As I stated in an earlier blog, I identified, in the most simplified terms, the key elements to attract funding: the 5 T’s – Team, Technology, Traction, 10X, and Terms. This blog is focused on the last, “Terms”, since it seems that many founders I meet believe, however absurdly, that their company is initially worth many millions, and, in some cases, billions. However, if you walk up to investors with a perverted view of this type of bloated valuation without looking at the 5 T’s, it will be a very short, fruitless meeting. So, whether you can meet the initial 4 criteria, everything will fall apart since you cannot agree on the “terms” – A.K.A., the cost of capital.
Recently, I met with a physicist entrepreneur who staunchly believed that his startup – with no employees but with a provisional patent, was worth over $350 million. I, in turn, thought he had the California marijuana medical card and enjoying the benefits of the prescription.
My first suggestion is that any entrepreneur should throw away any preconceptions, and, even with the technical skills from a MBA, ignore all of the teachings of business school regarding valuations. Only a few days ago I inquired the founder of a startup who sought $10 million, and he commented that I needed to see the financials. Wrong! All VCs or smart money reach their valuation determination based on their experience and historics within their industry while reviewing those five T’s. M&A valuations, as an example, is industry specific with the targets valued at EBITDA multiples and these multiples will change over the course of a year. All investment banks and advisory firms follow the same process. This analysis is no different for startups.
Let’s assume an actual example of startup seeking $10 million and then analyzing what variables will impact that valuation, or the cost of capital.
SCENARIO 1: $10 million being sought with no IP, no Traction, no Capital invested by the team; the Team is employed by other companies. One can safely assume that the team members represent the “best in class” managers – otherwise, the chances for raising money under this scenario are astronomical. Also, for this scenario and others, I assume that the projections are 10X in 5 years. In one meeting with boutique Boston investment firm, the managing director informed me that this scenario – the Team and nothing else — only warrants a 15%-25% management team ownership. One can also assume that these entrepreneurs have had no prior startup experience and none has invested any material capital to the company.
Some years back, I met a former Goldman Sachs senior manager attempting to raise $10 million capital for a bunch of currently employed pharma team. Each team member had an alphabet soup degree at the end of his/her name. I fathomed that they well compensated by their employers so far. And they wanted to maintain the same payroll as a startup. I meekly inquired as to what they were willing to give in equity for the $10 million, and she replied only 10%. I paused and asked why. She mentioned to me that they had such unique skills that no one else could offer. I then sent her a link to another company doing the exact same thing as her company. Not so unique. In the real world, even stellar teams don’t justify that equity stake when not delivering the other “T’s”. So I did relate to her that it would be extremely unlikely that she could raise such capital under those terms. True – in only 2 industries do I see management teams not taking payroll cuts under a startup – healthcare and entertainment. On the other hand, experienced investors would expect that the startup employees take some substantial discount in their compensation.
So, besides sacrificing 75-85% of the company, expect a startup management team take some hit on their payrolls under Scenario 1.
SCENARIO 2: Same thing – $10 million, but there is traction or sales, but still not hitting profitability. Now we have the “T” for Traction. Also, we are close to applying the EBITDA analysis for valuation in this scenario, making this easier. The analyst will make a comparison of the current EBITDA and compare that with industry standard. Then, since the startup will provide some projections, that will be included in a Present Value analysis with the interest being charged at a higher rate. Note that another way of measuring traction is through the inclusion of partnerships or distribution deals with established companies. That way cash flow can be projected with far less risk. So let’s add to the 15%-25% of the first scenario — one can safely add after some calculations some additional 25%-35%. Still, it looks that for $10 million now the company is giving up 40% of the company. Not an attractive position when it is necessary later on to raise more capital. (I do know of a company that sacrificed 40% for $2 million and subsequently struggled to get $10 million later on.)
SCENARIO 3: Same $10 million, the company has Traction, has a Team, and now has Technology. In this case we interpret that the IP can be any form of IP – patents, trade secret, etc. The patent has been filed by a notable patent law firm and it has not been granted so far. This company can now negotiate excellent terms that can get the $10 million while not giving up more than 10%-20% of the company. The company now has the right conditions for financing with the cheapest form of capital.
SCENARIO 4: Same $10 million, and all of the 5 T’s. I call this the potpourri valuation pluses: team member has had successful experience with startups with exits. Another can the “right” marketplace that has the potential for 10X growth – a market sector of great attraction to investors. Many investors behave like cattle and once they see an opportunity such as the recent Uber, everyone else joins the same bandwagon. When these investors start a bidding war for the same asset, this pushes down the cost of capital. I know of one specific company founded by what I call the surfer type entrepreneur. Whatever is in vogue or will be in vogue, he creates that startup. That company is currently a Unicorn and even with several rounds of private financing he still controls the company. Following such trends will further reduce the cost of capital anywhere for 5%-10%.
Now one sees from these scenarios how business school tools play a superficial role in determining valuations. I have met cunning entrepreneurs who knew these bells and whistles. And they know how to put together the right ingredients. And each scenario shows each step in scaling up the valuation. Then there are senior managers I have met that have no clue of these factors and constantly face frustrations in capital raising at their peril. Then they cannot complete pentagonal framework to valuation and the deal – agreeing to the expected “Terms” – the final “T”. I also observed that many scientifically bent CEOs believe that the patents alone represent full valuation to merit the $10 million at reasonable terms. Again, that dog won’t hunt. Too many things can go wrong – other similar patents, better management teams from competitors, etc. – create too much risk to investors. They need to see the other T’s to see whether the company has potential.