September 4th, 2007
With just an idea and no track record to speak of, it is not easy to value a startup at the idea stage.
In early stage company that is still losing money, a common method is to use discount cash flow. Briefly, project how much the company is going to worth 5 years later assuming it is established and stable, then calculate the net presence value with a huge discount.
How big is the discount? 20 to 50 times.
Why so high? Well, if you invest in 100 startup companies, how many do you think will succeed? 1 in 50? 1 in 100? 1 in 1000? The answer is closer to 1 in 1000 but if you are good, say 1 in 50, that means 49 of your 50 startups will die. The one that made it must be able to cover for all your investments including the 49 dead ones. Thus, minimum 50 times returns. Thats just how the investing business works at this stage.*
But even so, using this method won’t work for a brand new startup at the idea stage because there is no track record to do any projections. At best, it is a guess of what might happen – and chances are that what you expect is going to be very different from what you get when you finally get to executing your idea. So even though it looks nice in excel, it is just that – an excel spreadsheet, nothing more.
So we are still back to the problem how to value a startup with no track record. There is no right answer and your guess is as good as mine.
But for me, I place emphasis a lot on the team and their track record. If you are a serial entrepreneur (even if you failed before), you can expect a lot better valuation than a fresh graduate with a passion. Not to downplay the passion, but with no experience the chances you would succeed is smaller than someone else who has done it before.
At the end of the day, investing is like any business. Buying and selling, risk and reward. We want to make money for our investors and ourselves. If the numbers don’t make sense, then we cannot do the deal no matter how much we like you.
I feel quite sad because we have to pass on a few startups because of the unrealistic valuation the founders have**.
* For those who are uncomfortable with this huge discount, you might want to get investors later. The general rule of thumb is that the latter it is, the less returns the investors expect. For example, a pre-IPO round investor might only expect 50-100% return on their money.
** This problem isn’t limited to just startups. There was one particular 20+M deal that we couldn’t close because of just merely 1M gap after 6 months of negotiation.