How do you value startups that are mere ideas?
Paul Graham, the founder of Y Combinator, says ideas don't have any inherent value. If you think otherwise, try selling them. You will soon realise there are no takers. There is no marketplace for them. Paul Graham knows more about valuing ideas than anyone else because Y Combinator also funds ideas.
Recently, 2 people called me to ask my opinion on valuing their ideas. Both are non-techies who are building tech products. Both have friends willing to back their business plans. I told both of them they are extremely fortunate. Few founders have this luxury.
So how do we value a startup which is a mere idea?
There are no easy answers. Ideas have potential – some more than others. But it's difficult to put a number to it. I suggested a Discounted Cash Flow (DCF) analysis. I know many people consider DCF a sham, akin to making castles in the air. They think these are just numbers on an Excel sheet. You tweak one assumption and voila, the value skyrockets.
I agree with this criticism. A DCF analysis can be abused. But when done honestly, DCF is the most scientific way to value early-stage startups when there is no market data for comparison.
Anyways, I told them to run a rigorous DCF analysis to arrive at a rough value. But keep in mind that this number is not set in stone. This is just a starting point – a ballpark number without which you will be lost.
The advantage of a DCF analysis is it also gives you cost estimates. You will know how much money you need to build and launch an MVP, acquire X paying customers in 1 year, buy server space, etc.
Now comes the critical bit. Once you have a valuation number, you should check with your friends whether they are comfortable with this value or not. Try to make it a win-win for everyone by creating a fair deal. If you have done an honest job, your friends won't have any problems with the number. But be flexible. This valuation is just a number in the paper. If your friend is comfortable at a 20% lower value, take it. At this stage, the goal is to quickly build the product and test it.
One problem I see with most early-stage founders is they are too bothered about dilution. Many don't want to dilute 20% or 25% in the first round. They don't realise that any investment at this stage is a leap of faith. Even though they might think their idea is the next Google, there is a big chance that it will fail. Your friends are taking a big risk by backing you because they like you and believe in you. Appreciate their trust. Don't get stuck on dilution percentages.
One point before I wrap up. CCD, CN, CCPS, etc. are just fancy terms we hear in the venture capital world. Don't let these trouble you. Keep a simple investment structure. Ask them what would they prefer. If they are not sure about the current valuation and want a discount on the next round, do that. Otherwise, arrive at a value and close the deal. Finally, hire a good CA for documentation and filing.
Now you are ready to build something people want.