Use Productization to Cross the Chasm

Chasm CrossingFor example, assume you’ve developed a way to make awesome gluten free cupcakes. That recipe is your core technology, but you still need to productize it into a form that will satisfy your customers. To do this, you need to determine what flavors you will make, how large or small you will make each cupcake, if you will accommodate other food allergies with your recipes, and how you will package them: as singles or in multi-packs. These characteristics have little to do with the core technology, but they can have a significant effect on the marketability of the final product.

Without proper productization, you may be able to sell to enthusiasts and early adapters, but crossing the chasm into the main stream will require that you satisfy the needs of the majority. How do you know which of these characteristics are most important to them? As always, ask your customers.

Shark Math Part 2: Determining Valuation

In the last post, we introduced the terms “Pre-Money Valuation” & “Post-Money Valuation” and discussed how they are used to determine equity splits based on the size of an investment. We also mentioned that changes in valuation will directly lead to changes in equity. In this post, we will continue that discussion by describing methods for determining the Pre-Money Valuation of a company.

Revenue and Income Multiples

Perhaps the most common method of determining valuation is to calculate it as a multiple of revenue or income. For clarity, revenue means the total of all sales minus returns. Income is the amount of profit you have after all expenses are deducted. The multiples will vary based on the industry. Professor Aswath Damodaran teaches a class at the Stern School of Business at New York University devoted to determining corporate valuation. He has published tables that show average multiples for a variety of industries.
Revenue Multiples http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/psdata.html
Income Ratios http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html

Based on these tables, an Internet Software company with annual sales of $1,000,000 will have a pre-money valuation of $6,970,000 based on its revenue multiple of 6.97x. If that same company has an annual profit of $100,000 then its pre-money valuation will be $13,607,000 based on its earnings multiple of 136.07x.

Early stage startups frequently operate at a loss. As they mature, they may operate at break even for a period during which they invest potential profits back into the company to support growth initiatives. Thus, these companies may have to rely on the revenue multiple only.

Discounted Cash Flow

Besides multiples, Discounted Cash Flow can be used to determine valuation. To use DCF, you need to make assumptions about the cash a company will generate each year, and the prevailing interest rates.

For example, assume a company will earn $1000 next year and that interest rates are 2%. If you put $980.39 into a 2% simple interest savings account, then you will have $1000 in one year. So a company that will generate $1000 next year is worth $980.39 today. If you repeat this calculation for a number of years and add up the values, you can determine the current value of the company based on the projected cash flows. Spreadsheets even have built in functions to perform these calculations for you. In Excel, the function is called NPV, which is short for Net Present Value.

Keep in mind that there is always risk that the revenue projections will not be accurate, so investors will often ask you to discount the value as a way to mitigate the risk of missing your projections.

Additional Methods

There are many other methods available to determine valuation. Some are described in these books:
Founder’s Pocket Guide: Startup Valuation by Steve Poland, published by 1x1media
Term Sheets & Valuations by Alex Wilmerding, published by Aspatore books

Negotiation

Regardless of the method you use to determine your pre-money valuation, you should understand that it will only be the first step in a negotiation process. Your investors will likely use their own valuation method that will probably result in a lower value. Then you each get to defend your proposed valuations while chipping away at the valuation proposed by the other party.

If you need to go through a negotiation, you might wonder why you should bother with a formal valuation process. Here are a few justifications:

– It will help you establish a “reasonable” starting point for the negotiation
– It will help you understand the valuation being proposed by your investors
– It will demonstrate to your investors that you understand the importance of the valuation and investment process

With this information in hand, you’ll be better prepared to swim with the sharks in your local investment tank.

Good Luck!

Shark Math

The entrepreneur walks on stage, does a brief pitch, and then tells the Sharks they are seeking X amount of money in exchange for Y percentage of their company. One of the sharks complains that this gives the company a current valuation that is far too high. Whether you’re swimming in the tank, attempting to raise funds from a venture capitalist, pitching to angel investors, or trying to get a little cash from friends and family, you should understand how the math works.

Imagine that you are partnering with a friend on a new venture. You invest $1000 and your friend invests $500. Since you invested 2/3 of the total, you should own 2/3 of the company. Since your friend invested 1/3 of the total, they will own 1/3 of the company.

It works the same way with an investor. Except in this case, instead of you contributing cash, you will be contributing the intrinsic value of the company. For example, if your company is worth $3M and you raise $1M, then you will have contributed 75% of the total value and will own 75% of the company.

To understand this better, you need to be familiar with the terms Pre-Money Valuation and Post-Money Valuation. Pre-Money Valuation is the value of the company prior to the investment and Post-Money Valuation is the value of the company after the investment. Since the only difference is the cash that is invested, the Post-Money Valuation is just the Pre-Money Valuation plus the amount of the investment. In the above example, the Pre-Money Valuation is $3M and the Post-Money Valuation is $4M.

Back to the tank. If the entrepreneur asks for $1M for a 25% stake in the company, then you might think that $1M is 25% of $4M, so the entrepreneur has valued their company at $4M. This is a good rough estimate, but is actually incorrect. $4M is actually the Post-Money Valuation. To get the Pre-Money Valuation you should deduct the $1M investment. So in this case, the entrepreneur has claimed a $3M Pre-Money Valuation. It is important to note that these formulas are only meaningful if the entrepreneur and the investor can agree on the pre-money-valuation, so these calculations really serve as the starting point for negotiation.

In an upcoming blog, we’ll discuss common methods for establishing a “reasonable” Pre-Money Valuation, in the hopes of avoiding the dismay often expressed by the sharks when they hear the entrepreneur’s opening pitch.

Everything You Do is a Choice

A few years ago, my oldest daughter was part of a highly ranked high school marching band program. They were invited to compete in the first national marching band competition on the ellipse lawn at the White House. Like most early stage entrepreneurs, I was up to my eyeballs in alligators. I convinced myself that I was too busy to chaperone the trip and had to stay home and work.

  • I missed my daughter’s first trip to our nation’s capital
  • I missed watching my daughter perform at the white house
  • They won, and I missed witnessing my daughter earn the title of national champion

 

As you might imagine, this was a very painful lesson. I came to the realization that I needed to keep my priorities straight. Since that time, I have consistently made family my top priority. I became an extremely active band parent. Sometimes that meant stretching the envelope, but I kept focused on what’s really important. I travelled with the band on day trips and even overnight trips. Sometimes it was exhausting, but it was always fulfilling.

Upon further reflection, I’ve come to realize that my poor prioritization was a vocabulary problem. When the trip to Washington was announced, I accepted the fact that I had to stay home and tend to business. By using the term “had to,” I was surrendering control of my life to an outside force. But surrender isn’t really necessary.

It turns out there was no irresistible force that prevented me from going on the trip. It was a choice I made based on the circumstances around me. This is a really important distinction, because having a choice gives you more options. Instead of thinking “I have to stay home to tend to business” I should have thought “I choose to stay home to tend to business.” As soon as you hear those words come out of your mouth, you realize the absurdity of that choice.

Of course, there are consequences to choosing. You need to recognize and take responsibility for the consequences of each choice. This forces you to consider the pros and cons of each option. Instead of automatically accepting a meeting invitation, consider if it is really a good use of time. Instead of automatically accepting a customer’s request for a discount, consider if it is really a good business decision. You might surprise yourself with how often the answer is no.

Now, as I proceed through life (and business) I try to correct myself every time I think I have to do something. Instead, I rephrase it as “I choose to do it” and then decide if that is really a good choice.

Does Your Startup Need a Corporate Bureaucracy?

The “E” in CEO is sometimes interpreted to mean Everything. While this might be a philosophy it is also the operational model for many startups. Any time something new needs to be done, it is often the CEO that identifies the need and figures out how to fulfill the requirement. In some cases, this is because the CEO’s skills and experience are best suited to the new requirement. More frequently, it is because the startup doesn’t have the resources or expertise to tackle the new challenge, so it defaults to the CEO.

This assignment of new requirements to the CEO is often appropriate when the need is new. Once the task becomes routine it may be best for the CEO to delegate it to someone else, so the CEO can focus on new challenges. This is where many CEOs have difficulty.

The startup CEO should know the business model, operational philosophy and expected outcomes of each activity better than anyone else. They know exactly how they want this new challenge to be addressed and exactly what outcome they expect. They also tend to “know” that no one else can do the task as well as they can. So the startup CEO tends to hold on to these new responsibilities longer than appropriate.

The solution might involve the CEO documenting the problem, the steps that should be taken to address the problem and the expected results. In the corporate world this type of documentation is known as policies and procedures. The term may be anathema to entrepreneurs who might have fled the corporate world to escape stifling red tape and who greatly value the flexibility to pivot on a moment’s notice. They may view any type of policies and procedures as the first step on the slippery slope to creating a bureaucratic quagmire.

In the corporate world, policies and procedures are often distributed as a collection of professionally edited, highly detailed procedures packaged in a 3 ring binder given to new employees as part of their orientation training. For the progressive startup, a more efficient system might be used. In this case, new policy and procedure entries might be created by jotting down some bullet points published through a wiki, a shared Google doc, or a folder on a SharePoint server. The objective is to use your existing infrastructure tools, making it easy for the author to share the information in their head and for the intended recipients to find and access it. A lightweight system might be a good compromise that provides your company with the benefits of policies and procedures without imposing the traditional corporate overhead.

The benefits of a system like this might include:

– Helping the CEO (or any other policy writer) view the issue more objectively and perhaps result in greater clarity and effectiveness

– Enabling the person responsible for the function to see a clear description of expectations, increasing the likelihood of them producing desired outcomes

– Providing the opportunity for anyone else in the organization to review the policy and provide possible enhancements

Policies and procedures can enable effective delegation, which might ultimately be needed to scale the operation and free up management to focus on the big picture. How might your startup benefit from a little bureaucracy?

Welcome to the Tech Coast Works Blog

Tech Coast Works was established to to help innovators make the transition from concept to thriving business. We’ll use this space to talk about the many obstacles that must be overcome during this transformation, and possible approaches to surmounting these obstacles.

Most of the thoughts expressed here will be from Tech Coast Works’ Managing Director Jeff Greenberg. Jeff carries the bruises and rewards of 30 years experience in the high tech space, with the last 15 years focusing on the world of hi tech startups.

Join us as we journey down the road less taken.