What’s in a valuation? The secrets that early-stage founders need to know

Throughout my career as a coder, founder, investor, and adviser in a bunch of successful organizations, I’ve learned how to value companies and the crucial role an early-stage valuation plays in a startup’s future success.

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Recently, I spoke with founders from some of Southeast Asia’s most exciting early-stage companies about startup valuations and shared some secrets founders need to know when approaching venture capital firms.

From my perspective, founders need to understand three important elements in how VCs like Monk’s Hill Ventures (MHV) assess company valuations:

• If you’re an early-stage startup, recognize that a VC generally views valuation as more of an art than a science. Valuation is just one factor (and not even the most important one) when making a decision to invest.
• To understand what a reasonable valuation may look like, do your homework. Know your total addressable market and how similar companies in your sector, region, and stage of growth are valued because you can bet VCs know too.
• Negotiations over a company’s valuation are a test of your resilience, business savvy, and negotiation skills as a founder. At MHV, we’re backing the entrepreneur, their potential, and the large, complex problem that they are trying to solve – the hairier the problem, the better.

Secret #1 The valuation of early-stage startups is more art than science

Let’s say a VC takes all the things a business school would typically teach about valuing a business: cash flow, valuation computation, and so on. If we follow all those rules to the letter while sizing up a seed-stage startup, we’d probably end up concluding that the company is worth nothing at all.

That’s because, in an early-stage startup, there’s neither cash flow nor revenue. Any forecast a founder comes up with in a seed-stage document is only based on hope.

Hope may give a new business wings, but successful raises in seed-stage companies are more about applying a first-principles approach to assess the startup’s future potential.

Take the Singaporean roll-up startup, Rainforest, for instance. It raised US$36 million with nothing but an idea and three founders. Zooming out, you could debate whether it warranted a valuation of around US$12 billion.

How does a company with no current operations get valued at that level? It’s not because of its forecast future earnings (because there’s nothing to base those on yet). No, it’s because of the potential in the business and its founders.

When it comes to series A startups, especially those in Southeast Asia, where our regional knowledge plays a significant role, there’s “no real science” to a valuation. Instead, we try to evaluate a company’s founders and potential investment returns.

The way we and a lot of other VCs think about it is that if we invest in your company and the investment achieves a 50x to 100x return in six or seven years, does it really matter what valuation we get in at?

So founders take note: It may matter less what you think your company’s valuation should be and more about whether you can agree with investors on a reasonable valuation range based on first principles. Early-stage investors understand that valuations are sometimes less important than the potential upside of future returns and the character of the founders, whose job it is to grow the business.