By Robert Riverso - Manager of Business Development at Northwater Capital Management Inc. -

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:

  • Present-valuing future cash-flows (a.k.a. "Discounted Cash Flows" analysis) is futile at best given that start-up financial forecasts aren't worth the paper they are printed on (see my earlier post from July 14) - DCFs suffer from ‘garbage-in, garbage-out’ syndrome.
  • Establishing a value using comparable transactions is often difficult, especially if the start-up is in a new market or developing a new technology.
  • It is impossible to use traditional multiples, such as price-to-sales ratios, to value a pre-revenue company.
  • Assessing asset values isn't useful as a start-up typically does not have any material tangible assets and the intangible assets, such as ideas or patents, are very difficult to value at such an early stage of development.

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:

  1. Future potential: How many times have you heard an entrepreneur justify their worth by using the phrase “if we can just capture 1% of the market…we’ll be incredibly successful”? I can't blame them for the enthusiasm; after all, this 'big thinking' approach is what makes entrepreneurs so great.
  2. Accomplishments to date: Entrepreneurs normally highlight what has been accomplished to date as justification for large upticks in value.

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:

  1. Remaining Risk and Uncertainty: Investors think of start-up valuations the other way, based on "look at what is left to accomplish" and the risk and uncertainty around the start-up's ability to do so.
  2. Future Cash Need: Let's just say that investors normally (or should) take an entrepreneur's expectations for reaching cash flow break-even with a grain of salt. In almost all cases, the venture takes twice as much capital and twice as long to gain traction (if at all) relative to initial forecasts.
  3. Exit Potential: Investors attempt to understand what the most likely exit scenario is for a business of this nature. Investors need to ensure that their share of the exit will provide a sufficient risk-adjusted return for the investment. If the anticipated exit is small, a larger portion of the company (and thus the exit proceeds) will be needed to justify an investment.
  4. Control: Investors look at what level of control is required to get this start-up to the finish line. Investors need to balance taking enough control to have an appropriate level of influence with ensuring that the entrepreneur has enough of a stake to remain motivated and tied to the venture.
  5. Alternatives: Investors look at who else is co-investing in the deal, if anyone. If an investor is the only game in town, the valuation will take a hit as the risk involved is greater and the start-up has limited negotiating power.

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. -

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