The concept of value is extremely elusive for startup companies. How is a startup company valued and how is value created in a startup? One reason the concept of value is so difficult is that it lies in the eyes of the beholder.
Imagine a stack of startup company business plans or pitch decks complete with their visions, plans and financial projections. The best way to “calculate” the value of a startup company is by estimating the “net present value of the projected cash flows.” This is a spreadsheet exercise that involves using five-year revenue, expense, and cash flow projections and a pre-determined risk factor (discount rate) to estimate the “net present value” of the cash flows and an expected “terminal” value of the business.
Most of the startups in our stack will have about the same net present value—somewhere around $2-4 Million. So how do we sort out the “real” value of these startups?
“Real value” is in the eye of the beholder, or in the “mind of the investor.” If an investor believes the projections and is willing to write a check, then the “value” of the company may in fact be $2-4 Million. On the other hand, if no investor has enough faith in the projections to write a check, then the “value” is zero.
So, how do you create belief? For one thing, seeing is believing. So, creating a product, making a sale, hiring a team, managing a team successfully all are ways of creating belief. If it’s not possible to “see “a result, then the next best approach is to make a logical, plausible, supportable argument. This of course is the stuff of business plans.
Here are 8 components of the NPV calculation that make up the “real” value of a startup. Let’s look at each and see how your startup can create specific value.
- Sales and customers
- Costs and expenses
- Cash flow
“You need to surround yourself with quality human beings that are intelligent and have a vision”—Vince McMahon
Investors like to see the initial team so they can decide if they believe the team can “pull it off.” This doesn’t mean that all the C-level executives have to be identified. It’s probably better if the initial team is focused on development of the company’s initial product. So, investors will want to see developers who have previous experience in creating similar products. The means by which the initial team is compensated will influence investors as well. High salaries will be a turn-off. Equity compensation will impress.
“Every once in a while, a new technology, an old problem, and a big idea turn into an innovation” —Dean Kamen
By “product” we mean the entire package of the problem the company is solving, including its product concept, and the extent to which the product solves the problem in a cost-effective way. The best way to create “product” value is to build the initial product in a manner that demonstrates that it works, that it solves the intended problem, and that it can be made for a cost that will permit the company to have a profitable business model.
“Make a customer, not a sale.” – Katherine Barchetti
Sales and Customers
“The proof is in the pudding.” Nothing is more convincing to investors than happy customers. Anything a startup can do to demonstrate that customers will purchase their product at the planned price will greatly add to the starup’s value. It’s also important that investors believe there is a large market opportunity for the product. This is harder to demonstrate, but it’s usually possible—with some research—to come up with plausible estimates for the size of a market.
“The most reliable way to forecast the future is to try to understand the present” —John Naisbitt
Costs and expenses
Many startups fail because the numbers don’t work. Sometimes, product costs are too high to allow the company to achieve an attractive gross margin. Sometimes, personnel requirements and expenses are too high to permit profitable operation. It can be difficult to accurately forecast costs and expenses. Therefore, investors are concerned about the management team’s ability to anticipate costs and expenses and manage the business according to forecasts.
There are three things a startup can do to “create value” around costs and expenses:
- Demonstrate that the product can be manufactured for the projected cost
- Demonstrate that the required operating expenses permit a profitable business model
- Demonstrate that management is capable of forecasting and controlling costs and expenses.
“A small profit is better than a big loss”― Ron Rash
Startups have difficulty forecasting and managing profits, because profit is the difference between net revenues and expenses and the tendency is to over-forecast revenue and under-forecast expenses.
In their enthusiasm about their outstanding product, most startups are too optimistic about how quickly customers will adopt their product, the price they will pay, and the number of initial sales they will make. Very few startups achieve their initial sales forecast.
On the other hand, most startups under-forecast expenses because it’s almost impossible to anticipate all of the things they will have to do. They may be too optimistic about how productive sales people will be. They may overlook some customer support requirements. They may under-estimate the costs of logistics support. And so on. That’s the problem; unexpected expenses have a way of appearing out of nowhere and they always increase total expenses and decrease profits.
The more startup companies demonstrate their ability to forecast profits and manage their business according to forecasts, the more confidence investors will have, and the greater the value of the startup.
“Management is doing things right; leadership is doing the right things” —Peter F. Drucker
Investors need to have a high degree of confidence in the management team of a startup. Their primary interface is with the CEO, so their first concern is likely to be, “Why should we believe this CEO can manage the company to a successful exit?”
Investors will take a close look at the CEO’s previous experience. If he, or she, has been successful as a CEO in the past, then investors can perform extensive reference checking and get convinced that the CEO has a good chance of being successful again. Because this can be a “make or break” issue, having a CEO with impeccable credentials can add enormous relative value to a startup.
If the CEO does not have prior successes, the next best thing is to demonstrate over months or years that he, or she, is able to manage people effectively and, can in fact achieve the company’s goals. One of the best things an inexperienced or unproven management team can do is to develop a product, obtain some customers, and show that they can manage the startup phase effectively. The “bootstrapping” can have an enormous positive effect on a startup’s value in the eyes of investors.
“A small business can survive for a while without making a profit, but if its cashflow dries up, the impact is fatal” —Theo Paphitis
Finally, although cash flow is closely related to profit, it addresses a slightly different set of issues. Some of the important questions related to cash flow are:
- How much capital will be needed to build the business and in what stages?
- How many “rounds” of investment capital will be required after the initial one?
- To what extent must the company pay for inventories, capital equipment, facilities, or other assets?
- Will future positive cash flows give investors an attractive “return on investment?”
Value will be created if investors have a high degree of confidence in the company’s cash flow projections. They must be logical and well supported. If investors are concerned that the startup’s management does not fully understand it’s capital needs, they will be reluctant to invest.
“Alone we can do so little; together we can do so much.” —Helen Keller
Partnerships expand the resources of a startup and they provide third-party endorsement of the startup’s business concepts and strategies. Partnerships help to validate the assumptions of the business in the eyes of investors. They usually mean that another company, the “partner,” has done some due diligence and decided that the startup has some ideas with potential value and that they (the partner) can help to realize the value. Partnerships are especially valuable if the partner is a company that investors will know and respect. When startups partner with blue chip companies, their value can be greatly enhanced.
With this understanding of how “value” is created in startups, it may be easier to appreciate the role a “value-added” investor or advisor can play. Startups should always be looking for people who can help make their story more believable. That’s how value is perceived and it explains the difference between the companies that get funded and those that do not. Startups that score well in all 7 “value” categories have the best chance of getting funded.
About the author
Dr. Fred Haney is the founder and President of the Venture Management Co., a firm that provides assistance to high tech companies. He is the author of The Fundable Startup: How Disruptive Companies Attract Capital published on February 6, 2018, by Select Books of New York.
About the book
In The Fundable Startup, Fred M. Haney, an experienced VC, angel investor and company founder, explains startup strategies that will help you to:
- Understand the thinking of investors
- Create initial value in a product or prototype
- Recruit management that will help you raise capital
- Build a “virtual team”