Before I begin talking about it, I must put the usual disclaimers — this applies mostly to a tech startup in India, comes from our colored experience of valuing companies and often reflects the mood of the industry at this point of time. Each of these are important as we will see below. Also, please read my prequel post on stages of evolution of a startup to get the context and definitions right.
Valuation is in the eyes of the beholder
It won’t be a hyperbole if I say that startup valuation is more of an art than a science. There are only a handful of thumb-rules and rest everything is a highly subjective item. Another thing to understand about valuation is that while a general thumb rule is widely accepted, there are several well-known exceptions that prove the rule that this is a very subjective exercise.
In most cases, it will appear as if you have been valued less by your investors and the startup run by your friend was valued much higher. Please note that getting a round itself is relatively rare event. You can do your best to optimize on the available options, but once you are past it, look ahead and move on. Basically,
A high or low valuation is not simply a function of you, your business or the traction. Raising money is a highly subjective topic and by no means should a founder value her ‘true worth’ by it, because it is not.
Valuation is the final step
In my sales job, I learned a very key lesson that applies to many things in life: pricing is always the final step. Why? Because pricing is something that brings the deal to a Yes or a No situation. It is also a true test of how well the value has been explained to the buyer. Most institutional investors won’t even talk about valuation and deal structures unless they have gone through several rounds of discussions, both with you and internal. Our process mirrors a series of filters. There are easily tens, if not hundreds, of filters that we apply before we decide to roll out the term-sheet. And you should know that this is a Series of filters and it is rare that someone is able to bypass any of them. But that topic deserves a post of its own.
Demand-Supply rule
Let’s assume that you fortunately passed through these filters easily and there’s strong expressed intent of the investor to invest in your company. One dirty secret that you need to remember is — there’s no real science behind valuing a startup, in any economy, leave alone India where the availability of market data is quite shallow in itself. Coupled with the fact that technology is going to, sooner or later, disrupt existing markets (think book retailing) or create completely new markets (think local taxis), it is nearly impossible to accurately value early stage startups. Hence,
Valuation of a startup is a function of the demand it is generating in the investor market
As simple as that! Now, if you argue that at some point this valuation should catch up with the public market multiples, you are right. But that will happen at least 5–7 years after the first round of funding. A lot of technology, regulation and other macro factors can change in this period. Hence, experienced investors have come up with thumb-rules that they use to propose a deal.
A word on the VC business
Each institutional investor has a clearly thought-out strategy to deal with investments. This determines what kind of companies they like (think of filters, as above), the kind of exit value they seek and what is the minimum they want to make as a return per investment.
For example, Blume Ventures loves all things tech — both B2B and B2C. Conversely, we have tried and failed in building consumer brands. Hence, we don’t like to invest into your apparel brand or restaurant chain or even a niche e-commerce business. If we choose to invest into a company, we expect it to deliver at least a $100M exit value and we want to give back our LPs at least $10M at your exit. This means we need to be holding at least 10% at exit. Given 3–4 rounds of dilution after our first check in, it is possible to hold 10% at exit only if we start closer to 18–20%. Further, as a constraint on our fund size ($60M) and the number of companies we want to invest in (40), our ticket size per first check is about $500k-1M (₹3.5–7Cr) or thereabout. Our ideal scenario is that we start with approximately 20% stake in the first round. Some of our recent term-sheet reflect this strategy exactly as I described.
But, did you notice that we didn’t even think of a valuation so far? That’s because
Valuation is a derived amount in VC business
We don’t obsess about valuation so long as our stake target is met and the check size doesn’t exceed our comfort level.
Stay Tuned
This post must have given you some food for thought on how to deal with investors and funding rounds. In Part 2, we will talk about the benchmark numbers, round sizes and, most importantly, how can you use all this knowledge to your best advantage.
The article was first published in the Arpit’s Medium Blog here, and has been republished here with the Author’s permission.
Arpit Agarwal
