What Glitters may not be Gold - the Valuation Traps in Start-Ups

Beware of the Valuation Traps in Start-Ups !

Starting a Start-Up is hard. Sexy but hard. In some sense, being an employee then felt like the easiest job in the world.

The term start-up didn't exist during our parents generation. It was simply called starting a business, and the business slowly grew or failed, all without much outside attention and fanfare.

In our generation today, entrepreneurship is actually an academic course taught in universities. And young people are all jumping into the bandwagon to start companies.

And there is another part of the equation which have fired up the start-up fever - Investors Money.

You have then some barely-tested ideas and lots of capital - which is a recipe for some crazy outcomes.

One of them is the valuation. Some crazy ones !

Obtaining outside funding is a major milestone for a start-up.

I see it as the ride that takes you to the base-camp of Mount Everest, not the peak.

Start-up Founders - Please take note of the valuation traps:

a) Going for as high a valuation as possible

This is dangerous because if your start-up fails to meet the hockey-stick projections, you will face a revolt from existing shareholders if your next round is a down-round (ie. at lower valuations than the previous rounds).

b) Giving up your majority control on equity conversion

You have an investor who puts in $10m based on a equity valuation of $30m now. Two years later, your struggling startup is worth only $15m because things did not pan out.

Your investor now owns 67% of the Company instead of 33%.

He calls the shots now, and demands that you start making the coffee.

c) Expenses don't matter because valuation of start-ups are not based on profit or cash-flows anyway.

This is the worst fallacy ever for start-ups. It is true that start-ups will not be profitable initially. This however is not a blank cheque for start-ups to hire lots of people, and build fancy offices. To quote Benjamin Franklin - "A penny saved is a penny earned" , and valuations are fundamentally driven by cashflows and earnings.

We work alongside investors and start-ups to value young companies, and we advise both accordingly.

On one occasion, a season investor blew up the start-up founder's well-rehearsed pitch with just 20 words. The investor roared," Look, I only want two things from you. What are the monthly expenses, and how much are you paying yourself?"