Throughout his career as a coder, founder, investor and adviser in a bunch of successful organizations, Peng has learned a thing or two about assessing the value of companies and the crucial role early-stage valuation plays in a startup's future success.
During a recent closed-door roundtable with founders from some of Southeast Asia's most exciting early stage companies, Peng delivered a masterclass on startup valuation and shared some secrets founders need to know when approaching VC's.
Peng says founders need to understand three crucial elements in how VCs assess company valuations:
- If you’re an early stage startup, recognize that at least this VC sees valuation as more an art than a science and that VCs like MHV see valuation as just one factor (and not even the most important one) for the investment.
- To understand what a reasonable valuation may look like, do your homework. Know your TAM, and how similar companies in your sector, region, and stage of growth are valued.
- Negotiations around a company’s valuation are a test of your resilience, business savvy and negotiation skills as a founder.
"I want to invest in an operator, in someone who is building something real. You don't build something real by guessing."
Secret #1 The valuation of early stage startups is more art than science
Peng’s hardest-hitting revelation came at the start of the session: that for MHV and a number of other VCs across the region, assessing the valuation of early stage startups is more art than science.
Although MHV predominantly focuses on Series A companies in Southeast Asia, Peng was quick to point out that seed-stage companies in the region should also note how valuations are perceived.
"Let's say a VC takes all the things a business school would teach us to apply; for example cash flow, valuation computation… if you take all those rules and apply them to a seed stage startup, you'd end up concluding it's worth nothing", says Peng.
"There's no cash flow, no revenues. Any forecast you come up with in a seed stage document is just hope."
Hope may give new businesses wings, but successful raises in seed stage companies are more about applying a first principles approach and assessing its future potential.
"For example, take companies like (Singaporean) roll-up startup, Rainforest, which just raised $36 million. With just an idea and three founders. If you look at the value of the company after raising new money, you could argue a valuation of around $12 billion."
"How does a company with no operations get valued at that level? Because of its potential."
When it comes to Series A companies, especially those in the Southeast Asia region where MHV's regional knowledge plays a significant role, there's "no real science" to valuation and instead it's about assessing a company’s founders and potential investment returns.
"The way we think about it, and know a lot of other VCs think about it is, if we invest in your company and the investment achieves a 50x to 100x return, does it really matter at what valuation we get in if we're seeing that kind of return in six or seven years?"
The lesson? 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.
Secret #2 Avoid answering the question from VCs, what is your valuation? But, know how much you need to raise
One of the real challenges Series A founders face is identifying a reasonable valuation for their business before they engage with VCs. At MHV, Peng's team looks for 'win-win' valuation scenarios where both founders and investors agree on valuations that reflect first principles.
Founders need to avoid making the mistake of calling out a company's valuation upfront. As a founder, you’re typically focused on your own business - and rightly so. However, this means that walking in with a ready-to-go valuation is a mistake. Simply put, you're going to be wrong when you propose a valuation because you're not the experienced party. VC’s like MHV see 50 - or more - deals a year in your domain, and see valuations across the board.
Instead, Peng suggests there’s a good way to answer the question about what your company’s valuation is - and that’s to not reference yourself.
"For instance, you could say something like 'I've seen another company get funded at this level and the revenues were X, and the valuation was in Y range'. Give two or three examples. That's how you answer that question. It shows you're smart enough not to put forward a number you're not sure about." Indicate that you’re fine with what the market offers.
Founders need to take onboard that the principle of a win-win is all about both parties bringing an educated view of a company's valuation to the table. Being educated means doing your homework and knowing how similar companies in your sector, region, and stage of growth are valued. The idea is to settle somewhere in a range where both parties think it could have been better for them but come out saying ‘it's reasonable’.
Later in the session, one founder asked Peng whether one approach founders may employ is to establish how much they need to raise based on their strategic goals.
"Absolutely. If I asked what the valuation is for your company, as a founder, that's something you should avoid answering upfront."
"But then if I asked how much you need to raise, which is a typical follow-on question, then you'd better have that answer and be able to back it up."
Secret #3 Valuation negotiations are how VCs test the company’s founders
Beyond valuation as a tool for assessing potential investment opportunities and future returns, Peng let founders know that VCs also use valuation negotiations as a test to evaluate a company's founders.
"We use the process of settling on a valuation, not necessarily to get to the valuation, but as an exercise in getting to know the entrepreneur, and how they'll respond during negotiations.”
When a VC gives founders information on a range, founders should consider it a test; the VC is likely looking to see how you handle that information and what you come back with.
"We're very transparent in our negotiation process. You will know, for example, what you've left behind on the table because we will tell you what the range is, right? And if we've come in at a certain range, we're looking to see where you've got to."
MHV’s partners are always looking for founders' responses to crucial questions on how they intend to build their business. That’s the real business conversation that needs to be had, according to Peng, because founders that come lightly armed in that area decrease the likelihood a VC will invest.
In terms of what investors want to see, Peng has one final piece of advice for founders; "I want to invest in an operator, in someone who is building something real. You don't build something real by guessing."
Ultimately, the perfect valuation number for your early stage startup probably doesn’t exist, at least not as a hard and fast figure that you can easily back up. Instead, it's whatever yourself and potential investors reach as a reasonable valuation or range, working from first principles. When it comes to establishing a reasonable valuation, take note of the advice, strategies, and ranges that experienced investors share with you. It could be the difference between a successful raise and failure.