Venture capitalists valuing startup companies have a particularly difficult challenge these days, as public company comparable values have plummeted. This makes it even harder for the startup entrepreneur seeking venture capital know what their startup is worth. I’d like to highlight a particular phenomena that may come into play when VCs are valuing startups. This phenomena usually happens sometime after the Series A round, most likely at a Series B or Series C round. I call this the “venture capital valuation valley of death.” (I tried to come up with word for death that started with the letter “v,” but I’m a financier not a poet and alliteration is not my strong point.)
There is a point when a startup ceases to be valued only as a technology/idea and becomes valued a real business. Or, maybe this is more of a hope - after all, venture capital investors often recite the mantra, “we invest to build real businesses, not to do quick flips.” Quick flips are valued off of hype, technology IP and momentum. Real businesses are supposed to be valued off of silly metrics like cash flow multiples. OK, ok, revenue multiples. (Please don’t mention DCF’s. I just don’t care.)
Anyways, sometimes a really interesting technology/idea attracts interest from larger players - “strategics.” If this company is truly game changing or strategic to several potential acquirers then one or more of these larger companies may reach the conclusion that they need to own that technology and will pay a large price for it before the startup has begun creating revenues. Usually the strategics are thinking that they could easily finish the technology development and push the solution through their existing channels to their existing customers and reap significant value.
At this point, the startup may be more valuable to the strategic acquirers than typical financial valuation metrics would suggest. The technology/hype has run ahead of the traditional financial valuation. Now the entrepreneurs and venture capitalists have to make a decision - a) do they sell the startup now based on the promise or b) do they soldier on and try to create a real business. If b), the startup enters the valuation valley of death.
The startup’s value may flat-line or even decrease at this point. Before the startup has significant market traction (and I’m talking about traction in the form of real revenues) it is still going to be valued by strategics based the startup’s technology/promise/hype. Sure, a few customers indicate market adoption, but tiny revenues likely will not motivate buyers to bump their view of the company’s value.
The startup’s value doesn’t have to decline in the valley - it may just flat-line. A decline is possible as potential acquirers may decide to build the technology in-house instead of buying, and as potential bidders drop out the price the startup can get may slide. Also, the hype may wear off as potential buyers realize that there are other companies working on similar technology who they can purchase.
Then, as the company starts to get real customers and generate real revenues a funny thing happens - it starts to “grow” into its hype-based valuation. If the strategic players want to acquire the startup once the startup has a meaningful income statement then the financial nerds try to take over and do a valuation analysis. $XYZ million revenues times ABC revenue multiple indicates a valuation of so-and-so million dollars. If this is less than the hype-based valuation then the financial nerd has to face off against the person at the strategic who wants to buy the startup at the hype-based valuation. I can’t say who will win, but it is a fair guess to say that the business traction created by the startup likely hasn’t created a significant valuation improvement.
Only once the financial valuation grows beyond the strategic/hype-based valuation does the startup’s value increase in the eyes of the strategic players. This is when the startup exits the valuation valley of death.
The startup may be in the valuation valley of death for a number of years. There has to be a real belief that the startup can come out the other end and become a big business. Given the tough fund raising environment startups need to pay careful attention to their cash burn and make sure they have the capitalization to make it out the other end of the valley. Setting and hitting valuation milestones while in the valley of death is key.
Entrepreneurs raising venture capital need to make sure they are on the same page with their investors about the size of business they are hoping to create and the size of exit they are seeking. Make sure your investors have deep enough of pockets to help you accomplish your goals, and make sure their goals are the same as yours.
