3 Not Urgent But Still Important Things Every Founder Must Do

1. Valuation
2. Pro Forma
3. Competitive Analysis

Valuation, the five-year pro forma, and competitive landscape charting: all of these activities provide non-actionable data — i.e., information that the entrepreneur cannot (or does not) necessarily need (or, rather, want) to act upon. They are often considered “busy work,” and, for a time-pressed founder, busy work is an anathema. However, each are absolutely key to the success of a start-up. Below we look at each of them and why they are important.

I. Valuation

The question of how one should value an early-stage company is often asked, but usually has no good answers. If the opportunity is large enough (which is the goal with venture capital), a thorough valuation is perceived as irrelevant. If your company is going to be worth a billion dollars, your return will be high enough regardless of the value set at the beginning. Why waste the time and mental energy to set a value when you know that if successful, you will all win? That’s a fair point, of course.

Even if the opportunity is not so large, setting a valuation is difficult and, consequentially, often short-circuited. Unless a revenue forecast is based on historical data, its accuracy is questionable. And of course, if you are a start-up, you have no historical data. Long discussions about whether your start-up is going to make 1.4 million or 1.3 million are probably not helpful for either the investor or the entrepreneur if the answer is more likely between 0 and 2.5 million.

So, the capital markets have created a variety of methods to get around the valuation process. In particular, SAFES and Convertible Notes with caps and discounts are often used as tools to defer the valuation discussion to a later round. By setting a cap and a discount, the investor gets the right to participate at either a discounted rate or the cap. This allows entrepreneurs to set a higher cap than an early-stage company typically would because if they’re wrong, the investor still gets to participate when the next round comes around, usually at a discount. This approach also offers the investor the kind of protection that makes them feels better about their investment. While the pros and cons of this approach have been debated (see my discussion of convertible notes here), this approach is still the primary method of funding a start-up when the round does not have an established percentage of equity — or, in other words, is not priced.

The following articles provide some useful context about how companies are valued in the early stage:

7 Business Valuation Methods
Valuing Startup Ventures
Valuation Methods

From these articles, several methods emerge:

Adjusted Earnings: A valuation method useful if your company has a projected cash flow of $x and you are going to grow.

Next Round: A method in which your company can go to the next round with the proceeds, which will lead to a valuation of $x. You can adjust accordingly to compensate for the risk.

Discounted Cash Flow: With this method, you establish the amount of cash in the form of future dividends and (more likely for an early-stage company) future liquidity events, determine what percentage an investor wants in return for the investment of cash, and discount the present value to establish a return.

Comparable: The valuation is based on comparing the valuations and metrics of similar companies that have traded in the markets.

Build-It-Yourself: This method of valuation is based on the question “how much would a competitor or a similarly situated start-up or company have to spend in order to replicate what you have done?”

So which valuation method is best for an early-stage start-up? All of them. As you work through each method, you’ll realize their limitations in predicting value. For example, in the Comparable method, the lack of visibility into similarly situated start-up companies prevents one from extracting realistic values. In the Discounted Cash Flow method, cash liquidity is so far in the future that the assumptions made are inevitably tenuous but ultimately material to the value. Nevertheless, even a cursory review provides a meaningful analysis for both the investor and the entrepreneur. At a minimum, the analysis provides a check for your operating or investing thesis. At its best, the exercise will expose issues that either show that the investment is premature or weaknesses that need to be addressed.

All that said, a valuation expert once told me that the only thing that truly establishes value is what a buyer is willing to pay to purchase something from a willing seller. Everything else is mere speculation, and he had never seen anything actually trade for the appraised value (except and unless the valuation was setting the value). The finality of the market setting the price, though, is an important point — an entrepreneur can value his or her company at any price that an investor is willing to invest.

Personally, my current working thesis on value is that in the early stage, a company needs to be able to double its value with its use of proceeds from the current round. In other words, if you invest $1 for a share that is valued at $100, then the company needs to be able to invest that $1 in order to reach a value of $200. This perspective helps frame discussions with the company that focus on not only what the company is going to do but what others will think of the company in the future. It is a working theory, though, and a general guideline. I welcome feedback.

The valuation process — in whatever format — is healthy and productive. You have to look at the here and now as well as the future. The analysis helpfully highlights pitfalls and risks. It shows blind spots and forces a discussion on the challenges ahead. Even if it is not a priced round, avoid the temptation to ignore the valuation analysis. It may not be urgent or pressing, but it is necessary.

II. Budget

Budgets are crucial — and usually provided to investors — for even the most nascent start-up. Even if no revenue is expected within the first year, money is still needed to run the business, so even the anti-planners (and I include myself in this category) have a one-year budget. Going beyond that, however, is often disregarded, ignored, or just simply not done. Why bother, the thinking goes, to work out something that is speculative at best and not trustworthy at worst?

That case can, of course, be made. Any planning too far out may indeed be untrustworthy, speculative, or circumspect. Planning for events beyond a year in the future with the precision to provide actionable data is difficult. Indeed, internal and external forces may dramatically alter the plan and make the labor meaningless. You do not know what you do not know, and that is always true as you go far in the future.

Worse than working on unclear presumptions, however, is setting up misleading expectations. If you lowball your plan and end up achieving far above it, the team may not realize that they have not reached their full potential. In this case, a conservative plan may lead to missed opportunities. More often, the pro forma will be overly rosy — and it will also be used as evidence of failure. A five-year pro forma is often Exhibit A in the post-mortem of a failed venture. “You told us you would be at $X gazillion dollars,” says the investor, “and you’ve only performed at 50%.” That discussion has happened many times in the past and will happen many more times in the future.

But these reasons do not excuse founders from multi-year projections. This exercise is important for numerous reasons:

1. Capital takes more than a year of planning to raise. Regardless of the source of your financing, raising money takes time, so if you are going to need to make an investment into the business, you need to give yourself plenty of time. This is particularly true if you are raising from venture capital. As you start on this path, keep in mind the importance of your company’s narrative — and have the financial results to back it up. That takes planning far in advance. You cannot change the type of company you have in a capricious fashion. If you are a lifestyle business that reinvests its profits, you cannot suddenly become a venture capital rocket ship and vice versa. That is not to say that you always have to be one or the other: you can shift, and there are many things in between. But you cannot change financing strategies overnight. That takes years to build, and a multi-year pro forma helps your thinking in that regard.
2. Team are built over multiple years. Talent is tough to find and nurture; people are not on-and-off switches. People typically do not move jobs on an annual basis. The emotional and financial stress is usually too steep, even if it has become more acceptable. You must look out further than a year to see how you are going to build your business and what the team needs to look like to get you there.
3. A multi-year pro forma helps show the bigger picture. While some industries and investments allow for multiple years with little or no revenue, by and large, stakeholders need to see both progress and a bigger picture. They will need to see that over time they will have a stake in a larger vision, a bigger company, and a more dynamic organization, especially if the company’s stakeholders extend beyond you and your family. The beachhead model, which is a common and useful way to build a start-up, provides that you find a model that allows for an initial revenue source but then growth from adjacent revenue streams. A one-year projection can account and plan for capturing that first beachhead. But stakeholders know that a beachhead in and of itself is often not sustainable. You need to paint a bigger picture for them in your financial plan. While most investors are extremely — and appropriately — skeptical of hockey stick charts, many people nonetheless need to see them. You need to show how you can justify near-term losses. A bigger financial plan, found in a multi-year pro forma, is usually necessary.
4. A multi-year pro forma can reveal the hidden issues in your unit economics. Figuring out the basic economic proposition is critical for success. Your initial success may not be sustainable, and as your work through a multi-year plan, you can sometimes find the flaws or at least discover some pitfalls. As you figure out the fixed and variable costs in your delivery of goods and services, you’ll also find that the costs and the revenue are not always neat lines running in parallel. More often than not, the costs resemble a staircase; rarely is input Y going to get a smooth output of X. You have to think through your plan and build a platform, and a multi-year pro forma helps you to do so.

How do you build a reasonably good pro forma for multiple years? When it comes to revenue forecasting, work forward, not backwards. Start with the number of people currently in your wheelhouse as customers and go forward from there. For example, a new service firm founder may know 100 people who could potentially hire him. If he calls 100, then X% will schedule a face-to-face meeting; then Y% will hire him to do a job that costs, on average, $Z. Build out and acknowledge potential impediments to the buyer’s journey. Start with the universe of people that you can reach with your planned advertising and walk through the reasons these people may choose to use your service or purchase your product — and the reasons they may not. When considering revenue models, remember that while recurring revenue has its obvious advantages, it isn’t the be-all, end-all. There are other valid revenue models out there. Make sure that you’re being realistic about all inputs necessary in cost structure, including fixed and variable costs. Finally, be brutally honest with yourself. Poke at everything.

And what of the overly rosy pro forma? This speaks to the necessity of communication. At some point, as they move forward with business, an entrepreneur may realize their predictions were wrong. In most cases, you just need to come clean, be honest, and own up to it as soon as you know your predictions inaccurate. Explain why they did not materialize and, more importantly, present your plan for moving forward. More likely than not, your stakeholders will work with you, and if an investor did not provide for a contingency, then that failure is on them.

The multi-year plan is a necessary tool. Maybe the adage “think global, act local” is apt here. You want to act in the here and now: what are your short-term goals, and how do your daily actions drive you and your organization to meet those goals? But you want to be thinking on a larger scale: where are you ultimately driving? Thelma and Louise is a great movie, but a terrible way to grow a business.

III. Competitive Landscape Charting

While you and your company are indeed unique and special, do not delude yourself into thinking you are so unique and special that you created lightning in a bottle, or that you and you alone have developed a solution to one of the world’s largest problem. Entrepreneurs are not that unique. You do not exist in a vacuum.

Unlike the previous two articles in this series — on valuation and multi-year pro formas, respectively — the rationale for surveying your competitive landscape is relatively simple: if you don’t, you could end up in a situation in which you look like an idiot. If you’re talking to an investor about your start-up and, through a simple Google search, they can find a competitor about which you know nothing, it doesn’t look very good for you. As a general rule, not looking good to investors and other stakeholders is unwise.

This ‘don’t be an idiot’ rationale should be enough to inspire even the most inexperienced entrepreneurs to action. Yet for some reason, many entrepreneurs still don’t pass this basic Google test. In fact, most entrepreneurs will take a cursory look at the competition when they start their business, and then put the thought out of their head, put their head down, and get to the work of building their business. This hard-driving, bull-your-way-forward mindset is helpful, but you have to pull your head out and look around on occasion. Do not lose the forest for the trees.

In fairness, a competitive landscape exercise is one of those things that should not change a founder’s daily efforts. Entrepreneurs have to focus on controlling what they can control. Competitors are out of their control. What competitors do should not affect your day-to-day work. A reactionary organization is not inspirational and probably a market laggard. If your start-up is so fragile that a competitor changes your direction, you really need to evaluate your overall existence.

Nonetheless, a consistent, but not overbearing, review of your competitors is essential for every entrepreneur. First, you want to stay one step ahead of the Google test. You need to be the domain expert of your industry with a knowledge ahead of the novice generalist. You also, as a practice, need to not get lost in the trees, and a competitive landscape charting exercise helps in that process.

This exercise also requires more than just a cursory Google search. We recommend a charting exercise like the one Bill Aulet, managing director of the Martin Trust Center for MIT Entrepreneurship, suggests in his book Disciplined Entrepreneurship. Aulet argues that the competitive landscape and the customer’s priorities are inextricably intertwined: a customer will decide to purchase a product or service based on comparison between options. Aulet’s Competitive Positioning Chart allows entrepreneurs to see how their solution fulfills the customers’ needs in comparison to the competition. To create a chart, follow the following steps:

1. Find out who your competitors are. What solutions do they offer? What are their strengths and weaknesses? Why do customers choose them? Why might customers choose to leave them?
2. Determine your customers’ top two priorities. What are the two main things are they looking for in a solution? Are they interested in reliable service at a low cost? Are they interested in hands-on assistance and individualized solutions to unique issues?
3. Once you determine your customers’ top two priorities, create a simple chart with an x and y axis. The x-axis will represent the customers’ first priority and the y-axis the customers’ second priority.
4. The left side of the x-axis and the bottom of the y-axis will represent the “bad” side of the priority — i.e., a solution that doesn’t meet that priority well. The right side of the x-axis and the top of the y-axis will represent the “good” side of the priority — i.e., a solution that does meet that priority well (see the example below).
5. Plot your business and your competitors on this graph. Ideally, you’ll find yourself in the top-right quadrant. If not, you’ve got some work to do.

By going through this process thoroughly at least every year and at a high level, you will ideally have the following insight:

1. Knowledge that should not set but will inform strategy;
2. Industry knowledge about potential exit partners;
3. Industry knowledge about potential strategic partners;
4. State-of-the-industry knowledge that helps you realize (and benchmark) your customer’s acceptance; and
5. Recognition of your industry and allowance for industry leadership.

And, of course, you will not look like an idiot.