Pursue value. Not valuations

In today's startup culture, founders and investors obsess about valuations.

Valuation of a company is a culmination of other people's guesses of your worth. Or, your own guess of your worth. A result of negotiations between two sets of egos.

It's a make-believe number on paper. Well, dare I say it isn't the real thing.

But still...we like to pursue valuations.

Here's how the story goes...

Say four people launch a digital health startup. Create the entity with 10,000 shares. They feel that with them coming together with a business plan is something to value. Must be worth at least $4M.

That makes the price of each share: $400 (4,000,000 by 10,000).

They manage to convince angel investors to seed $200K for $400/share. That gives angel investors 500 shares (200,000 by 400). That's 5% of the company.

Mind you, no one knows if the entity is really worth $4M.

Then they raise $2M in Series A investments for say a negotiated valuation of $10M.

For the sake of simplicity, let's assume the new investors own 20% of the stock.

The company now has more users. Not exactly paying customers but that doesn't matter.

That traction is used to build a discounted cashflow analysis (DCF). To justify what the net present value of the company must look like. That's easy to do.

Very simply put, develop a cashflow statement for the next two years to identify sources of revenue and costs. Then add percentages here and there. To grow and arrive at a hockey-stick curve. (Everyone loves exponential growth curves).

Now the company is ready to raise $10M.

They convince Series B investors that they are worth $25M. Series A investors are happy because their 20% is now worth $5M (20% x $25M).

The company has more users using their product. May be they somehow make $1M in revenues. But that doesn't matter because this isn't about revenues or profitability. Other metrics matter to demonstrate growth.

Now they raise $50M. Valuing the company at $200M. This higher valuation is in everyone's interest. The founders, angels (if they haven't already been bought out), Series A investors, and Series B investors. Everyone's stock price increases. Everyone makes money. On paper. Unless they exit.

The assumption here is that if the company is put up for sale. Someone will pay $200M in cash (real money) and buy everything they got. (It's not what usually happens).

Negotiations are often about exit valuations. If an investor comes in at the $200M point, you'll ensure a higher valuation at say $300M in a certain period. So that their money grows. On paper.

You have to keep feeding the beast you've created.

That's how the valuation game goes. One of my b-school professors called it a Ponzi scheme. Ponzi or not, it's a game indeed.

The problem is it catches up with you...eventually

Just the other day I was chatting with a VC-friend. A few of their portfolio companies are stuck in limbo. He has his Limited Partners to answer to.

The companies raised money at high valuations. But couldn't build up business sufficiently to justify the valuation. At some point, everything catches up. Someone wakes up and says, but the emperor has no clothes. It's bizarre throwing more money.

It's at that point that founders and their investors are badly stuck. When they fail to raise more money, the game ends. Almost abruptly.

Founders who've spent their time raising money than nurturing their organizations are caught off-guard.

When you don't invest more in your product, it ages and dies. Your users will stop using. If you don't meet payroll, people won't show up to work. If you don't pay rent, your landlord will shut you down.

It's the story of many a startup. Billions of dollars are burnt in the pursuit of valuation.

What a waste!

But value is a different matter. Value is what companies really create

Valuation is an outcome. Must not be confused with the real task of building organizations.

Companies are built because they can create something of value. A product or a service. That can be useful to someone so that they are willing to pay for it. That's how revenues happen. With profits. That's real money.

It's only in recent years that more people are starting up in the pursuit of paper-based valuations. If you really think about it, it's no value at all. An entrepreneur-friend said, it's like being a post-man for cash - delivering it from one end to the other.

As entrepreneurs and investors, we have a moral imperative to pause and reflect. On our under-lying reasons at every growth juncture.

We live in disruptive times. Where advances in science and technology can solve real problems. In many domains. This opportunity must be put to meaningful use.

Pursuing value helps us build better companies. It creates better entrepreneurs.

Entrepreneurs who worry about the basics. Like revenues, costs, and profits. Who focus on developing people and organizations. Who learn to take care of clients and their needs. Who learn to build better products and services.

Not because they need to raise the next round. To bail-out the folks from the previous round. But because it's the right thing to do.

Such an entity invariably is valuable. It's precious.