24 Aug A fair valuation for seed stage investments
The most usual cause of angst between entrepreneurs and potential investors is the valuation being given to the business – and therefore the equity being given up by the entrepreneur. This tension rarely arises because either party wishes to shaft each other. This would be daft at the start of a long-term relationship where there is benefit for both parties for the other to be pleased with and well-motivated by the deal. I believe it is because there are no commonly agreed approaches to valuing early stage investments.
Valuing a start-up is only vaguely related to the science of valuing an established business – there is not enough earnings data to make objective calculations. First Chicago/Venture Capital, Berkus, Risk Factor Summation or other such valuation methods are useful and objective if there is good disclosure and availability of risk data. But we believe valuing a start-up is much more of a conversation. Ultimately the only valuation that counts is when two parties are prepared to buy and sell.
We have this simple framework that helps structure the conversation and keep both parties objective with matters of subjectivity. It is a qualitative framework not a quantitative equation, but one maths principle is deliberate. It has multiplication signs, not plus signs. If any of these elements are missing the result should be zero. Even if one element is fantastically positive, a seasoned investor should be hugely wary if one of the others is missing.
So to each element in the framework:
Evidence: the proof points the start-up has that their proposition is going to be interesting and valuable to the target market. Ideally there will be some actual customers and revenue. But even at an earlier stage than that, any idea should have some kind of insight and research to back it up.
There are lots of cheap ways to gather feedback – both qualitative and quantitative – from potential customers. My favourite example is from James Averdieck when he launched Gü – the desserts brand. He mocked up his packaging, filled the boxes with sand and snuck into Waitrose and put them in a fridge display. He also had the foresight to print off a ‘shelf edge’ label. He stood back for a minute until a customer picked up the ‘product’, and then a really tense 30 secs until she popped it into her basket. (He ran after her and whipped it out before she got to the checkout.) A few experiments like that gave him confidence to give up his day job, take investment and launch the brand. In today’s digital age it is even easier. There are loads of digital tools that put products in front of customers for feedback, or an entrepreneur can start a conversation on social media to gauge reactions.
Momentum: building a business is about getting things done, and investors should see that an entrepreneur has built up a head of steam, has a clear plan for the next steps and has previously delivered on promises. A business that has been touting itself funding for a while – even if there are good reasons, such as the founder still being in full time work – will smell a little stale. Worse still is a business that has been trying to raise investment for many months.
Potential: of course, early stage businesses are all about potential. Making this as real as possible helps to quantify value. For example, mock-ups of a product or customer experience, visuals of a pipeline of futureproducts, research into the growth of a market or the holy grail of letters of intent or contracts from future customers.
Too many valuations currently are overweighting the value of potential, based purely on a great idea with very little in the way of evidence or momentum. This seems to be particularly true of crowdfunding, probably as there is not a proper conversation between entrepreneur and investors.
This framework – usually further backed up with numbers and projections – keeps us objective. It keeps us from getting swayed by what’s hot and from blindly following the market.