Unveiling the QAI First Principles
Valuing startups is an enigma. It's an intricate puzzle with pieces like historical performance, market uncertainty, uniqueness, and asymmetric information between founders and investors. The process becomes even more intriguing when we consider the role of valuation caps, pricing, and the quest for an objective model that everyone can grasp. In this blog post, we'll unravel the concept of valuation's first principles, shedding light on the core assumptions that underpin this complex practice.
The Early-Stage Valuation Dance
In the early stages of a startup's journey, founders often take the lead in setting the valuation. They define the startup’s worth in the market and proceed to sell this valuation through mechanisms like the "valuation cap" on SAFEs or Convertible Notes. However, this dynamic shifts when a startup secures institutional funding. Here, the lead venture capitalist takes the reins, determining the price at which other investors join the party. The first "priced" round typically occurs at this institutional raise.
At Doriot Venture Labs, we believe it’s a mistake to postpone pricing until the first institutional round. Nonetheless, this approach is prevalent in today's market. The pressure is on the venture capitalist to price the deal accurately since all previous investors will align with that valuation. Thus, DVL is pushing for an "objective" valuation model that all stakeholders can understand, making the conversation revolve around a set of fundamental assumptions.
Valuation: Where the Assumptions Matter Most
The heart of the valuation matter lies in the assumptions made by both founders and investors. These assumptions form the foundation upon which the startup's valuation is built. Let's explore the essential commitments from both sides.
Founder(s): Five Potential Exit Scenarios
The founder bears the responsibility of shaping vision for the startup's future value. Therefore, founders should be prepared to address a fundamental question: What potential exit scenarios are envisioned for this startup? These scenarios span from achieving a grand slam to encountering a strikeout, with a spectrum of possibilities in between. To solidify the valuation, it is crucial for the founder to specify the market comparables used to support these future exit values and, most importantly, to outline the probability of each scenario. This exercise fosters transparency, offers clarity to the founder's vision, and ensures alignment with investor expectations.
Lead Investor: Identified Risks and Future Dilution
The lead investor holds the responsibility of translating the founder's future vision of the exit value into its present-day worth. In this pursuit, investors must conscientiously pinpoint and quantify the various risks entailed in the deal. These risks can span across macroeconomic factors, market timing, competition, and more. The transparency in identifying and assessing these risks is invaluable, as it aids all parties in comprehending potential challenges and their corresponding solutions.
Furthermore, the lead investor's seasoned experience should shed light on the extent of future dilution that the startup may encounter on its path toward realizing a future exit value. In many recent cases, companies that have achieved unicorn status have navigated multiple rounds of financing. Understanding the implications of future dilution equips founders with a clearer perspective on what awaits them in their journey.
A Valuation Model and Waterfall Schedule
Armed with these core assumptions, the application of the QAI First Principles Valuation Model allows us to efficiently and quickly build a valuation analysis. This analysis not only identifies an objective valuation grounded in assumptions from both founders and investors but also generates a waterfall schedule, a schedule illustrating the distribution of proceeds under diverse future scenarios. The adoption and deployment of an objective valuation tool has the potential to help both founders and investors maneuver through the intricate and messy terrain of startup valuation.
The Simplicity in Assumptions
In short, conducting a startup valuation need not be overly complex. It becomes more straightforward when both founders and investors commit to and defend their assumptions about the future. This mutual understanding and transparency not only streamlines the process but also fosters stronger partnerships built on trust.