Tuesday, October 28, 2008

Startup Valuations

I've had conversations recently with several early-stage founders about valuations for the purpose of raising money. It dawned on me that many early-stage companies are backing into their projections based on how much money they are trying to raise and how little equity they want to give up in terms of valuation.

Here's the process:
Step 1: Decide to raise $'s
Step 2: Talk to an investment banker who says minimum worthwhile raise is $3 million
Step 3: Set valuation at $6 million, so as not to give away more than half the company
Step 4: Build projections based on spending $3 million in the next 18 months and profitability that will eventually support a 10x return on a $6 million valuation
Step 5: Become unprofitable based on spending the $3 million raised
Step 6: Miss projections, run out of money, return to Step 1

This process seems to set up companies for a world of pain.

I do believe there is a better way, from my own experience:
Step 1: Create a profitable company by operating on a shoestring
Step 2: Use the profitability to hire more people
Step 3: Generate more profitability and repeat Step 2
Step 4: Enjoy the freedom from not having investors, not constantly raising money, and not feeling crappy about missing projections and being unprofitable.

I'm constantly surprised at how few business people think this way. I must be the crazy one.