When it comes to choosing an investor, valuation should be just one of many selection criteria. The nonvaluation terms of a deal are also critically important. Minor changes in the deal terms can lead to wildly different economic outcomes for the founders. Work with your lawyer to watch out for terms like the liquidation preference, number of board seats, option pool, founder vesting, and type of security. Any one of these can be much more materially significant than a 20 percent difference in the valuation.
Beyond the terms of a deal, bringing on a new investor is the beginning of a long relationship. You will have to work relatively closely for years to come. Investors can be a major distraction, so working with someone who respects your time can make a big difference. Also, an investor with the right connections can open doors. Interview CEOs of the portfolio company to get a feel for how helpful the investor is.
There’s a lot to consider besides the valuation that an investor semi-arbitrarily assigns to your company. As with anything else in life, you get what you pay for. Don’t miss an opportunity to form a great alliance over a few percentage points.
“What’s my company worth?” This is one of an entrepreneur’s most frequently asked questions. It’s also one of the hardest to answer. It is possible to value a company with a fancy financial model (e.g., Discounted Cash Flow), but the valuation will be based on projections that are little more than WAGs—Wild Ass Guesses. The dirty little secret is that, regardless of how sophisticated your model is, it’s impossible to say exactly what an early-stage company is worth. This is especially true with pre-revenue companies. In fact, valuation is so tricky that most seed-stage investors prefer convertible debt because it postpones the value question until the next round of financing. In the end, your company is worth whatever someone is willing to pay.
That being said, there are a few rules of thumb that should help you get to a ballpark estimate. Valuations of seed-stage investments are usually in the $1.2–$1.8 million range. VCs typically want to own 20 to 40 percent of a company in exchange for a $2–$10 million investment. To calculate the valuations of established companies with sales and profits, valuations are normally in the range of 2 to 3 times sales or 8 to 10 times profit.
If you really need an expert opinion, there are professionals who specialize in early-stage valuations and can give you an “official” estimate of your company’s worth.
This is the easiest money to get, and the hardest money to take.
Investors are necessarily skeptical of entrepreneurs trying to take their money. They will doubt your revenue projections, market size analysis, likelihood of key partnerships, or technical feasibility. In short, they will substantially discount most of what you tell them. In the end, investors have to ascertain whether you have what it takes to build a big business. If you can’t convince investors that you are capable, nothing else matters. As a result, make sure that much of your presentation is designed to establish credibility. And the earlier you prove yourself worthy, the better. Doing this at the outset creates momentum and interest that will carry you through the presentation. The opposite is also true—if your investor audience doesn’t believe that you can build the business, they’ll check out early.
Credibility is primarily established through experience, which de-risks your business in an investor’s mind. Be sure to highlight your team’s relevant experience. If you have a lot of technology risk, but your chief engineer has previously built something very similar, say that at the outset. If customers are hard to get, but you’ve already created and sold a business in this industry, say so in your opening comments.
Credibility is key, so build it early.
Landing an investor is always exciting. Maybe you were running on fumes, only weeks away from missing a payroll, and now you can keep pressing forward. Or maybe you just nailed your customer acquisition model and this investment will allow you to really take off. Without a doubt, a capital infusion can open doors and create new possibilities. But there is one important fact you need to know before you take an investor’s money—the day you cash the check is the day you commit to selling your business. Whether the buyer is a private company or listed on one of the public markets, the reason an investor buys a piece of your company is that she thinks she can sell it for more money down the road. Investors almost always cash out only when you sell the business.
What’s more, high return requirements can put investors and entrepreneurs at odds. In extreme cases, entrepreneurs have been offered deals that would have made them millionaires, yet their investors refused to sell, holding out for a higher offer that never came.
Take on an investor only if you’re comfortable with the fact that you will have to sell your company. And, when that day comes, realize that your vote won’t be the only one that matters.