TiE Launchpad Session 4: Selecting a VC and the art of valuation May 24, 2010

In the Boston area, idea stage incubator programs such as Techstars have served to provide some level of basic guidelines for entrepreneurs on what value to assign to a team of 2 co-founders and a power point that outlines a decent idea. At 6% stake for $18000, that sets a baseline value for a startup company at $300,000. If the 2 co-founders now go ahead and build a product/service offering now what is the incremental value this adds to the startup’s valuation? If the product or service has basic customer interest then how valuable is the company now? If the product or service is not ready but there are beta customers lining up in the droves to be early adopters then what? How do we compare the valuation of 2 companies who are in similar stages from a business standpoint but are in totally different industries? How do investors assign a dollar value to the ‘experience of the founding team’? A plethora of such variations and start up valuation is deviated by necessity into the realm of art from science.

The last TiE Launchpad session saw a VC, Carl Stjernfeldt from Castile Ventures, and an entrepreneur,  Ramji Raghavan from Movik Networks,  provide their viewpoints on what to use as guidelines in valuing a  startup for investor negotiations. The overall viewpoints expressed were not just focused on valuation but also on planning and evaluating the needs around external investment. Some key takeaways from the presentation and discussion were:

· Plan your timelines around scaling, hiring, sales and every aspect of your business carefully

· Focus on cash flow. Most entrepreneurs tend to focus on their EBITDA in their business plans but it is the cash flow that allows you to live another day

· In the current climate, assuming your business is at a stage where it is VC investable, allow for 4-6 months to raise and close a round. An interesting observation that was aired was that the delays could be to test the entrepreneurs for their persistence

· Raise 10-20% more than what you expect to allow for a buffer. Plan for such a buffer in future rounds as well and as a corollary to that, ensure that that VC syndicate has sufficient dry powder to support you through such future needs

· Do your due diligence well on the VC firm especially to review their portfolio to see if they have competing investments. Understand where the VCs have been successful with their investments and where they have failed. Partner interests matter as well

· Irrespective of the investment decision of a VC meeting, make sure to make the most of the opportunity to gain from their experience. Follow up on those action items BEFORE the next meeting with a VC

· The 40-40-20 rule. Expect to give away 40% of the company to the VCs ( at about the $3 million mark), 40% for founders and 20% for an option pool. If you don’t like your pre-money valuation the way you are most likely to get VCs to increase that number is by getting a competing term sheet from another VC.  Now, while this seems to make clear sense up front, I am curious to hear from entrepreneurs who have had the opportunity to use this approach to really hear how successful they have been especially against the better known VC funds

· Valuations on expansion stage businesses are based on projected business metrics and valuations on growth stage  businesses are based on measurable business metrics

· There are tons of peoples and titles floating around VC firms but bottom line is that, there are only 2 kinds – those who can write you a check and those who cannot

· Another interesting viewpoint that I have heard commonly and which was aired during this session as well was that VCs bring more than just money. I have also heard a lot of entrepreneurs who have been funded support this viewpoint as well. My interest on this issue stems from some interesting initial findings that were being seen by some research conducted by Prof. Ola Bengtsson (formerly of Cornell University and currently at University of Illinois, Urbana Champaign)

Overall, my takeaway was that entrepreneurs are better served by focusing on their business and execution since the valuation that their company draws from a specific investor is not really something that they can control. The greater the credibility of the business plan and execution potential of the founding team, the greater the chances of driving a higher valuation anyway. In effect, as entrepreneurs, we need to focus on the science of running our businesses and let the investors take care of the art.

About the author: Vikram Venkatasubramanian is CEO and co-founder of SIPtopics, a software startup company that is developing TopicPhone™, a soon to be released telephone service targeted towards seniors and visually impaired callers that allows them to state the topic of the call and be connected directly and in a hands free manner to end points in businesses and business services. He can be reached at vikram@siptopics.com