Entrepreneurs Beware: The Perils of Overpricing Your Company It’s understandable. You know the sweat that went into building your company – the late nights, sacrifices and tough decisions. But that doesn’t always translate into a higher valuation. For the average entrepreneur, valuing a company is one of the most challenging moments in the quest for growth. Certainly, you don’t want to undervalue your organization but – then again – seeking out investor money at too high a price may have its pitfalls as well. In this article, I explain why more is not always better.
It’s A Credibility Issue Seed and venture funding is hard enough to come by. These investors are looking for returns in the multiples and you want to avoid pricing yourself out of consideration. But more importantly – and anyone who has seen an episode of Shark Tank will know this well – the very act of setting an asking price speaks to your ability to exercise judgement when making tough calls as an entrepreneur. Be ready to justify the basic math through financial know-how, careful assumptions (which should not involve the words “if we can acquire just 1% of all Facebook users”) and market research. Know your numbers well.
Valuation is Linked to Burn Rate What happens when a company’s valuation shoots up 250% while its cash flow stays remains steady? Cash starts flying out the door. Employees of dubious necessity are brought on board, often at higher salaries than during leaner times. Founders may draw higher salaries and spend on new technologies and office space. In effect, raising cash leads to a loosening of the belt in pursuit of an anthropology of success that might not match the underlying reality. No matter what an investor will pay, spending should generally reflect the fundamentals unless your model is based on massive user acquisition.
Valuation Needs Room to Grow A funding round may seem like the pinnacle of success. Yet since you haven’t actually made an exit, there’s a good chance that you’re going to be asking for more money before too long. And when you start with an aggressive valuation, it’s hard to demonstrate the kind of exponential growth that investors expect. This runs the risk of a ‘down round’ in which a VC may value the company as worth less than what an earlier investor paid for it. As a result, it can be hard to get prior investors to agree to close the deal. This can also have a demoralizing effect on the team if it happens during a period of stalled growth.
What’s the Takeaway? This is not a call for entrepreneurs to be overly modest. That’s hardly a part of the entrepreneurial ethos, and you’re in this to make money. Instead, I encourage entrepreneurs to seek out diverse perspectives on valuation from mentors who know enough about your industry to offer an informed opinion. If you are without a mentor with that kind of experience, consider finding one through the Service Corps of Retired Executives, more commonly known as SCORE. There is no magic valuation formula. The price-to-earnings approach is intuitive but still relies on a multiple. The best your can do is to understand valuation from multiple angles, learn what other similar companies have been offered (which you
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can begin to research on Angel.co), and know your numbers as well as you know your customers. But most of all, seek out the wisdom of experience. Ask mentors what they would pay for the business and explore the logic behind their math. ---ADAM JIWAN, Managing Partner of Ridge Road Partners LLC
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