Common Startup Misconceptions and Mistakes - Assessment Of Time And Money Requirements

The old adage that veteran investors and entrepreneurs will tell you is that it will always take more than the expected time and money to achieve milestones in a young company's life cycle. The biggest misunderstandings occur in association with business launch and profitability milestones. There is wisdom in this pronouncement. However, entrepreneurs very rarely get the needed advice to avoid the frustration of missing dates and having to raise more money to get their companies off the ground and at break-even levels. The following are a number of reasons why entrepreneurs miss the mark and how to avoid this happening to your business.

Investor Pressure - Ironically, investors are usually the ones forcing entrepreneurs to provide then with dates and numbers that are most likely not going to be met. It may be that an entrepreneur has to cave in and give investors the dates they want to hear. However, the mistake entrepreneurs make is not acknowledging to their team and themselves that these are not the expected delivery dates. This cascades into a potentially dysfunctional situation where dates are never made and team morale drops. The best advice is to craft a realistic time line and expenditure guidelines for your team and create an operational model around them. Even if investors are pressuring you to deliver faster it is of no benefit to your business if you consistently miss these dates. In the end a savvy investor is more interested in the truth and not about being placated.

Overly Optimistic - Entrepreneurs are naturally excited and enthusiastic about their companies. This comes with a feeling that anything is possible and a get it done attitude. This is great from a motivational perspective and it does result in pulling in dates that would otherwise be extended in a later stage company. However, optimism and drive should not overshadow the real picture. Listen to your team! If your team is giving you a good reason for a date of delivery, or you do not have the resources to accomplish what you would like in a certain time frame, you should acknowledge it and plan accordingly. Pushing a team to deliver on unrealistic dates has all kinds of consequences.

Lack Of Experience And Expertise - You can't know what you don't know! Face it, entrepreneurs commonly encounter challenges that they and their teams have never faced before. This is a natural part of the fun starting a new business. However, do not be naive in believing that you have any idea of what it will take to get something done until it is actually completed. The real danger of continually predicting aggressive completion dates and not achieving them extends far beyond the external perception of investors and the marketplace. It can also have a devastating impact on the morale within your company. No one likes to repeatedly miss goals and objectives. If a business is missing dates or delivering low quality product it could be that the business does not have the right skill set mix. This is very common and is easily addressed by focusing on the skills that are missing and bringing them into the company as soon as possible.

Cost Estimation - It is difficult to get a handle on cost until you have had some experience engaging suppliers, buying various items, using contractors and adding employees. Market conditions and the economy change making some items cost less and others more than expected. Before you go to far down the road creating or pitching cost estimates get some operational experience with the business and then back those into the pitch and business plan.

Sales/Revenue - The best way to predict revenue without any real operational history is to look at your competitors that are recognizable businesses. These competitors do not have to be exactly in the sweet spot of your space. These predictions may not be an absolute indicator of revenue dynamics for your business. However, they will provide real life numbers that are useful to you, your team and to investors. Also be careful of the hockey stick long term predictions for revenue. Keep the number to the first year of actual operations. The future is too hard to predict and investors no longer buy the hockey stick metaphor.

Conclusion - Realistically, projecting completion dates, revenue, operational costs and calculating the bottom line is difficult for a new company. It is best to stick with an investment amount you need to fund the early operational costs of the business and work from there. A knowledgeable investor will get this. Certainly your business has to be game changing in some way to attract attention. Showing potential numbers associated with the upside of your business is great. However, do not over pitch your company forcing your team and yourself into unrealistic goal setting. If you do you will back your business into a corner that will potentially have a long term negative impact on your business and your employees.

What Is Your Start Up Worth?

Establishing a valuation for an early stage company is challenging. There is little financial history to predict future earnings and the real character of the company is still forming making it difficult to find comparable references with similar financial history.

Entrepreneurs are frequently unfamiliar with traditional ways to value companies and may approach valuation as an ownership issue rather than the market's assessment of their company's worth. Conversely, savvy investors attempting to acquire an ownership stake in a company may attempt to take advantage of an entrepreneur's desperate need for working capital by artificially deflating the valuation using the current company valuation and not the future growth and earning potential of the business.

Despite these challenges investors and entrepreneurs do need to agree on valuation based on a reasonable scientific method of establishing valuation.

This will keep fund raising negotiations on track, less emotional and instill confidence in current and future owners that the valuation is real and a legitimate reference point for future rounds of funding.

To this end I have elicited the expert advice of Lucia Wallace, Senior VP at Houlihan Lokey, to help craft this blog. Lucia is familiar with negotiating valuations for companies of all sizes in various stages of maturity. She has taken an interest in early stage companies and has provided good advice on what valuation approaches are best for early stage companies.

We will start out with an overview of traditional methods used to value companies and how they do or do not fit early stage companies.

Discounted Cash Flow (DCF) - This valuation method uses an estimate of future cash flows generated by a company. A discount co-efficient (discount rate) is applied to the estimate. This discount rate is based on the level of risk associated with the estimates.

In many cases a start up has no historical reference for cash flow making the DCF method of valuation suspect. A business owner may inflate the cash flow to demonstrate the great potential of the business to please investor expectations. An investor may deflate the predicted revenue to obtain a greater percentage of the company (or would assess the business owner's expected cash flows as having a high degree of risk). With no real history of cash flow the debate over cash flow valuation can result in an uncomfortable negotiation scenario were each party is arguing for a valuation without any real basis for the argument. At the end of the day, the discount rate is supposed to reflect the appropriate level of risk - which is extremely difficult to pin-point (if you do not want an excessively wide range of values).

Book/Asset Value - There are a number of valuations based on the value of the assets of a company. For technology based start ups this may be the value of the product/technology developed to date, patents, cash on hand, etc. However, the primary asset of a start up or early stage company is the collection of intangible assets (patents, technology, workforce, management team, advisors, access to cash, etc.), which is very difficult to value. Hard assets (furniture, plant, real estate, equipment value, etc.) have an easier determinable value, however, generally make up a small portion of total value of a company. Future value is the important piece of the puzzle because early stage companies are usually growth companies with the real investment value of the company in the future not the present.

Visits/Traffic/Eyeballs - A web oriented company can predict its future value based on expected web traffic. There are good comps for this. However, not all visit/traffic business models are the same. For instance, if there is a product platform developed to support content delivery or a unique business process has been crafted to differentiate the company the visit/traffic approach does not give you the full valuation picture. In the end the traffic has to be tied to some demonstrable and supportable revenue number. Just indicating that the company is going to generate traffic is going to be challenged.

So how do you get a substantiated value for a company that makes sense to investors and to start up business owners?

The best approach is to compare your company to another similar company. Back in the day an investor made an investment in an entity with no financial history. From that point on a "comp" has existed for all future investors and entrepreneurs.

The world has become more complex, in a good way, providing all kinds companies to choose from to establish a valuation for your early stage company. A start up can establish a valuation based on Market Multiples for comparable companies.

Market Multiples - Market multiples can be derived from either publicly traded companies, financing of private companies, and/or M&A transactions. Using this approach, you calculate the multiple on a financial metric (e.g., enterprise value /current value, enterprise value / future value (one or two years out) or enterprise value / current or future EBITDA) for the comparable company, and apply that multiple to your financial metric.

• The easiest way is to find publicly traded companies, as both valuation and financial information is easily available. Let's call these Public Comps. Note that the valuation in the public domain is generally for a "minority" ownership (i.e., a few shares), and not for a significant or even "controlling" ownership position. If you are selling some aspects of control, you need to account for that.
• You could also use a private company that has recently received funding, and pre-money valuation has been publicly disclosed, and you are familiar with some financial metrics (e.g. approximate revenue). You can calculate revenue multiples (or multiples on unique visitors, or EBITDA multiples) based on these Private Financing Comps. More likely than not, however, you won't have detailed financial information, so its difficult to draw detailed conclusions from this approach. If you are creative, though, you might be able to gather some information from the investor About the private companies in their portfolio - many are proud of these investments and publicly display them on their web sites, talk about them and market them to other investors and consumers.
• You can also use an M&A transaction (M&A Comps), for which both the transaction value and the target's financial information are available. Similarly, you can calculate revenue, cash flow or earnings multiples implied by the M&A transaction. Please note that an M&A transaction also reflects a premium for gaining control.

Trade of Shares For Investment - Valuation, investment and equity distribution are all tied together. I discussed equity distribution in a previous valuation Blog.

Keep in mind that the investor is investing in a very early stage company. This = risk for the investor. To mitigate the risk of the business plan not playing out exactly as planned the investor may ask for a greater percentage of the company then may be might expect. This should not be confused with conceding "control" of the company to the investor. In most cases, the last thing the investor wants is to control/manage your company. This is why they are so interested in the team running your company. You should be focused on getting the investor interested in your company, establishing measurable valuation and obtaining an amount of working capital that will conservatively allow you to focus on running the business and not remaining in perpetual fund raising mode.

In conclusion, start up valuations are hard to evaluate with traditional valuation approaches. The best way to obtain a satisfactory valuation for the business owner and the investor is to compare your company to similar companies that have public valuations. Yes, the valuation of the company may impact percentage ownership. Valuation and equity discussions will be intertwined in negotiations so make sure the basis the valuation and equity distribution are clear.

Emerging Economies Taking A Technical Lead

Recently, I have been working with entrepreneurs from emerging economies and have developed a new respect for the products and services they are producing. These products and services are not clever knock offs or replicas of of products from developed countries. People in developed economies rarely think of developing countries as places to find innovative high tech solutions for business and consumer demand in sophisticated economies. It appears things are changing.

I conducted research on the growth of technical development in emerging countries to ascertain the root cause of what I have been observing. The research revealed that there are several speculative reasons why developed countries have begun to produce advanced and innovative high tech products and services.

Technology Transfer "The Consequence Of Outsourcing" - Most of the documentation on this subject addresses the unintentional transfer of knowledge as an inevitable consequence of outsourcing. Technical and operational acumen follow outsourcing. Places like India, China, Malaysia, Philippines, etc. are classic examples of developing countries that have created impressive technology centers as an outcome of outsourcing of product development to developing countries.

Creating Demand For High Technology Products In Developed Countries - Tech companies like Cisco and Intel have worked hard to create markets for their products in developing countries. This has resulted in the establishment of IT infrastructure that is being used by government, business and schools in developing countries. The population's interaction with these systems results in the development of technical competency and high tech operational proficiency.

Encouraging Technology Development - Government and charitable organizations have funded technology oriented programs designed to provide access to technology and to educate segments of the populations on the use of technology. These programs have been designed to address segments of the populations that would normally not be exposed to high tech products and services.

Government Focus On High Tech Solutions - There are progressive governments in emerging countries that are developing information systems to address specific socio ecomonic challenges. The governments are not looking for help from outside organizations. They are initiating the programs by leveraging existing human and IT resources within their countires.

These initiatives have contributed to the proliferation of technology in developing countries. However, they do not fully account for the unique characteristics of the products, services, ideas and companies that I am seeing. I am witnessing very creative ways of leveraging reasonably advanced platforms and product ideas that I do not see in the developed world.

A deeper dive revealed that there are key categories of development that are standouts. My experience has identified mobile and payment processing systems are yielding the largest amount of impressive application development.

It appears that the reason these areas are seeing more creative offerings is that the developing countries have different usage models and challenges in these areas as compared to developed countries.

Mobile Computing Platforms - In developing countries the mobile device is the only computing and information sharing device. These devices are proliferating at an astounding rate giving entrepreneurs incentives to figure out ways to deliver applications specifically and exclusively for this environment. Combine this with an increased technical proficiency of the population and you begin to see unique products and services for mobile devices you do not see in developing countries.

In contract, developing countries have alternate dominate computing platforms. Laptops, desktops and in some cases digital TV platforms provide good mechanisms to deliver information content. Mobile platforms are also in this category. However, the operative word is "also". The mobile devices is not the only option and in many cases not the preferred information access point for the majority of the population.

Payment Processing - In developing and emerging economies the credit card is not a common or even reliable form of transacting. Combine this fact with the proliferation of applications that requires some form of payment and you understand the demand for innovative payment and transaction systems. The really interesting products being developed in Africa, China and Malaysia combine some form of basic deposit system with an online transaction system completely divorced from traditional credit card and traditional banking institutions.

The notion of virtual currency and its exchange is more prolific in China then it is in the developed world. People in developed countries may consider virtual currency to be the exclusive domain of gamers engaged in the trade and acquisition of virtual goods. In China the populations has taken virtual currency to a new level exchanging and redeeming virtual currency for conventional currency. It could be argued that the rise in popularity of online games in China may be a direct result of people realizing that the online game world is an economy that allows the population to transact, exchange and accumulate currency. It provides people with a wealth creation option that only exists in an electronic and virtual information world.

These is not doubt other areas of development will experience a creative surge in the introduction of new and interesting applications. Alternative energy, is one that should spawn an entirely new set of products and services resulting from the need to craft solutions that uniquely address energy challenges in the developing world.

The importance of emerging economies taking the lead in providing innovative and creative high tech solutions lies in the associated investment opportunities within these economies and the export of the products and services to developed countries. Investors within the developing world as opposed to financial institutions in the developed world may be more likely to take advantage of this opportunity. This dynamic could create interesting changes in the sources of wealth creation and distribution throughout the world.