The Elusive Valuations… 2

Continuing my search for answers to valuations, I came upon a realisation – Valuations are less about the numbers and more about the story. Anyone can come up with the calculation, but can you justify it? This may not seem like a great revelation, but let me give you my perspective.

Start-ups come up with a valuation number based on how much equity they are willing to dilute. So, if I need an ‘x’ amount and I am willing to dilute only a ‘y%’, the post-money value is x/y%. Now the entire game is of justifying this post-money number. Why a start-up would want to dilute only ‘y%’ is a different conversation.

There are market benchmarks to measure the value given to any company. Depending on the business model, the valuation could be based on the number of users, daily engagements, underlying assets, market multiples etc. Further, the value can also be derived from possible synergies. But all these methods and calculations try to address a very basic concern – RISK. Start-ups are risky propositions. It is not a secret that over 90% of funded start-ups fail to deliver. Valuations are thus a function of the perceived risk of failure. If the start-up fails to generate returns, the investors lose their entire investment.

Managing investors’ risk thus becomes the backbone of any investment deal. How can founders reduce the perceived risk of failure?

Strong Fundamentals: Having a proven product, a robust business model, identified revenue streams, and a solid asset base reduce the perceived risk for investors.

Investor Rights: Allowing added rights to the investors like liquidation preference, ROFRs, Anti-Dilution, Dividend participation, Board participation, etc. helps build investor confidence and reduce perceived risks.

Exit Options: If investors can see a definite exit plan set out for them which ensures a reasonable return on their investment, the investment risk reduces substantially. But again, it depends on whether the investors are looking for a long-term position with the company or are happy with returns on a shorter time horizon.

Synergies: Founders looking for investment should focus on strategic investors over financial investors. If synergy benefits could be made evident to the investors, the risk associated with future cashflows or business model viability go down exponentially.

Investor Signalling: Having marquee investors on the cap table is an effective way of signalling to the investors that the company is worth investing in and has bright prospects.

The lower the perceived risk, the higher the valuation. With every milestone the company achieves, the perceived risk reduces and the valuation goes up – introduction of the MVP, granting of a patent, first commercial product, first sale, and first contract – all contribute to a lower risk and a higher valuation.

Valuations are built on prospects and aspirations; each milestone takes the company one step closer to making them a reality.

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