July 20, 2009

"The Valuation Conundrum" - By Sanjay Anandaram

“How much will my stocks be worth in 5 years?” was the question the senior corporate executive asked the CEO of a startup. “I don’t think my stocks are worth anything now, so I want a big salary raise considering the fact that I’ll be spending the next few very productive years of my working life with you” was the refrain from a senior manager of a young startup. “What will your exit valuation be” asked the junior VC partner to the entrepreneur as if anyone had the answer!

All too often such scenarios play out in young companies. These questions are not easy to answer with any certainty given the state of the company. Yet, these questions need to be addressed. The trouble occurs when these perfectly legitimate questions consume the startup team such that enormous energy is expended in explanations and negotiations with employees and investors leaving the startup shaky before take-off.

It is important to keep some basics in mind.

First, in young early stage startups, valuation is almost entirely subjective. Qualitative issues such as quality of the team, the market size and growth, market opportunity, uniqueness of the offering, the business model, the amount of capital being raised and likely to be raised, the kind of exit, what valuation have comparable companies in similar circumstances received, the competitive pressures on the investor, investor’s investment model etc are factors that determine the valuation. Being subjective, the beauty lies in the eyes of the beholder. However, professional, quality, and smart investors while negotiating hard generally do not squeeze the entrepreneur beyond a point knowing that the key to their success is a motivated and charged up entrepreneurial team. One cannot make money at the cost of the entrepreneur so while starting valuations might seem tough, investors are open to parting with equity if the team executes to the plan. Assuming one has researched the investor(s), there must be some faith in their judgement. At the same time, naivete should not be the cause of being handed a lemon of a deal. You too should be professional, smart and demonstrate understanding.

Second, the qualitative valuation starts becoming more objective over time. So while entrepreneurs fight tooth and nail to secure a “high” or “good” valuation in the early days of their company, what many don’t realise is that having secured this “high/good” valuation, the company needs to execute to justify this valuation. What this means is that the company must demonstrate growth in revenues, cash break even, profits and profitability, productivity and so on. The company therefore has to be aware of expectations and demonstrate its value in financial terms. Of course, there are businesses like Facebook that are valued very high in spite of not having any profits because they demonstrate enormous growth month-on-month and have a visible credible path to making serious money in the future. But these are the rare exceptions. In short, the more mature the company, the more objective will be the valuation methodology.

Third, if the company fails to execute and therefore justify its earlier “high/good” valuation, the value of the company will be re-set to a new lower number in the next financing round. This, while not being a happy moment for the team, is certainly an important reality check. If the company, however, executes to its plan or exceeds it, the valuation will be more than justified and will increase for the next round of capital infusion.

Fourth, at the end of the day, valuation is a number that’s a function of how the company is actually performing and how it is perceived by the outside world. It is the job of the CEO to deliver on both these aspects. Investors invest in the company based on this promise.

Fifth, money is only made when an exit occurs (typically, an IPO or an acquisition) so returns, while looking good on paper thanks to “good/high” valuations, mean something only when cash hits your bank account. Till then, valuations are like money in the mirror – look good, feel good but worthless.

Remember, a “good/high” valuation will only be obtained and realized in cash if a good or great company is built. That should be the focus rather than worrying about intermediate valuation points.

What do you think?

Sanjay Anandaram is a passionate advocate of entrepreneurship in India; He brings two decades of experience as an entrepreneur, corporate executive, venture investor, faculty member, advisor and mentor. He’s involved with Nasscom, TiE, IIM-Bangalore, and INSEAD business school in driving entrepreneurship. He can be reached at sanjay@jumpstartup.net. The views expressed here are his own.