Why valuation shouldn’t matter in a fundraising round… for either party

Keyword: shouldn’t (in a healthy raise)

Startups are destined to either succeed OR fail.

But, what those two options look like in a given startup are open to interpretation. It’s subjective.

Here’s an example.

For two hamburger shop owners running the same business, their dreams can vary as much as their values and lifestyles are varied. One founder may only dream of having one store; the other may dream of franchising it into McDonalds.

Normally, that choice wouldn’t matter to anybody except the individuals. At least not in the bootstrapping realm. However, it becomes a significant issue when discussing fundraising where goals (aka, outcomes) matter. After all, both founders may need to raise the same sized seed round to achieve their visions, so the amounts alone cannot determine a founder’s vision. If a shop costs $50k to open, regardless of vision, both could make headway by raising a round.

But as an investor, which would you prefer to invest in — McDonalds or the one-store-owner?

… easy answer, obviously.

The struggle to the investor comes of course when picking which company to invest in.

They may prefer the experienced founder of the single-burger-joint (Jim) as he and his ancestors have run joints for eternity. Whereas, the one dreaming of opening up a thousand stores in the next 7 years (Jane) may have zero experience doing so. You might say Jane is un-investible, but assuming they can both succeed in their own-right, you’d much prefer to have invested in Jane (hindsight is 20/20… as is in the case of some of Elon Musk’s successes right?).

Let’s assume you know a founder’s vision, because you have asked them directly. And let’s say Jim was raising his $50k at a $100k valuation (Shark Tank-style), versus Jane who is raising the same $50k except at a $5M valuation (Silicon Valley-style). Again, assuming both are successful, yet you can only invest in one (investors have to pick) you might jump to still invest in Jim as you’ll have a whopping 50% equity and maybe receive dividends in his fledgling company. However, if Jane was successful in achieving her vision, it’d be worth $100k per restaurant, being, well 1000*$100k = $100MM valuation for a 1000-restaurant franchise. (Assuming no dilution)

Your equity would be worth $50k/$5M * $100M = $1M… you’ve turned $50k into $1M.

Now which would you prefer?

It sounds simple (and I sound stupid) when I write it like that. Then why do investors worry so much about the valuation? They should worry instead about the goals of the founder.

As silly as it sounds, many startups will be worth less than the $100k restaurant once the founder gives up and decides to bootstrap their venture funded business and value it using a Revenue or Discounted Cash Flow multiple (not what any serious investor wants).

So, of course it depends on probability of success and what success looks like. And that should be the focus of a fundraise, NOT the equity.

Founders, if your conversation is entirely focused on the equity discussion, you’re not selling your vision well enough. And, Investors, if your conversation is focused on the valuation then you probably shouldn’t be tempted to invest as you probably don’t believe in a large enough vision.

This is the same reason why I’ll never (again) start a business with a price-focused product. Why work on an unfulfilling business which aims to simply under-cut competitors? Work on something that generates so much value that people BEG to pay a reasonable price for your product/service. Create something NEW.

And if you do, your $5M valuation shouldn’t matter… if you’re convincing enough that your business will be successful AND show investors how significant your business can be, then they shouldn’t argue about valuation.

Speedlancer’s round was impossible to close until we showed the true potential for it to become a multi-million dollar company way above our funding valuation, and showed that we could quickly get to break even or profitability (safe point) with a reasonable probability.

At $1M ARR, even a $5M valuation is almost instantly justifiable on a Revenue multiple or DCF (discount cash-flow) basis!

So, founders, show your investors how quickly you can get to break even AND what success ultimately looks like… that de-risks it massively, and shifts the discussion to equity.

So, steps to choosing a valuation look like this [translate to investor perspective if you are investing in a startup]

Step 1) Think about the potential for your company and where you want to take it. Do you really need/want to raise? [for startups at high valuations: can it get to a multi-million dollar valuation, expanding to multiple verticals in multiple markets? If not, consider bootstrapping and taking your time, or raising at a lower valuation]

Step 2) Think about specifically how much you need to raise and what you will spend the funds on. Create a forecasted expense budget.

Step 3) Have a reasonable and exciting revenue (and gross/net profit) goal for where you would like your business to be 12 months after your fundraising round. Does it get to break-even? This is your safe point.

4) Show how your safe point is just the beginning.

5) Pick a valuation on a reasonable Rev multiple, based on your safe point, also factoring in a little extra for future growth potential, but nothing that’ll rip off your investors.

… then the stretch is (only?) to prove to potential investors that you’re x% likely to reach that target and that if you do get there that’s just the beginning. (your potential investors will indicate to you what’s a reasonable ‘x’ in your case)

That’s how to do a responsible raise that doesn’t rip you or your investors off. By focusing back on Rev (your safe point), it de-risks the investment, aligns interests for whatever your goals may be, and positions you for the next phase: Great Success.