A few years ago a CEO of a pre-revenue startup reached out to me for guidance. The company was preparing to raise money.
The CEO said to me during the initial consultation, “We’ve had a 409A valuation done on the company, and the valuation indicates the company is worth $20M.
“We’re trying to raise $2M, so I’m going to say that we will give investors 10% of the company. Sounds good, right?”
“No it doesn’t,” I said.
Experienced investors don’t care what you value your company at.
Before I could continue, the CEO said, “Why not? We have this 409A valuation. They have to accept it.”
“Let me explain further,” I said. “The market determines the valuation for your company, not you. And the market in this case is your potential investors.
“Early stage valuations for venture backed startups are very mechanical in nature. Investors need to own a certain percentage of your company to make investing in your company worthwhile. If you have an ask of 10%, you will not get any investors.”
“But we’re going to worth billions in a couple of years,” the CEO said. “With 10% ownership, investors will make a ton of money.”
“I understand where you’re coming from,” I said. “However, every CEO investors meet believe their company is going to be the next big thing. And most companies are not the next big thing.”
“We will be the next big thing,” he said. “If they don’t want in, then I’ll find other investors.”
“I hear you. But I’ve got to be honest with you. You’re not going to get that type of a deal unless you get really lucky.
“I don’t think I can be of any help to you.” I then quickly ended our call.
The market (potential investors) always determines the valuation of your company.
Experienced investors have tons of experience negotiating investment deals. You likely don’t have any experience.
The worst thing you can do is try and set the valuation. If you set the valuation too high, then you may turn off investors. If you set the valuation too low, then you may leave money on the table.
So, instead you should answer, “We’ll let the market determine the valuation,” if you are asked what the valuation of the company is.
Your company may not have any potential investors or buyers.
I was working with an entrepreneur that wanted to consolidate an industry dominated by small “Mom and Pop” companies. “Lou’s” idea was that he could buy the companies for 1X revenue or less, make the operation of the companies more efficient, then the value of the combined operations would increase.
Lou hired a broker to help him find potential targets. Then he would meet with the owner/CEO of the business, do his diligence, and see if he could come to an agreement with the owner.
Lou’s company was the only company that made an offer on any of the companies he pursued. In other words, Lou was the market, so Lou set the terms of the deal.
That’s the challenge you will likely face whether you are a venture backed company or a bootstrapped company. The only way you can increase the valuation of your company is to create competition amongst potential investors.
Creating competition is easier said than done. Most companies are lucky to get one term sheet or letter of intent to buy their company. Just remember that the market (potential buyers and investors)determines the valuation, not you.
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