Getting a high valuation for your startup is not the measure of success many founders believe it to be. Below, the different elements behind getting a good valuation are deconstructed.
Books and lawyers can help entrepreneurs learn the art of negotiation, but when it comes to valuing a company, negotiation is only part of the equation.
Many founders want a high valuation. It’s on the last slide of the pitch deck. They meet the investor and pitch energetically. They get to the last slide, pauses and say the big number. Theylook the investor straight in the eyes. The room turns silent. They think it’s all about being confident. To look like they are worth it. I used to think so too. Now, I know better.
Getting a high valuation is not like a Turkish bazaar where starting high and expecting half pays off. The truth is that valuation is tricky. In fact, it’s downright peculiar. After 3 years of startup investing and raising funding for about 14 startups, this is what I know:
Valuation is not value
Valuation indicates "value". It is a poor choice of word. It has little to do with value. I once talked to founder. He told me that an investor had given his startup a €2 million valuation. He said that he was a millionaire because his startup was worth €2 million. He was wrong. Valuation is not value. Value is something a buyer assigns to an asset. Investors are not buyers. They don’t want to buy. They want to sell. They are investors. If they wanted to buy, they would want a majority of the shares. They don’t. In most cases, startups don’t have any value. None wants to buy it.
Then what is valuation? Valuation is distribution of shares. It calculates how many shares the investor will receive. That is all it is. Does this matter? Certainly! But, not as much as founders think. Only two things really matter: 1) how much influence the founders have 2) how much money founders get in an exit scenario. None of them are a direct function of the share distribution.
Instead, influence is a function of the rights assigned to the particular shares. It is possible to have large shareholders with limited influence, and have small shareholders with significant influence.
How much money founders get in an exit scenario is a function of the price of the company, liquidation preferences assigned to specific shareholders and the amount of shares held. Two of the three elements are detached from the distribution of shares.Conclusion: valuation matters, but not very much.
Valuation is primarily social capital
Even though valuation is not that important, founders still want a high valuation. It feels good. It’s a vanity number that influences the morale of the team, increases chances of getting media coverage, and impacts the level of support you get from your personal network. In other words, valuation is social capital. Human hierarchies areformed bysocial capital. In that context, valuation is important.
The limits ofvaluation
Getting a high valuation depends on more than just the haggling. If founders understand what those things are, they can increase their valuation. If founders know which things matter the most, they can maximize their valuation.
What matters and how much below:
The first thing founders should know is this: The valuation has limitations. Not because investors have a sense of fairness. But because (institutional) investors have specific investment strategies.
Investment strategies restrict investors. In practical terms, it means investors aim to own a specific amount of the company and can only write checks within a certain size frame.
At Accelerace Invest, we often meet founders who ask for amounts we simply don’t do. The reason is that investors have investors. And the investors of the investor don’t like to see their asset managers go rouge. Many founders don’t know this.
In essence, this means that founders should understand the investment strategy of the investor because it governs the limitations for the valuation.
Getting the maximum valuation
Maximizing the valuation is basically a function of three things. 1) Performance of the startup, 2) competing funding offers the startup has received (term sheets) and 3) negotiation skills.
1) Performance of the startup is a function of A) the historic performance of the startup and B) the future performance of the startup.
2) Influence by alternative funding offers are a function of C) the status of the competing investors and D) the number of competing investors.
3) Negotiation skills are a function of E) the founders own skills and F) the skills of the advisors they use.
Now that we identified the variables, let’s assign the weights.
What is most important? 1) The performance of the startup, 2) the competing funding offers or 3) the negotiation skills?
The performance of the startup
The obvious answer is the performance of the startup. If a startup makes a ton of money, the company is really valuable, right? Yes and no. The problem is that some startups get a really high valuation with no significant traction.
The second obvious answer is negotiation skills. Being confident and have the right arguments, right? In combination with stellar performance and investors flocking around you, negotiation skills will work in your favor. Without performance and other investors interested, confidence and arguments are hollow and delusional.
What about competing funding offers? Are those important for valuation? Experience tells me that they are. In fact, they often trump everything else. If investors flock around a startup, the game suddenly changes. I’ve seen it with a couple of startups I helped raise funding. Their fundraising processes were no longer just a game between the founders and the investors. It became a game among the investors.
With multiple investors in play, the game turns social. Some investors are friends. Some are not. Some have a low status and other have high status. Played right, this game can work in the favor of the founders.
Founders can get investors to compete, bid and form alliances. Suddenly, the main argument for investing can be: "This really well-known business angel or VC fund is investing at this valuation". The valuation becomes detached from performance or negotiation skills. It is driven by the game investors play among each other.
So, to maximize your valuation, leverage competing funding offers.
This article was originally posted on David Ventzel’s blog.
The post Valuation doesn’t matter much, but here’s how to maximize it appeared first on Nordic Startup Bits.