It has nothing to do with your firm’s fundamentals, and everything to do with how you view the world.
It’s a rookie mistake: Fledging entrepreneurs tend to over-value their companies.
There are any number of reasons why. Let me just list five.
Ego. “If SpaceX, Uber and FlipKart are worth billions, then certainly my company has to be worth X,” with X being a lesser—but still eye-popping—number.
Envy. “I am as smart as the guys at Credit Karma, Houzz or Slack. So my company has got to be worth a bunch.”
Greed. “I’ve worked hard on getting their idea underway and the McLaren (or the house in Santa Barbara, or the G5 is the least I deserve.) If we value the company at say $60 million, I’ll have a payoff for all that hard work soon.
Lack of knowledge. It could be a matter of comparing the valuation of their company (apples) to cumquats (another company that really isn’t the same); or using outdated valuations models, or … The reasons doesn’t matter. What does is your company is probably worth (much) less than you think it is.
Lack of perspective. “This is such a sure winner we will scale to tens of millions of users in a nanosecond.”
Now I understand that world does not always make sense and sometimes companies that solve for no known problem receive mind-blowing valuations. Juicero comes to mind. (Google its latest woes.)
But eventually the world comes to its senses, but before it does, an entrepreneur can get a distorted picture of her company’s worth.
And it usually starts at the beginning of the fundraising process. Say you are starting a company that you’re sure is worth $10 million out of the gate. When you go to family and friends for capital, they are not really likely to question that valuation because for amateurs (as they likely are,) it seems like the outcome is binary. The business will either be a huge success or a write-off, and in either case the valuation isn’t critical. They just want to be helpful. And so let’s assume they invest a total of $1 million in your company that you valued at $10 million.
The company is launched and makes rapid progress and so you go back to your family or friends for another $2 million, based on a valuation of $20 million.
Things continue to go well, and so you go out for a third round of capital—say $3 million—based on what you now figure is worth a $30 million to $50 million valuation.
Your family and friends are tapped out, so you talk to the pros, venture capitalists, serious angel investors, or private equity firms and they are indeed impressed.
“This is a great business,” they say. “It’s worth $15 million.”
This happens all the time. Professional investors employ well-tested models for assessing risks and almost always arrive at a lower valuation than the optimistic entrepreneur. Suddenly, the business founder is faced with the unpleasant task of reporting this “down round” to friends and family. It’s tough to give friends and family bad news that will undermine their confidence in the entrepreneur’s judgment.
They will ask: “After all the progress we have made, and all the work we’ve done to improve the product and increase our prospect, how can the company be worth little more then when we started? And how can it be worth half of what you just valued it at?
The answer is simple: The friends, family, and founder were naïve to begin with about the real value of the company because their main mission was to get the company launched, and they had no real experience or capacity to assess the risks or realistic potential inherent in the investment.
True,ometimes early investors will ask for “down round” protection,which means if a subsequent valuation of the company makes their shares worth less than they paid, theywill get “made whole” by getting more stock issued to them. Not so bad.
A bigger problem? Employees with stock options may get spooked by the decline in value and choose to leave.
Given all the potential problems, here’s where I come out on this.
- Over-confidence and over-valuation (by the entrepreneur) tend to go together.
- Unicorns (Wall Street’s name for companies valued at more than $1 billion) are called unicorns for a reason. They’re rare. Rarer than a winning lottery ticket. Very few start-ups are worth $1 billion. And very few fledging companies are worth what their founders think they are.
I understand the desire to get your company’s valuation as high as possible as soon as possible, but that can lead you astray.
The solution is simple and it has two parts.
If possible, get experienced investors to come in early. The lower valuation they demand often can be more than offset by the doors they can open for you and the advice they can give you about strategy, hiring, market, product and the like.
And when you set out to raise capital for your new company, you can dream of being a unicorn but look for the funding that you actually need to launch your startup on more modest terms, to keep it growing, and to build the evidence that will prove that it’s a potential big winner to professional investors. In the end, if the company is going to be a screaming success, there will be plenty of gains to go around.
Treating your investors with respect will build trust that can pay dividends for a lifetime. Being greedy will close doors to good people for a lifetime. (Yes, investors are aware that entrepreneurs are passionate about their ideas. But someone will be more likely to invest in your idea—and keep doing so in the future—if you show some humility and try to look at your venture from the point of view of someone risking money to help you turn it into not just a reality but one that delivers exciting returns.
A slightly different version of this appeared in AlleyWatch.com
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