Having recently spent a substantial amount of time reviewing new business opportunities, I'm beginning to realize just how hard it is to come to agreement on the value of an early stage company. I had thought that this would be challenging, and certainly it has been. However, I continue to be surprised by the metrics (or lack thereof) that are offered by founders and the shaky foundations for their logic. So below is my advice to founder-types on what they should avoid when trying to negotiate the worth of their progeny with any outside investor.
First Lesson - You can't use discounted cash flow analysis as a method to measure value when there are no cash flows. Almost every time a valuation discussion with a founder begins, someone whips out a discounted cash flow analysis. I guess business schools all teach some version of DCF. and perhaps business incubators perpetuate this teaching by suggesting it to budding companies. But the DCF method for valuing a business was based upon "predictable" cash flows. Without predictable cash flows, applying mathematics to speculation does not make the result any more real. And, increasing the discount rate to account for the "risk" that these cash flows may not occur, while better, still results in factoring a mathematical formula against a speculative occurrence - still not helping the result to become any more real.
Lesson Two - One or Two Customers does not a trend make. As Abraham Lincoln once said: "you can fool some of the people all of the time." And this is often just the case. Or at least you haven't yet proven that your idea has widespread appeal. Extrapolating value from the first few customers to anticipate broad market acceptance is at best optimistic or at least premature. In mathematical terms, you need a set of points, not just the first few, to spot a trend. Early adopters are just that. Market acceptance occurs as Geoff Moore would describe, when you cross the chasm, when real customers purchase products as a matter of course, not as a pioneer. Anything less may be an indication of future opportunity, but certainly not proof.
Lesson Three - You can't pay your bills by trying to cash in on someones interest in your solution. I can't tell you how many times a founder has told me that things are going great because several potential customers, partners, venture capitalists, angel investors, (you can fill in the noun here) has told them how "interested" they are in taking the next step. I can't speak for everyone here, but it seems like a very American personality trait to use the word "interest" to mean "please leave now since I have a lot of other things to do and I would rather not tell you how I really feel about what you are trying to convince me of." If you don't believe me, try being a bit cynical next time someone tells you how interested they are in what you are pitching. But even more important, interest (even if real) is a long way from cash in the bank. Founders by nature are optimistic. But they need to gain a healthy does of cynicism and perhaps an objective sales process, before they can begin to value the "interest" they are receiving.
Lesson Four - While selling the first few of anything may be difficult, it doesn't mean your organization will be capable of selling a sufficient quantity to become profitable. I recently became enamoured with an early stage company and its solution. I spent a good amount of time investigating how the company was selling its solution. What I found was that the direct cost of sales and implementation was something in the range of 10X or more the gross revenue the company would receive from this customer (who had shown interest - see lesson Three). But just like the businessman in the well told joke, I was told, don't worry about the cost, we will make it up in volume. Well, really what I was told was that these were just early sales and in the future this would be much easier and cheaper. While I agreed that there were some very clear ways to reduce the cost of sale, there was no real plan for doing so. No one had thought through how they were ultimately going to deliver this solution at a profit. And while early cash flows and even beginning profits are interesting and necessary, unless the company is capable of generating some kind of real gross margin on its solutions, this is no place for an outside investor.
Lesson Five - Sometimes you have to give up more than you would like to get your idea to market quickly enough. I've run into several situations with founders who need to raise capital, but they only want to raise a small amount because too much will be too dilutive to their early investors and themselves. I always approach these situations with admiration. I too would want to not give up any more equity than necessary if I had a early stage company that I believed was quite promising. However, don't let dilution blind you to market reality. If your idea is good, then get it to market. If your idea is completely protectable - i.e., you got an encompassing and defensible patent that will be difficult to work around - you might be able to ignore this lesson. For everyone else, if you slowly inch your way into the market, and it is in fact a good idea that you have, as soon as you have proven sufficient viability, you have opened the door for someone with more capitalization and more resources to steal this market from you. Taking market share early is often the best tactic. To borrow and idea from a seminal marketing book Positioning authored by Ries and Trout: getting to market first is important, but getting there firstest with the mostest (big presence and share) is critical. In today's global market, you can be sure there is someone somewhere who is waiting to pounce. If your slow path to market risks someone taking over leadership ahead of you, it would likely behoove you to take the larger-than-you-would-prefer dilution, and ramp up your plans early.
So how does this help you come up with a mutually acceptable valuation? My advice is be honest. Most investors (with some notable exceptions) do not want to steal your business from you. Usually, it is more important to have you completely engaged in the business, than it is for the investor to get your equity at a bargain price. Investors like to have rational conversations with factual underpinnings. They often are enthused when they hear some healthy skepticism in their conversations with founders. If you can run the business and grow it fast enough without asking for any outside funding then do it! But if your business model requires that you capture market share and ramp up sales more quickly than your personal capital requires, then understand that being realistic may be just the ticket you need to capturing a share of the investors wallet.