If you’ve decided that your startup is going to need venture funding to succeed you NEED to determine your valuation creation milestones and create a time-line on how you will hit them. Entrepreneurs (and MBA students who visit with me) are constantly asking how venture firms value startups. Entrepreneurs care because this impacts their dilution during a fund raise (MBAs care because… well, likely because they are nerds for that kind of stuff.)
The truth is that venture valuations are not the hard and fast science that business school professors suggest. Valuations of pre-revenue/early stage companies are not easily determined by typical valuation frameworks. Instead, venture investors typically look for key milestones that indicate that a startup is on its way to becoming a profitable, at-scale business. In the mind of a venture investor, as a company achieves these milestones they increase in valuation, as it clearly demonstrates the company is marching towards becoming a viable business and increasing its valuation along the way.
If you believe that your company will require venture funding, you should make sure your strategy takes into account the value creation milestones of your industry. This differs from industry to industry; generally, the easier it is for companies in your space to acquire customers (or users) the more of an emphasis is placed on customer numbers. For many internet businesses, this means you should remember to place a focus on user acquisition and validate your customer acquisition model. The next milestone is often proving your ability to monetize these users, although it will vary by your business model.
If your company will require millions of dollars to achieve a working prototype, make sure you know what the pre-prototype technical milestones are that will clearly demonstrate that your product is on its way to viability. Also, demonstration units in the hands of customers who are willing to provide feedback and talk to potential investors is one of the more powerful valuation milestones for these types of startups.
Another important idea is to have created measurable metrics that you will use to track your progress against these milestones. Hopefully you and your investors are paying enough attention, so that it becomes apparent if you’re going to miss your milestone well ahead of time. Usually your investors will work with you to find a way to help the company stretch its out-of-cash-date so that you can slide into the finish line.
What happens to companies who miss their milestones? That depends on the situation… did you burn too much cash developing the prototype and run out of money? Or did users fail to materialize despite the creation and launch of your better mousetrap? Outcomes that I’ve seen include:
1) You hit the wall. Your investors have lost faith and no longer believe that the dogs will eat the dog food. Tired investors can make it very difficult to raise funding from new funding sources. This is likely the kiss of death. This happens when the goal seems too far off, market conditions or competitive forces have moved against you or your team has failed to convince the investors that you can achieve success.
2) Your current investors provide enough cash for you to limp to the next milestone while you desperately try to execute a full round of funding. Often your investors will ask you to you be conservative with cash in these situations, which can mean dropping features and letting team members go. Not usually that fun.
3) Total or partial reset. The investors, sometimes with a new outside investor in the lead, reset the company’s valuation down while re-investing. This effectively reduces the ownership of the common equity holders (as in you, the founder and your team.) You are essentially repeating an earlier fund raise… imagine another Series A raise. Usually involves scaling the team back to a core group; super painful. But occasionally the right answer when the idea was right, but the execution was off or the target market was a bit different than originally intended. Your original legal documents should detail what happens to your capital structure in this case - hopefully you hired a good lawyer during the original investment.
4) Your current investors pony up enough of an extension round for you sprint through the milestone. Because of your inspirational leadership (and smart “investor management”) you’ve made it clear that you are on the right track and the product/company is quickly or correctly progressing to the goal. Every one’s drunk the Koolaid and it tastes great! Now execute, execute, execute…
5) You raise an outside led, up-round for additional funds that you use to hit the next several clumps of valuation milestones. You must be good! Now go get that product made. When I’ve seen this scenario actually happen it has been with experienced, top-notch CEOs with stellar teams in good spaces.
So, I’m still a young VC, and there are likely other things that can and do happen that I just haven’t seen yet. Feel free to post other outcomes that you’ve experienced or seen.
One of the key take-aways from this is that you need a little cushion when you raise capital. Little delays/issues can add up or big problems can come out of left field, and knowing that you’ve got that little extra bit of runway to get you there can really help you sleep at night.
