Propel Blog: A tool for entrepreneurs seeking small-cap funding

One of the challenges that every entrepreneur faces is the issue of valuation. In other areas of business, valuation is typically tied to revenue, past performance, assets, and/or discounts of future cash flows. Since pre-revenue startups lack these things, the question becomes: how do you value a pre-revenue company?

There is no definitive answer here, but there are frameworks for thinking. While they may vary substantially from one investor to the next, the one that we have seen most frequently from angel investors is the following is a variation of “Relative Valuation”.

“Relative Valuation” is commonly used as a check/balance in various M&A activities, and the principle is quite simple: how do you stack up against other comparables in your space? In the start-up space, comparables fall into two categories: competitors and start-ups in general. In practice, investors are going to look at other deals similar to yours, and are likely to know the valuation at which these companies were invested. By looking at several of these deals, they can build an acceptable range for valuations in the start-up space. Deals that fall outside this range are met with increased scrutiny, and are less likely to close investment at their proposed valuation.

While the acceptable range is by no means exact,  there are pretty clear points where investors tend to become disinterested in a company. Just a year ago, $1.5M to $6M  post-money was regarded as perfectly reasonable; now, by contrast, the range is closer to $1M to $3M post-money. This is due to a number of factors, including uncertainty in projecting the future, a lack of viable exit scenarios, and the simple fact that investment is a ‘buyer’s market’. What this means is that a startup without revenue is unlikely to get by with a pre-money valuation of more than $3 million, and even $3 million valuations are more the exception than the rule.

The next question, then, is how an investor determines where a startup belongs on this scale. The best way to envision this, I think, is as a system of checkboxes. Some examples: Does the company have a prototype? Does the company have patents? Does the entrepreneur have previous successful exits? Is there a large market opportunity? Is this company acquirable? The list goes on in this fashion, and is focused mostly on sustainable competitive advantages, market size, intellectual property, management team experience, and exit potential. As I’m sure you’ve guessed, the more checks you are able to accrue, the more justifiable a higher valuation becomes.

As the sophistication of an investor increases, the number and complexity of the checkboxes typically does as well. If you are going to go after some of the more sophisticated capital that’s out there, then that means that you have to have everything pretty nailed down, so that you have the ability to provide compelling answers to in-depth questions. If you are still just getting started, on the other hand, then don’t plan on getting any of that institutional capital. Stick to friends, family, and individual investors who are connected to your project until your company can stand up to a deeper level of scrutiny.

As oversimplified as this explanation is, it’s a good framework to understand some basic drivers in the valuation process. Applying the same type of systematic approach to the company will help you to understand the gaps in your business model, so that you can identify and address critical risks before pitching to investors.

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For most of the entrepreneurs that we work and speak with, the value proposition is a work-in-progress. There are a lot of reasons for this, not the least of which being that a good business model offers a great deal of value, and that it can be hard to distill that down into a simple statement. One point that can be extremely helpful, though, is to make sure that it is tied back to your competitive advantage.

What does this mean? The term competitive advantage, in of itself, can be just as inexact and all-encompassing as value proposition. Luckily, though, Michael Porter has done the heavy lifting for us. So everyone dust off your copy of Competitive Advantage, because I’m about to give you a quick and cursory review.

A competitive advantage is something that gives you a sustainable edge over the competitors in your industry. It comes in two forms: a cost advantage (you sell the same quality, at superior price) or a differentiation advantage (you sell superior quality, at the same price). In truly exceptional cases, you may see both, but that is truly rare, and doesn’t last. Most good companies choose a competency and build their business models around it.

But even that means very little, in of itself. The real meaning comes when you dig a little further, and say: what makes competitive advantages? According to Porter, they are due to resources and capabilities. Resources are assets: they can be something as tangible as intellectual property, or as intangible as reputation. Established customer bases and industry relationships are further examples of resources, which are divided into three categories: tangible, intangible, and human.

Capabilities, on the other hand, are defined as the ability to effectively utilize resources. They can include research, innovation, financial control, design capability, brand management, commercialization strategy, and much, much more. Functional analysis and value chain analysis can both help you a great deal in determining your most important capabilities.

Once you have determined your competitive advantage, in terms of your resources and capabilities, you will have a sound basis for articulating an extremely well-formed value proposition.

For further information on resources and capabilities, check out the following link:

http://www.blackwellpublishing.com/grant/files/CSAC05.pdf   

That’s chapter 5 of Robert M. Grant’s Contemporary Strategy Analysis, titled “Analyzing Resources and Capabilities”. It’s really fascinating stuff, and there’s a lot to be learned from it. 

-Myles

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I originally wrote this post for my personal blog, but thought that the content was well suited for this forum.  I altered a few things, but the message is the same.

Business, and life in general, is complicated.  It’s intricate.  Value can be created by understanding and embracing these facts.   Understand that ‘complicated’ requires time to figure out, to understand as a mechanism.  This is why constant learning matters. It’s often said that no plan survives contact with the enemy.  Business usually follows this pattern.  You plan, then you encounter the real world, at which point, your ability to learn and adapt determines whether you reach your goals or not. 

Embracing ‘intricate’ means viewing it as an opportunity.   Intricate inherently has a high level of interconnected parts.  Those relationships have various ways of producing something of value and benefit -  if you keep this in perspective, then the world around you turns into a puzzle, which you can assemble to unlock value and connections that others don’t necessarily see.  This framework is hard to keep up.  In the modern age this is a hard framework to stay within because there is so much ’stuff’ in our everyday existence.  Most of this ’stuff’ just turns into the ‘hum’ of society. That’s part of the challenge though - to bring critical views to things we take for granted or just assume as having a fixed and appropriate nature.

Complication and Intricacy - daunting, but worthwhile gate keepers to take on.

be good.

Stephen

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Oftentimes, an entrepreneur will express confusion as to why investors generally like our services, reasoning that our presentations and executive summaries, by highlighting the strengths of the company, are designed to conceal weaknesses. This makes sense, as it’s quite reasonable to assume that investors want to simply evaluate a company on its own merits.

What is important to note, however, is that concealing a company’s critical weaknesses benefits no one. If flaws that have been concealed come to light in due diligence, then everyone’s time will have been wasted, and the entrepreneur will quickly lose credibility.

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