

Instead of $5M for 20%, you can probably raise $10M for 25% or even 30% – but they’re not going to ask for 50%.

Just remember, you need a great plan that shows you can deploy the capital effectively in about an 18-month period.

The value of a plan

By figuring out how to  more money and grow faster, you can increase your round — and, therefore, valuation.

When some people hear that, they think it’s a hustle.

But the truth is, plans are valuable. A great business plan can already put you in a better position to dethrone or outpace the competition.

Think again in terms of the VC. They’re thinking, “How much money can this entrepreneur deploy effectively and essentially double the valuation in 18 months?”

A bigger, better plan shows the opportunity for greater ambitions and bigger growth — and that’s what VCs are interested in.

Sam Altman has spoken about the virtue of being more ambitious, with a focus on scaling and hiring:

“At the very beginning of YC, we encourage more ambition.The potential of a big, bold impact is critical to attracting people to your mission down the road. If you start a company that people won’t get passionate about if it’s successful, you’ll run into problems scaling.”

Once you can create a solid plan to be able to execute on higher ambitions, you can get VCs — and talent — more excited.

Summary

Venture-funded companies are chasing huge opportunities where time and cash are the biggest constraints. When you find an opportunity, prove an initial model, and need funds to grow, don’t be afraid to plan for more capital.

This means a bigger round and higher valuation for your startup.

No matter how much money you raise in your Series A, your post-valuation is usually going to be about 5 times that.

If you go and raise $20M from Sequoia Capital, it will likely be close to a pre-money $80M and post-money $100M valuation.

When you’re preparing for your Series A, have an ambitious plan, but also be ready with an extra-audacious plan that could change the fortunes of your startup.

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Augie is a co-founder and Managing Partner of Atrium LLP. As a dealmaker and former Big Law partner, Augie developed one of the most successful startup law practices in the Bay Area. His clients have included the driverless car industry’s first “unicorn” startup, the world’s fastest-growing SaaS company, the first venture-backed consumer packaged goods company in the food industry, as well as several of Silicon Valley’s most prominent venture funds in investments spanning mobile gaming to heavy industry.

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