EDITIONS
Startup Advice

Why entrepreneurs should focus on value rather than valuation

Sripati Acharya
29th Jan 2016
5+ Shares
  • Share Icon
  • Facebook Icon
  • Twitter Icon
  • LinkedIn Icon
  • Reddit Icon
  • WhatsApp Icon
Share on
"Twenty years from now, you will be more disappointed by the things that you didn't do than by the ones you did do. So throw off the bowlines. Sail away from safe harbor. Catch the trade winds in your sails. Explore, Dream, Discover." Mark Twain.

As a seed stage investor, I come across many entrepreneurs and they come in all shapes and sizes. Above everything, I admire their courage, tenacity, and willingness to do something new Apart from these qualities that make entrepreneurs stand out, a lot of factors go into making a successful startup. Some factors that cannot be controlled by entrepreneurs include market timing and luck. However, an entrepreneur can make a choice between focusing on valuation and value.


yourstory-valuation-and-funding-feature

Valuation is an important aspect and something that entrepreneurs needs to pay careful attention to at the time of fundraising. It is a thorny issue that comes up while raising the initial capital, and then at each subsequent round. However, a manic focus on valuation boomerangs in unexpected ways and can ultimately destroy value.

Let’s say there’s an early-stage company that has previously raised some initial funding, is seeing good traction, and is now ready for the next round. They have had very positive conversations with VCs and two offers on the table. The first one is for a $5 million raise on $15 million pre-money valuation. This will result in a post-money valuation of $20 million with a 25 per cent dilution. The competing offer is for a $10 million raise at a $20 million pre-valuation. This results in a 33 per cent dilution at a post-money valuation of $30 million. Which one is the better offer?

In order to answer that let’s fast forward to the next funding round, which would typically happen within 12–18 months post the previous round. In case of the first offer, for existing investors to not have a down round, the funding needs to occur at a minimum $30 million valuation, which is the post-money valuation of the company. And for it to be considered a positive event for the company, at least a 50 per cent bump up from the previous round. This makes it a $45 million pre-money round.

In the second case, it is a $20 million post-money round and a good outcome is a pre-money valuation of $30 million.

The difference here, between $30 and $45 million valuation, is significant. What might be a short and heavily contested fund raise with multiple term sheets at $35 million can become a long fund raise cycle at $45 million. This can have a negative effect on moral of the founders and employees and restrict growth investment during the fundraise.

In other words, there is smaller margin for error when raising a larger round at a higher valuation. Not that raising money at higher valuations is bad, but it should be done with the complete understanding that the built-in expectations are higher to deliver higher results, faster. It also has implications on valuation expectations for subsequent funding rounds.

When Baidu.com went public in 2005, it opened at $27. It ended the day, however, rising more than 350 per cent, at $122. The story goes that the founder, Robin Li, instead of being over the moon, was worried. Why? Because he was prepared for running a company with expectations consistent with a $27 share price, not $122. Baidu has done well since then – now at a split adjusted $2,000 – nevertheless illustrates that increased valuation doesn’t come for free.

As an entrepreneur, focussing on value is prudent – value that is being delivered to the customer, value which is created in the company from sustainable differentiation, value that the end customer is willing to pay the desired price for.

Valuation is a side effect of all of these efforts.

Valuation is heavily dependent on market conditions. It is a function of supply and demand for funds in the market. The same company could have a valuation that is two times in a ‘hot’ market with identical metrics than at other times. Valuation, for this reason, can be a dangerously misleading success metric – one that the entrepreneur has little control over, yet one which is the most visible externally as well as within the company.

For an entrepreneur, it is much better to focus on something that is under their control versus linking success to something that is not.

5+ Shares
  • Share Icon
  • Facebook Icon
  • Twitter Icon
  • LinkedIn Icon
  • Reddit Icon
  • WhatsApp Icon
Share on
Report an issue
Authors

Related Tags