The dark art of valuing a company
Kickstart reviews over 600 companies for investment per year―think about that for a minute. That’s two to three companies per business day. The variety is stunning. Everything from simple consumer products to complex AI systems for radiologists. These products are sometimes only ideas. In other cases, they are already generating millions in revenue. The sheer variety is part of what makes my job so incredibly fun.
We can’t be experts in many of the opportunities we see. So we apply some simple heuristics to determine if it’s an idea we want to pursue. If you’ve ever met with a VC, some of these will be familiar: Is the opportunity space large enough to be interesting? (more on this in next month’s article). Is the solution creative, compelling, and valuable enough to drive customers to take a chance on a scrappy little startup? Are the founders smart, curious, engaging, and gritty? Is there some x-factor: a special skill, unique experience, or serendipitous circumstance that gives this company an edge in bucking the laughingly long odds in building a big company? Are we well suited, if not uniquely so, to help make a difference beyond our check?
Among others, these questions separate companies that get a quick “no” from those we invest time to investigate further. “No” doesn’t mean you aren’t on to something really cool. It may just mean that it’s not for us.
We ask more precise questions on the journey of learning, dive deep on the founders, and endeavor to get a whole lot smarter about the opportunity. This process will usually take at least a few weeks, but the variation can be huge—from months to minutes. As one extreme example, I made a verbal commitment to a $600,000 investment 45 minutes into our first meeting with the CEO.
For investments we decide to pursue, our attention turns from evaluation to deal-making. If we want to lead the deal, which we usually prefer, this means proposing and agreeing on terms. There is a lot of detail that goes into term sheets, but founders and startup watchers seem to focus on one far more than all others: valuation. While valuation may be the ultimate vanity metric of startups, it definitely preoccupies the founder’s mind.
So, how do we come up with a valuation? It’s a highly scientific process involving deep-data sets and multivariate regression analysis. And if you believe that, I have a lovely bridge here to sell you. The reality is that at the pre-seed and seed stage, valuation is a dark art. It relies on benchmarks, subjective assessments, competitive dynamics, and other qualitative criteria. More than anything, we rely on decades of cumulative experience and over 100 prior investments—or, if including follow-on checks, well over 200 decisions—to inform the view of what a company is “worth.”
Recognizing that no deal is truly standard, let me take you through a fairly typical pattern of thinking on company valuation. First, we seek to understand the industry and opportunity size. Larger markets with lots of customers generally mean a bigger target and, therefore, more upside. Second, we evaluate any data that we have on company performance: customers, price charged for the product, margins, retention, contract length, and value, etc. Hard data makes for better analysis. The more we have, the easier it is to apply objectivity to a valuation.
Third, we think about the business model. High-margin SaaS businesses with sticky customers and recurring revenue generally earn higher valuations than transactional businesses with lower margins (although there are many exceptions). Fourth, we carefully evaluate the management team. This assessment, while nearly entirely subjective, affects valuation more than founders think. At the pre-seed and seed stages, we are joining the founder for a journey that is not yet mapped out, let alone knowing the exact destination. We are placing extraordinary trust in the team’s ability to figure it out along the way. The more confidence we have in a team, the more risk we feel we can take with deal terms, all other things equal.
So, with this analysis done, we’re ready to set a valuation, right? Not so fast. Lots of other factors affect our thinking, including these:
How much do the founders own?
At times, companies have gone through fits and starts finding product/market fit, burning through prior investment that came in on lower valuations. This may mean less than optimal founder ownership when we are preparing to invest. When it comes to founder motivation and commitment, ownership matters.
What may the future hold for additional rounds of financing?
Companies need to win every round, so the present valuation should be set in a way that increases confidence in a comfortable uptick at the next raise. Market conditions can change, companies can under- or over-perform their forecasts, critical leaders might leave, and countless other things can happen that make crystal balls quite clouded.
Projecting future rounds of financing has become harder than ever before. The last few years have seen a massive flow of new funds into VC at nearly every stage. This has meant a shift in terms toward what we’d all call “founder-friendly.” No problem there, but I’m seeing a big risk for what my friend and fellow VC Jeff Stowell calls “pricing to perfection.” This basically means that nearly everything has to go perfectly from the close of this round to the pricing of the next to avoid possible disaster in the form of punitive terms, if terms are available at all.
Smart founders take the long-term view and don’t want to pile on that risk. It’s tempting to get while the getting is good, but I think many of today’s venture rounds will be proven to have been too good by the time companies have to raise again. Markets have cycles. Pretending that they don’t isn’t in anyone’s interest.
How much money does the company really need?
The wisest founders I work with realize that raising too much money, even when it’s there, can lead to dumb decision-making. I’ve said it before and believe I will say it until I die: scarcity is a virtue.
One of the most salient signs of a smart CEO is knowing what you really need and not taking more (except in the form of a modest buffer for things that may go wrong). As of my deadline for this article, I have two companies raising Series A rounds for which there is market appetite for over twice the amount of money the company is deciding to take. More money artificially pushes up valuation (to solve for dilution), which then compounds the risk that future financings are harder.
Is there competition for the deal?
Great companies have options, and while we’d like to feel we’re the most amazing seed fund on earth, most founders will seek multiple options to make sure the round gets done and that there’s a great match to the investor they choose. Smart founders don’t decide on terms alone, but that doesn’t mean that terms are immaterial when presented with more than one choice.
So, let me summarize: Terms aren’t everything…
We strongly believe that deal-making is the start of a long journey together. Unlike a bargaining conversation over a used car, the dynamics of the deal set the tone for the relationship, and the relationship really, really matters.
After our deliberation of everything I’ve described above, we start a dialogue with the founders about terms. While some funds are comfortable just lobbing term sheets at founders, we strongly prefer a dialogue to surface any possible disagreements that could kill a deal. Once we know we are in a similar range, we can solve for a solution that works for both.
This dialogue can, at times, result in some crazy disconnects, both on the high and the low side. If the founder’s expectations are far higher than we would consider, that usually brings the discussion to a quick close (although we usually learn this long before this stage). On the other hand, while it doesn’t happen often, it can be tempting to lunge at deals that―for any number of good reasons―seem incredibly attractive in price.
Founders with modest expectations on price aren’t necessarily wrong. If that’s what it takes to get a financing done, then that’s what it takes. Indeed I’ve wondered if there’s any real correlation between the valuation of a company at first investment and the ultimate success we see in our returns.
…but terms also matter a lot…
Terms matter because terms and initial check size determine ownership, and the effect of ownership quickly compounds as companies prove their success. With the most successful companies, seemingly trivial disparities in ownership can mean the difference between returning the entire fund, sometimes multiple times over, or simply a really nice outcome. When you have a company worth $2 billion, the difference between 10 percent and 7 percent ownership at exit is a cool $60 million. The math is easy. Valuation, and by extension ownership, really matters.
…and terms are hard to get right…
Sure, oftentimes, the best companies command the best prices. Of our top five companies in terms of enterprise value, two of them were priced at what I’d say were uncomfortably expensive terms at the time of our first investment. We thought hard, gulped, and moved ahead. But the converse is also true. Some of our most challenged companies were among the more expensive at first investment. It’s hard to find a pattern here that results in an easy formula for deal-making. This business is not that simple.
…but if terms were easy, it wouldn’t be venture.
I’ve often been tempted to envy the growth stage funds that are evaluating long track records with what may seem to be far greater predictability in how the company and investment will perform. There’s some basis for that envy. The uncertainty about success at pre-seed and seed is kind of insane and definitely stressful. But then again, if it were completely sane it wouldn’t be nearly as interesting, and not quite venture capital.