A Blog by Jonathan Low


Jan 28, 2015

Are Early Stage Tech Valuations Determined At Random - Or Does It Only Seem That Way?

A couple of billion for a 12 person team and no revenues.

This worries you! Have you no vision?

Or do the people paying those prices just have more money than sense? Because that's how it seems sometimes. The secret of course - not that it's all that mysterious since it takes a well populated village - or in this case, something more like a gated community filled with lawyers, bankers, accountants, pr guys and pliant regulatory authorities to make it all come together.

Weddings, animals, fitness travel and beauty are among the consumer concepts. Speech recognition, anything related to payments and everything mobile are pretty sure bets as well.

The reality is that there is some science - math, really - involved, but a whole lot of art, attitude and assumption, as well. Comparables - comparisons with similar companies that have gone public or been sold remain the bedrock valuation reference, even when the comparisons are at best aspirational and at worst utterly delusional.

Certain formulas have emerged which attempt to make sense of, if not justify, the prices paid. But ultimately this is about what entrepreneurship has always entailed: hard work - and hope. JL

Jonathan Friedman reports in Venture Beat:

At the end of the day, your valuation is whatever someone else is willing to pay.
To many, it seems like early stage startup valuations are determined at random. Given that these companies often fetch higher valuations vs. their counterparts in other industries — despite lack of significant revenue, hard assets, or even direct public companies to evaluate them against — this misconception is understandable.
But of course valuations are not generated at random, and there is some method to this madness. Below are four key factors that VCs take into account, both consciously and subconsciously, in determining a “fair” valuation for startups they are looking at.
Ownership Targets
Unless you are raising a party round where everyone is chipping in due to FOMO or option value, experienced investors may determine your valuation based on their loose calculations as to how much ownership they may need in your future exit to “move the needle” vs. the rest of their portfolio.
At the same time, smart investors also keep an eye on the cap table to make sure it won’t be a cause of misalignment down the line, negatively impacting founder motivation for generating long-term investor value.
Supply and Demand
We all learned in econ 101 that in an efficient market, supply and demand is the key determinant of price. But does this apply to the startup world?
At the micro level, if multiple investors are competing for a deal, offering startups attractive valuations is one way investors may distinguish themselves. In addition, startups with high investor demand often times are able to raise more money. This in itself can create a higher valuation.
On the macro level, a startup’s valuation is influenced by the supply and demand of capital within that startup’s industry and geography. For example, if you are located in Silicon Valley and working on a Fintech startup, chances are good that you will have a higher valuation than a medical device startup in Israel. This has to do with the different expected returns and cash flow requirements between these industries and geographies, and also with the supply of capital chasing startups in these sectors.
Deal Terms 
There is a famous angel investor who, when determining valuations, tells startups: “name your price and I’ll name my terms.” Smart investors calculate valuation differently than most founders, as they take into account factors such as ESOP, warrants, pro-rata rights, and liquidation preferences when determining expected outcomes. I won’t go in-depth on this subject as it’s covered in detail elsewhere, but the point is that price is one of many factors that determine actual valuation.
Investor Conviction 
What about predictors of startup success, such as quality of team, market opportunity, and traction? These are all factors that influence an investor’s decision of whether to invest in a startup. However, they don’t impact valuations beyond the fact that investors may be more flexible on valuations in opportunities they are especially excited about. All investors have at one time or another “overpaid” to invest in a company they really believed in, or walked away from others they believed were overvalued.
At the end of the day, your valuation is whatever someone else is willing to pay. Think of the above four factors (investor ownership targets, supply and demand, deal terms, and investor conviction) as levers to use in your negotiation to determine a “fair” valuation for your early stage startup.


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