In case you missed it: SeedLegals updates November 2022
We've streamlined Advanced Assurance applications, improved EMI valuations and we're launching SeedSAFT alongside an adv...
>> Continued from Part 1, What drives your company valuation?
Let’s start with the vision and mission. What are you setting out to do? What problem are you going to solve, what broken process are you going to address and how do you plan to disrupt and innovate. Without disruption, it is unlikely you are going to attract customers, partners or buyers, let alone employees that will need to follow your dream. Without innovation, you will struggle to address the current needs in a revolutionary way. What is your simple vision and can you make it a mission?
How good is your team? How many Founders are there? Have they worked together before and are they going to get along? What are their key skills? Do they have the required leadership, the relevant expertise and industry background? Have they worked at leading technology companies or industry leaders? Do they have solid education or a prior background as entrepreneurs? Have they experienced fast growth? Do they know where they are going? Is the strategy clearly laid out? Does the management team including the founder display the right set of skills that corresponds to the key challenges of the company going forward, and in particular in the next 12 months? What is the culture of the company, what is the style of its key people? Are they doers that will deliver? Or dreamers still thinking about how to bring their vision to market? Clearly People risk is the biggest risk component. The more expertise the better, the larger the relevant set of skills the lower the execution risks.
Do you have a product and is it ready to go? And if not do you have the right team to build the product, do you have a CTO, do you plan to develop your products in house or do you plan to outsource them? Has your product been tested? Does it work? Has it been validated by customers? How will the product evolve? What piece of evidence do you have of the product relevance to your target market? If you don’t have a product, are you still far away from revenues which will close the door to many VCs and investors who will be looking for revenues? If your product is not there yet, there is a risk that you never deliver the right product on the market or that someone else does before you.
How big is the market you are planning to disrupt? How fast is it growing? How do you think about the market? Will you be able to address the market with the first version of your product? Have you validated the top down and bottom up market analysis? How many clients are you targeting and how much will you sell to them? What is your addressable market and what market share do you plan to hold after 3-5 years? Is your domestic market enough to build a large enough business? The larger the market the better, if your market is small it means that you need a large market share to build a sizable business and you will have a harder time convincing your investors, especially in early stages.
How do you plan to find customers? Or have you done so already? Is this a BtoB or BtoC play? A sales play or a marketing play? Or a business development play towards a network of partners? How soon are you planning to expand? Via geographic or product expansion? Have you launched your product and what evidence do you have that there is a product to market fit? When are you planning to do so and do you have traction since launch? How does that traction materialise? Through revenues or usage? Depending on your go to market strategy, do you have the relevant skills like sales, marketing or business development to implement your strategy?
How simple is your business model? Is it a proven business model? Or will your customers need time to understand it? The simplicity of your business model is key to lower business risks because if you don’t know how to sell your products and what price you will charge to your customers or whether you will charge your products or services at all, then it is likely that a lot of people will spend a lot of time looking for a business model that makes sense. This is particularly true in innovative models like marketing where not only the business model does not exist but what the company is selling is not even clear.
A good business is a business where there is some certainty around the fundamentals. How much are we selling and at what price is one thing but more importantly, how do we make money and how much do we spend to acquire a customer. All the metrics around customer acquisition costs and life time value of a customer are key metrics which a lot of investors have a lot of knowledge and expectations about. Be sure that you clearly understand how your business is going to make money and generate profitability. And sure some companies have take a lot of time to get to profitability but the best companies are the companies that get there the fastest. They don’t need to raise as much capital and present a lower financial risk and it is so much better to be in control of your destiny with sound unit economics and decide to raise more funding when you want to accelerate rather than when you are running out of cash.
Some people will say that the financials in an early stage startup mean nothing and that the numbers are so uncertain but it is precisely the team’s ability to prove that there will be significant revenues and profits generated in the future that investors are looking for. It starts with the plan and its ambition. If numbers are too small, many investors will see this as a small opportunity and will pass. If the numbers are too big and not driven by credible assumptions, they will also pass because their confidence in your plan will be too low. The consistency of your financials is very important, the various ratios or key metrics and variable you are defining in your plan are going to reflect how you think about your business and what are the things you are going to look at. So yes everyone expects uncertainty but remember that if your numbers are too aggressive some astute investors could ask you to link the valuation to those forecasts. Beyond the long term consistency of the plan, the short to medium term consistency of your financials is also key. You need to show how on a monthly basis, you are going to deliver your business plan. What runway are you building when raising your round of funding and what do you plan to have achieved when you run out of fuel. Make sure you are able to show your investors that the next time you plan to raise some money, you will have made significant progress for the next round valuation to go up significantly. If not there is a major risk of flat round which nobody is interested in.
Always aim for a balanced deal with your investors. It is not a them versus you. It is a journey that you want to take together. Always look for alignment of incentives in the deal you sign. A balanced deal is a deal that respects market conditions and a deal that is fair. If you can make the deal seis or eis compatible, do so, you will attract more business angels. Always plan to give terms to your investors that you know you will have to give to your larger investors. Plan to give non participating liquidation preference to all your investors, it is just fair to so and would not be fair that you make money on what they have lost. Plan to give anti-dilution protection to your VC investors but avoid any full ratchet unless the market has changed dramatically. If you plan to go on a journey together with your investors make them feel that you welcome their participating in the decision-making of the company, at the board or through investor majority consent. And provide information to your investors, this is a good way to ensure that they help you when you need them. Don’t be too greedy on valuation, it is better to strike a balanced deal than a deal where your investors need to wait for the first opportunity to go up in equity.
Always think carefully at who will be your potential buyer. Sure you may always end up having an IPO exit but it is less likely. So the key is who will buy the company and why and whether they will be ready to pay a high price or not. It is generally safer to see innovative buyers than traditional incumbents as they will always be lucky to have higher growth and be valued on higher multiples themselves and if they are they will be ready to pay similar multiples for your business. Also make sure that you multiply the opportunities for partnerships with the players who could be your acquirers, if you impress them it will increase their appetite to buy you. Finally be sure that your ability to disrupt is going to annoy a lot of big players when you start being successful. So doing things they do in a way which is a game changer for their target customers means they will have more appetite to get you on board.
So where do we go from there on valuation? Well you now have all the valuation drivers. Your valuation is then going to be a combination of your plan and the risk analysis of that plan. The venture capital method is looking at an exit valuation after 3- 5 years, on the basis of your revenues, or more likely gross profits and EBITDA using market multiples. Such valuation is then discounted to today to derive a valuation of the company today. Sophisticated investors are going to use a discount rate that will vary tremendously and this is why the range of valuations can be so large. Be sure that the discount rate they will use will be at least 30% which is the minimum return which large private equity funds are applying to their own investments. So early stage VCs are likely to use higher discount rate levels, well above 30%, to cover the uncertainty and risks as well as make sure that their winners will cover their losers. So the best you can do is address your risk ladder and create scarcity value by scoring high on most dimensions. If you do more investors will see you as the opportunity not to miss and your valuation will go up. There are rules of thumb than investors also use which make no sense