By Robert Riverso - Manager of Business Development at Northwater Capital Management Inc. - www.northwatercapital.com
If you have ever watched an episode of CBC’s Dragons' Den or ABC's equivalent, Shark Tank, I’m sure you have seen some great businesses fail to reach a deal because the targeted valuation was way too high. It’s a shame really but whether it is greed, ignorance or poor negotiation technique, in most of these cases, entrepreneurs are shooting themselves in the foot by being too aggressive with their valuations and limiting their chances to successfully reach a deal – after all, would you rather have a smaller piece of a large pie, or a larger piece of a small pie?
Well, I can attest to the fact that these situations are not limited to the world of television. I've seen great pitches fall apart only once the targeted valuation was disclosed; so much so, that we normally ask what pre-money valuation the company is targeting before we get into the meat of a pitch – save our time, and theirs, if we find the valuation to be completely unrealistic.
I bring this up because it raises a fundamental question facing entrepreneurs and early-stage investors, alike – how do you put an appropriate dollar value on a start-up which normally has no customers, no earnings and no assets?
When I began working in the venture capital industry, I was surprised by the approach to valuing potential deals. With a relatively freshly minted undergraduate degree in finance, I was prepared to create detailed Excel models to devise precise and justified valuations using textbook techniques. How naïve I was. I quickly learned that the traditional approaches to valuing companies do not work well in the start-up world. For example:
So without these techniques, how do you approach valuation for a start-up? The reality is that valuation in the start-up world is more of an art than a science – and with that, the door is left wide open to interpretation.
From the start-up’s perspective, entrepreneurs normally use two key lines of reasoning to justify their proposed valuation:
Now the disconnect. The way investors think about a start-up's valuation is very much the opposite. Although future potential and accomplishments to date are important, investors consider additional factors which play into the valuation. I have highlighted the major factors as follows:
My suggestion to all entrepreneurs out there is simple - before meeting with a potential investor, be realistic about the stage you are at and consider these factors when crafting your pitch and selecting a valuation.
With all of this being said, I must highlight that one major lesson that I have learned is that beating each other up over valuation is not the best approach to negotiation. Entrepreneurs and investors, alike, tend to think of the 'valuation question' as a zero-sum negotiation. If one person wins, the other must lose. However, you must realize that both parties are committing to working with each other for the foreseeable future. The last thing you want is to have a disgruntled entrepreneur feel like he/she has been taken advantage of and lose motivation, especially if they are the brains behind the operation. Your interests must be aligned from the get-go or the venture will be on the road to failure from the start.
By Robert Riverso - Manager of Business Development at Northwater Capital Management Inc. - www.northwatercapital.com