What is a startup worth, really?
There is a 20 year "rule of thumb" that most investors use, even if they have forgotten where it came from - The Berkus Method. Is there more to learn?
Founders often feel their brilliant / genius / unique idea is worth £10,000,000 because they can see US VC and third time around founders getting seed capital at those valuations. It comes as a hard lesson to them when they get no takers at that price.
(Confession: in 2000, I did raise money for my own start-up at that valuation, and paid the price later)
The rule of thumb that most investors use was developed by Dave Berkus, a US-based “super angel” and well-known technology futurist. He wrote it down in the mid-1990s as a way of coping with the valuation of very early stage technology companies. This rule of thumb was necessary as most of the formal, accounting, methods of valuations of start-ups are based on the discounted net present value of future cash flows – and many start-ups simply don’t have anything except costs in the first six months to a year. While start-ups spend a lot of time producing financial forecasts and beautiful graphs with J-shaped curves, the experience of most investors is that fewer than one in a thousand start-ups will meet or exceed their projected revenues in the first five years. (My personal experience is that around 99 and a hundred will fall short, one in a hundred will meet their projections, and one in a thousand will so dramatically exceed their projected revenues that everybody is left with their jaws on the table).
Many people then looked at the factors that made for likely success, where likely success was defined as: “achieving at least $20 million in sales at the end of year five”. A company with that amount of sales is likely to survive, is likely to be an acquisition target, or can shift to paying a dividend. In other words, investors are likely to get some sort of return – even if it is only getting their money back.
What they came up with was five risks which, if they were mitigated, genuinely added to value.
(I’ve assumed dollars equals pounds)
If they have - This helps because +Add this to value
Sound Idea - Basic Value +£500,000
Prototype - Reduces technology risk +£500,000
Quality management - Reduce execution risk +£500,000
Test client or partner - Reduce marketing risk +£500,000
In rollout - Reduce production risk +£500,000
For the sake of simplicity, this would mean that a company that had all five factors would be worth £2,500,000 pre-money and would raise £850,000 for 25% of the ordinary shares. That should be enough to hire a team of seven people for 18 months which is a good runway for a start-up.
What is in it for the investor?
Working backwards, and if investors still have 25% of the company for their investment at exit, we can assess whether this was a good investment. A company with £20 million in revenue at the end of year five and a modest profitability of 10% that is still growing gently is likely to be worth 10 times profits, which in this case is the same as one times revenue or £20 million. The investors would have £5 million in value for £850,000 of investment over five years. That 56% IRR is pretty healthy.
The reality is, most companies take eight years to exit and have 5 to 8 rounds of further investment, which means that the early investors are normally heavily diluted by later rounds – most seed investors exit at 5 to 7%. And at 7%, the return is only 13% IRR. The other investors in founders take the rest.
That does not detract from the initial model – it works well, and is in line with a common assumption in the UK that a “good idea with a good founder is worth £1 million”
Can we do better?
But this still leaves a huge gap where founders have taken the idea a little bit further than a desktop prototype and have assembled a team around them and started to build some really strong processes around some excellent strategies and policies. This is often the case where small start-up teams exit from accelerator programs or start-up mentoring programs.
I would like to suggest that investors should look at those additional values, even if the company itself has not yet achieved the £1 million of revenue that would enable a shift towards formal valuation methodologies.
If they have - This helps because +Add this to value
Innovation management - Creates sustainable innovation +20%
5 – 7 in core team - Reduces team building risk +20%
Diverse team - Increases innovation +20%
Social impact - Increases sales growth +20%
Environmental focus - Decreases waste and costs +10%
There is excellent evidence that having the right size team for innovation, having innovation processes, ensuring that the senior management team is diverse and has a strong focus on social benefit and environmental factors all lead to increased growth rates, higher revenues, and lower costs. They encourage customer loyalty, good quality recruitment and talent retention, and can create a defensible innovation moat around the initial product. All those help investors achieve a valuable exit faster.
If all of these are present, plus the 5 above, we are looking at a ‘start-up’ valuation around £5,000,000. Not at all unreasonable, and it provides a basis to raise £1,500,000 or so. That is happening quite frequently in the UK.
There is a benefit having a simple valuation model at the early stage, as it reduces confusion and helps people make decisions fast. But there is a cost: it can ignore some very important factors. A good investor and a good founder will be able to discuss these in reach a better conclusion.
Is it ever enough?
The argument is, of course, circular. What really matters is having the capital to push the company over the various hurdles as fast as possible. The quicker a company can reach 1 million in revenues and 100% annual growth rates, the quicker it will get to being a sustainable and defendable proposition with a moderate chance of dominating its market sector (if that is the ambition), changing the world (the ambition that I prefer), or being sold for a capital profit (which is a choice, if you must).
Building the team that can build the models to understand whether enough capital is raised to get over those hurdles in the right order and at the right speed is the job of the founder, and quite possibly one of the hardest jobs in the world. That is why it is rewarded so highly.
There is a choice between selling more shares now to achieve faster acceleration at lower risk, versus retaining more control now but at a risk of missing deadlines and deliverables. I would generally suggest raising slightly more capital earlier on and pushing harder knowing that there is enough gas in the tank to raise a second round while there is still some momentum. All sensible founders wish to ignore being pushed into raising new capital while they are looking at a three-month cliff at which point they run out of cash. Founders in that position have no negotiating ability and find the distraction of fundraising can dramatically decrease growth rates and values.
What is your experience?
What has been your experience of raising early stage capital, and what methods did investors use to set the share price?
Have you used advanced subscription agreements or convertible loans in the UK, and if so, what happened?