The Art and Science of Valuations: A VC and Founder's Perspective

Welcome to the Venture Capital Podcast with Peter Harris and John Bradshaw. Peter's with the University Growth Fund. I'm with Codebase. He covers the VC side, I cover the founder side. Today's topic, students, is valuations. V A L U A T I O N S. Valuations.

Good spelling.

I went to a spelling bee this past week.

Did you really?

Uh huh.

Did you win?

It was for my nieces.

Oh, okay.

What's in your mind?

So, valuations. So you know, I've been thinking a lot about valuations in our industry because I think a lot of people look at valuation in ventureland and it's, it's kind of this black box, right? It's like, what, how do you know, like, what your company is really worth? And you know, valuations, especially at the really early stages, seem kind of arbitrary.

Right.

And so I thought it would be valuable to do a podcast where we talk about, you know, the fundamentals of valuation and then how that gets applied to venture capital and then from the theory perspective and then also the art side of it and talk about it from both the VC perspective as well as the entrepreneur's perspective. Because I think, like, in all the discussion around valuation, the fundamentals kind of get lost. And then when you read what's online, a lot of people point to like the venture capital method of valuation or whatever, which honestly I think is a bunch of baloney. It's some professor who's never really done it that's trying to create some sort of theory to justify it, but it's not actually, like, relevant because the art side of it is so impactful. And I think it can surface a bunch of interesting topics for us to kind of dive into. Everything from, like, how does the venture capital fund that is funding you, their fund size, impact your valuation?

Right.

Frankly, it typically shouldn't, but it does. And so I think, like, there's some interesting things to talk about there.

Okay, do you want to dive in?

Sure. So I think the first thing is to really understand the fundamentals of how valuation is set. What I teach my students, we have them go through this case study that I put together years ago called the Golden Goose. And the idea is you have an opportunity to buy a goose that lays golden eggs. The goose will live forever if properly taken care of. And you have to determine how much that goose is worth. And so I walk my students through how to build a discounted cash flow model. And the idea being that a discounted cash flow model is widely considered, like, some of the foundational principles of valuation because it's this idea that there is going to be some sort of cash flow or some sort of benefit that accrues to the investor or the owners over time, and that you're basically going to take all of those benefits today and into the future and you're going to discount them back to today based on the amount of risk of you actually receiving those cash flows into the future. And you add them all back, you discount everything back and you add it up and that gives you your valuation. And so for these golden geese, you know, they leave, they loot, they leave one egg, golden egg per month. And so you can find the price of gold and you can kind of run these calculations perpetuity into perpetuity. Yeah. The thing that I think is interesting about that is like, we don't, obviously as a fund, we don't invest in geese that lay golden eggs. Neither do we do discounted cash flow analysis on the companies that we invest in because they are, for the most part losing money the entire time that, that we hold them.

Neither do VCs treat startups like they're golden geese.

Yeah.

What do you mean by that?

Just a joke.

Fair enough.

Yeah.

Because they're kind of like, well, if you're, you're producing and you're winning, great, but if you're not, see you later.

Yeah, yeah.

But anyways, at a fundamental level, you and I, we do this valuation calculation in our head all the time, right? So if you think about like the last thing you bought, right. Maybe it was like, I just bought a laptop. So when I went to evaluate that laptop, I had to put evaluation on it and like, subconsciously or consciously, right. I was effectively adding up all the benefit that I'm going to receive from that laptop over the life of the laptop and then making an assumption like, I may not get five years of life out of this laptop and it might break, it might get stolen, I might spill something on it and destroy, Might get super bogged down and slow and not perform the way I thought it was going to. So you have all of these risks and those risks decrease the value of any benefit that I'd get in the future. Relative today, a dollar today is worth more than a dollar tomorrow simply because I don't know if tomorrow's going to happen. We do these calculations in our head, we add up all the benefit and, and we put a value on the product and we compare it to the price that we're paying. So one of my good friends, Spencer McLeod over at G Squared, he has a Saying that he repeats often, which is valuation is the price you pay, value is what you get. And so it's the same thing here. In terms of that laptop might be worth, in terms of the productivity it's going to allow me to generate, might be worth like several thousand dollars.

Right.

But I only have to pay, I only had to pay like $1500 for the actual laptop. And so like I get that, that surplus of value. But that same thing is happening when you're making investments.

Right.

It's the same basic logic, which is you look at these businesses, you analyze like all the different things that a VC analyzes or any investor analyzes. So the market and the competition and the financial performance and the management team and the business model and all these things. But ultimately all of those things that you're doing due diligence are on, are to inform what those future cash flows could look like. And the thing that makes it really challenging in venture capital. Well, there's several things, but one of the biggest things is that those cash flows, those profits that come out of a business, one may never come out of the business and two, if they do, it's going to be way, way off into the future. I mean, you look at companies like Amazon, most valuable company, depending on the month, but one of the most valuable companies, not profitable for the majority of their life.

Right.

And still people were willing to invest and give them a valuation even though they were losing money based on the future cash flows. And those investors that made those investments ended up doing really well.

Right.

So anyways, that's your foundation, which is if you're a company, you're an entrepreneur, you got to be thinking about what is the profitability of my business at scale over the long run, am I going to be able to generate huge amounts of profits that are going to be able to offset not making any money for a long time.

Right.

And they have to be so big that like not only do they have to offset the time, they also have to offset the risk that I may never even generate those kinds of profits.

Right.

I feel like you're looking at this way too logically. I don't think VCs are. I think they talk about this, but if you look at most negotiations, at least in Utah, that's not what's happening.

I know, and that's why I want to bring it back to. Here's the nuance.

Right.

Because this is. So I agree with you to an extent, but at the same time, theory.

There's theory, but it's all a Negotiation.

It is a negotiation. Again, this comes back to the like, price is what you pay, value, value is what you get.

Right, Right.

But I think valuations are just, they don't matter. They don't matter. And I think VCs to get a deal will, will sell you a hyped up valuation with all these other terms in the deal. So for example, family members working at a company that was worth a billion dollars and they're like, oh my gosh, the employees are like, the company just crashed, it was worth a billion dollars. It was a third party group, independently evaluated and they can't get over their head. This is never worth a billion. It was never worth more than 80 million. But it's a propped up number. So in my mind, valuations don't matter and it's all the other things that matter.

I can see where you're coming from.

I just like, valuations do matter. But like, like if you look at the real market, if that company were to sell for cash on the public market and have a true auction.

Yep.

There's no way we would have been bought for anywhere near a billion.

Sure.

And if you look at, there's all.

These other not like the VC instruments, it's not like the VCs were going to make a ton of money because they put a ton of structure into the deal. That does certainly happen.

But look at a startup today, like 10 years ago, boom Startup, which was an early stage fund we started, would give people $15,000 plus mentorship, which is you and I know is worth nothing. I'm sure to them. They thought it was worth a lot, we hoped it would be worth a lot. And at that point it was for 7 to 10% of the company. If someone did that same deal today, same type of company, same tech. In fact, I feel like the market is more mature and the multiples are lower. Now VCs would look at them as being crazy. And it's a huge shift where like today it's possible you could raise half a million instead of 15,000 and walk away with only giving up 7 to 10% today. Again, that would be a richer deal, but possible for a C deal.

Yeah.

Well, no, I mean certainly valuations have gone up a ton, but I would also argue the market has increased dramatically from where it used to be. Okay, think about it this way. Like every year there are millions of people that move up this, the ladder on the standard of living and start demanding more products and services.

Right.

Okay.

They also start, they're more educated, they start contributing More to broader society, they have more disposable income. So, like, overall, like, your global market keeps growing.

So in 2010, you think the valuation for a Boomstar company of 15,000 for 7 to 10% was a fair deal and that things have drastically shifted since then?

I mean, that's a good question. I don't know if I would say it's a fair deal because it does feel like a little bit aggressive and taking advantage of the regional discrepancies. But look, people did it, so I'm very much in the camp of, like.

Several people did it. There's a whole line of people wanting to do it.

If people did it, then, yeah, it was fair.

Okay.

Right.

Nobody forced them into it.

Right.

So.

But if someone did the same deal today in Utah, at least that person would be labeled as being predatory, is my opinion.

That is true. Today. They would be predatory. Yeah. So, but look, like, again, you don't have to take the deal, but look.

At a deal today, and then we'll go into your metrics. If I was fundraising for a deal today.

Yeah.

Let's just say it could fundraise and let's say I'm just raising half a million.

Yeah.

It's. The range that I could give up realistically is somewhere between 5 and 35%, most likely 15 to 20 for half a million.

Right.

With like. But again, that's. That's a huge range.

Yeah.

And if you look at the. The total exit of what's going to happen, like that valuation, in my mind is more of, hey, this is what the market's currently doing. And maybe you. Maybe you're saying it's subconsciously bubbling down. This is what I kind of need to have a win.

Yeah.

But in my mind, I think it's tricky. Or the person we were talking to this week who wants to raise 1.9 million. My point was, is if the model is VC backable, it's not that much harder to raise 1, you know, 2 million as it is to raise 5 to 10 million. Sure. And you'll probably give up the same amount now. I think there's a little bit more work that has to go there, a little bit more customer validation. And so maybe you'd say, John, there's a lot more that actually happens in that step to raise 5 or 10.

Yeah.

But my point, like, that person was highly successful, has done several big deals.

Yeah.

So, yeah, I mean, they probably end up having to give up more of the company if they raise 5 to 10 than 2. But the ease of Raising is probably similar, right? Because if you're raising a larger amount of money, you're going to go after deeper pockets, and those deeper pockets can.

And your team might also.

You can write bigger checks all in one go. If you're going to raise 2 million, a lot of funds will be like, love what you're doing, but my minimum check is five.

Right.

And so you're not a fit for them. And so you just crossed out, like, a huge segment of the overall market that would fund you. And so it's still hard, right? I think, too, you know, look, again, I don't really buy into this. Like, VCs are predatory in certain areas. Certainly there are situations where that occurs. But the flip side is really good. Sophisticated entrepreneurs, they don't take deals like that, right? Because they're sophisticated. And the flip side is, like, as a vc, I want to back more sophisticated founders because there's a greater likelihood that they're going to be successful. I think the people, frankly, that take bad deals only take them because those are the only deals that they can take.

Right?

And so then it's a question of, like, well, are you taking advantage or are you just offering what the company is actually worth? And really what should be occurring is the founder should take a step back and say, do I really want to do this deal?

Right?

Like, do I even want to run this company this way and raise money or not?

Right.

Clearly, there are always, like, exceptions to this, where people take advantage of people who, you know, lack information and are ignorant. But, like, in today's day and age, like, there is almost no excuse for that because there are so many resources, including this podcast, right, that is being put out there so that founders can hear this and think, like, okay, I shouldn't just take the first offer that comes along. I should get multiple offers to lock to people. And then I should be thinking about not giving up too much of the company too early because then it's going to be harder to raise more money later on.

Right.

Did you see the post this week from that one guy that on. On X Twitter, and he was saying, like, he was like, begging founders in Utah to raise money from outside of the state.

I did not see that.

Because they would get better valuations.

That's been a common belief for a long time.

Yeah, it has been a common belief for a long time. And part of the reason was, look, I. I know that, like, the world is more flat today than it ever was before, and there are incredible people all over the place, but there is a Certain amount of value that accrues to companies in very talent dense areas like Silicon Valley. Talent and capital. And so if you're in Utah, you shouldn't expect to get the exact same valuation as somebody in Silicon Valley because you don't have the concentration of talent, you don't have the concentration of capital chasing after the deal. You don't have as much awareness.

Right.

There's all these things. And if you compare your startup to one in the Bay Area, the one in the Bay Area is going to have a lot of those advantages. You won't. And so there's a legitimate argument for saying, like maybe they shouldn't be, but.

What'S driving the valuation of a company in Silicon Valley versus in Utah? And one of the points I would bring up is as a fund, you want to make sure founders have a certain percentage so they, they're, they're in the game.

Yep.

And the cost of living in Silicon Valley is s. So much higher that I think if they, if Silicon Valley investors, regardless of the actual exit.

Yep.

If they got funded in Utah, the, the, the, they would burn up their cash and they wouldn't have enough equity to like, they burn up their equity and they wouldn't have enough to stick around.

Yeah.

I mean, theoretically the dollar, a dollar raised should go further in Utah than it does in Silicon Valley should.

Right.

For that, that, that very reason. And so it really doesn't matter how big your valuation is. I mean, it's just like this, like, you know, measuring stick game. Like what should matter is you have good ownership of the company, you have good partners around the table, you have a valuation you can easily grow into with the capital that you.

Right.

And if you, if, in my opinion, if you optimize for anything outside of those things, you're setting yourself up for failure.

Right.

Because, or at least you're dramatically increasing the risk of failure because it's like if the valuation's too high and you didn't raise enough money or you didn't use the money appropriately to grow into that valuation, you're kind of done. Because venture capital is momentum game.

Right.

For the most part. And if you're not growing, you're kind of sunk and kind of dead. Nobody really wants to touch you.

If your valuation's too high, you can't raise your next round.

Yeah, that's right. So anyways, getting back to it.

All.

These factors come back to what I was explaining earlier, which is this theory, Right. Which is, it's these future cash flows and it's this Risk of something occurring in the future, like a positive outcome. And so you as a founder need to be focused on the things. I mean, there's two kind of things to focus on. One is what are the things you can do to drive down risk?

Right.

And those would be like, product, you know, demonstrating traction, product, market, fit, an amazing team, et cetera, et cetera. And then there's other things that are like, increase the outcome. And so that's like market size, defensibility, uniqueness of your product, barriers to entry. Like those kinds of things that allow you to grow a really large business and extract a lot of value out of that business as you grow. And as you do those things, right, those are going to have an impact on your valuation. So a really, really killer team that's more likely to be successful is going to be able to demand a much higher valuation than a less successful team. So anyways, those are all just the factors that I think are important to think about. Then there's all these other things that you were kind of alluding to earlier, which is like. Is like two women in a garage with a business idea worth three to five million dollars.

No, no startup in a garage. Wait, did you say two women or two.

Yeah, two women.

Okay, no startup. I'm just gonna say no, no startup. No startup in a garage.

No startup.

Right.

Men, women, doesn't matter.

Right.

Like, your startup is worth what someone would come and write a cash check for now, and most likely it's less than 50k.

Right. So if even 50k.

Right.

It's just an idea, and yet you would want to raise at a valuation that's at least, probably at least a million dollars, because you're gonna. You're gonna give up too much of the company. Because what happens is you're gonna. Let's say you give up 30% in that first round, your Series A, and you get to a Series A off of that round, which would be remarkable because that doesn't happen very often, but let's say it does. You've already given up a third of the company. Series A investors are gonna want 25 to 30% of the company too, which means you're gonna be left with 50% of the business. And then every subsequent round, they're gonna want 10 to 20% of the company. So by the time you finally exit. And this is the other thing is like, companies stay private longer, which means they need to raise more and more and more and more money over time. And so they get hit with more and more dilution and so by the time you're all said and done, you might only own like single digits of the company. So then you either have to believe that this thing is gonna be really, really, really, really massive, or it's frankly probably not going to be worth your time and you'll probably bounce. And VCs know this. And so what ends up happening is the VCs will look at your seed round and say you raised at too low of a valuation, you raised too much, or what? The point being you gave up too much equity in the company. We're not willing to fund going forward because we don't believe you'll have enough skin in the game to stay committed for the long haul. Because it's going to be tough and hard.

Right.

And that's how these early rounds where people are quote unquote being taken advantage of, end up screwing up their business before they almost even get out of the gates.

If you have to raise again, if you have to raise, otherwise that person got a sweet deal. If it's a golden. If it's a golden goose.

Yeah, potentially. But that's pretty rare.

Right.

Because if you're raising money, you probably need the money to grow and to build and you're probably gonna need more money.

I mean, that's one of the problems that some of the local venture service studios have because they take 30, 40% and no VC wants to touch a deal afterwards for the reason of the founders won't have enough in the game.

Yep.

And also VCs hate it when they feel like someone's getting unfairly enriched in any deal.

Yeah, well, it's just like this idea of dead equity on the cap table.

Right.

It's like, okay, well this venture studio has a bunch of ownership, but they're not adding any more value to the company. And that means that's ownership that we can't take and give to new employees who are going to add a ton of value to the company.

Right.

We can't take that equity and give it to investors who are going to bring cash into the business, which is another form of value.

Right.

So that's the challenge. The venture studios always argue back. They're like, well, we're basically like founders in the company. But the challenge is like they're varying levels and degrees of involvement.

They're not because they don't have a four year vesting plan. Yeah, they get a, hey, we delivered your product in six months and no vesting.

Right, Right.

There are a few that, that stay very, very heavily engaged. I know science out of LA tends to be more engaged, but then I think most of them are less engaged in that.

This is the second mentioned on the podcast. I think if it works well, if you are never going to have to raise again and you couldn't have got there in the first place, then it's a fair deal.

Sure.

But if you end up turning into a winning deal that VCs want to touch, yeah, it destroys the deal. And only once in my life have I seen a VC just go to bat for a founder that had come through a scenario like that.

Yeah, yeah, that's pretty rare. They have to have something really special going on to make it worthwhile. The other thing, there are all these other things that impact valuation too that don't make any sense. Clearly ensuring that a founder has enough ownership to remain incentivized is super important to VCs and of course to founders alike. But also the thing, and this is my own pet peeve, but venture funds now have gotten, for the most part, bigger and bigger and bigger. This is especially true in 2021. And you know, it used to be that there was only one fund out there, nea, that was over a billion in Aum. And everybody was like, oh, that's so crazy. Why would you ever need a billion in Aum? Now all of the big top tier venture funds are multi billions in Aum. And what that means is under power law, all they've done is said, okay, instead of being able to get a home run return on a company that had a $500 million exit and would have returned our entire fund, we now need the company to get to a multi billion dollar exit.

Right?

Because we're going to end up owning like 20% of it. Our fund size is 2 billion. Therefore this company, we can only invest in deals that have the potential being worth 10 billion.

Right?

And the way they justify it is like, hey, we're going to need to own 20% of your business. But we also have this $2 billion fund which means we need to write like a $30 million check. The founder's like, I don't need 30 million. I don't even know how I would spend 30 million. And they're like, it's fine, we'll just increase the valuation, right? And so you have this fund size which is like totally separate from the operations of the business that are dictating valuation. And I think that's part of the way in which, that's another way in which you get to these valuations that don't really pencil out on paper. And the belief has to be that the outcome is so big in the future that we're willing to pay a high price today. And we're just going to inject tons of capital into this business and hope that that capital carries them. And if it doesn't, it doesn't and the company goes under. And we only have to be right like 1 out of 10 times for this model to work. And so you can have these companies where the founder gets super excited because they're like, oh, I just raised at this crazy high valuation and I raised a ton of money and it's something like super, you know, brag worthy to everybody.

Like look at me, a billion dollars.

Not realizing that like the venture fund is going to think about them the same as like a smaller fund would think about like you know, a regular deal that's much smaller at a lower valuation. So anyways, I just think it's interesting, it's things that to like, keep in mind. I had this conversation with a friend of mine recently who was raising money and he was like, yeah, I get it, but it's just, it's so hard when they come and they're just like throwing high valuations and money at you.

Right?

It's so hard to turn that down, which I, I totally get. But I mean, 2021 was a good example of all these companies that raised way too much money because they could at super high valuations. And now we haven't really had an exit environment for the last like three or four years because all of these companies are frankly overvalued and not willing to sell. And a lot of them have gotten themselves to like cash flow break even. But the general consensus now that I'm hearing talking to people is that something like 10 to 20% of angels today are actually IPO worthy because even if they're at break even, they're no longer growing. And you really have to be a growth story to go public these days and you have to be profitable. And there's just very, very few businesses that are able to do that. And so you have all these kind of like zombie companies out there floating around that aren't really growing. They're kind of cash flow, break even, they're going to kind of float. And you know, maybe what happens is they get picked up by like a K1 who comes in and rolls them all up, cuts out all the cost, makes them even more profitable and sells them in a private equity play. But it's, I don't know, it's really Just like unfortunate because you've had, you know, some amazing talents, some amazing businesses that are kind of zombies at this point.

Amen.

Anyways, that was a lot of rambling. Any other thoughts on valuation? I think I missed.

You just figure out who's doing deals and who's similar to you in the area. That's roughly your valuation.

Yeah, it's like yours is just comparables.

So like when I was looking to raise last time, I looked at David Blake from degreed and I'm like, what was his valuation? And I said, well, I know I'm definitely nowhere near David Blake, so that's my ceiling. And you talk to some other people who. There are some funds who are like I call bottom feeders. Like, what was the valuation? You.

Yep.

And I said, okay, I know I need to be somewhere in the between.

Yeah, yeah, yeah, for sure. And I think, you know, to a certain extent a lot of valuation work happens that way where, you know, if you had raised in 2021, you'd have a very different valuation than if you raised right now.

Right.

And if you had raised in 2018.

Or if you raised in 2021, you may not be able to raise now because of your valuation.

Right, right.

Or not. At a valuation that you're willing to or want to take.

Right.

So yeah, I mean there's all these like market cycles sentiment, how much cash is being pumped into the system and chasing after alpha after deals. So I mean there's a lot of factors that go into valuation and it is kind of this dark art.

A little bit.

But anyways, hopefully that's like helpful context of all the things that VCs think about when they're putting evaluation on a company and trying to decide if they invest or not. Because at the end of the day, as much as I talked about like all these things that are esoteric to valuation that don't really matter, the VC still has to believe. Like if I invest here, there's a story where this thing is eventually worth 10 times that. And the only way it's worth 10 times that is if there's a story at that distant future point where investors believe it's another maybe like 3 to 5x from there. And so that's one of the things you have to keep in mind as an entrepreneur.

What's the last thing that you're the last question when talking about valuations? When I was pitching last time I talked to someone from Excel, I was trying to find my text message, but I had deleted all my messages that were more than 18 months old. But he says, john, if you're not trying, if you can't show that you're trying to become a trillion dollar company, Excel's not interested. And I don't remember the exact number, but I'm like, wait. I'm like, I was looking for. I'm like, we can easily get to 100 million in revenue. We get to a hundred million revenue, that'd make us worth, you know, like a billion dollars. And he's like, not interesting.

Yeah.

Not interesting. Yeah, because their fund size is so big, right? They're like, if, you know, you need to be worth $100 billion, right. Because our fund is, you know, several billion in size. And so we end up owning, you know, X percent. Like, we need to be able to return the fund and then some off a year. One deal. So, yeah, there we go.

Well, thanks for watching, you guys. If you've got questions, go to VC FM and you can find us on the socials. Ask us questions, and we'd be happy to help out.

Awesome. Thank you.

Thanks.