As challenging as most valuation questions are, the answer to this one is straightforward. Investors typically pay nothing just for an idea. What they will pay for is the execution of that idea. Or, as one VC fund manager put it, whether you have got off the couch and done something about it.
That is blunt, but not a controversial view. Steve Jobs stated that one of the things that hurt Apple after he left in 1985 was that John Scully, the CEO, got a disease and that was the disease of thinking that coming up with a really great idea was 90% of the work.
Along those lines, Thomas Edison said both “the value of an idea lies in the using of it” and “genius is 1% inspiration and 99% perspiration”. Having built an empire by commercialising an electric lamp from electric light technology (an idea) invented 70 years earlier, he spoke from experience.
The value Edison generated was in implementing the idea.
Understanding investors’ view of the (nil) value of an idea has important implications for those looking to raise funds for their start-ups. It shows that what is put in place to develop the idea, rather than the idea itself, is really what attracts investment at that stage.
There are a variety of techniques to estimate exit value, ranging from ‘gut feel’ estimates based on market forces to detailed quantitative calculations.
Of particular importance is the strength of the founder team, as is often the existence of a functioning product. How ‘hot’ the sector the start-up operates in, and the market size, likely penetration, and evidence of market traction already achieved are further key factors. Another is the degree of relativity between investor ‘desire’ and inventor ‘desperation’.
Although investors agree that ideas, of themselves, typically have no value, this is not to say valuation considerations for early stage investments are ignored. They are often front and centre, especially the question of what an investment in a start-up might be worth at some future time.
In other words, investors are very interested in the value of the idea once it is successfully commercialised. This is because having an understanding of this ‘exit value’ allows investors to work out the size of the investment required to achieve their return on investment targets. For inventors or entrepreneurs, it provides guidance in relation to what size investment to ask for or accept.
Although there is no perfect method, there are a variety of techniques to estimate exit value, ranging from ‘gut feel’ estimates based on market forces to detailed quantitative calculations.
An approach often used is the ‘venture capital’ approach. This requires estimating the value of the early stage business at the point it achieves its profit projections, typically based on multiples for companies with similar economic characteristics (the terminal value).
To that terminal value is then applied a high risk factor, sometimes more than 80% for early stage businesses, to derive a current value to use in deciding whether to invest. I.e., if the value is $2 million, and the investment is for $500,000 in shares, the investor might demand 25% of the shares.
Even using a robust approach, any valuation undertaken early on will be highly subjective and the margin for error is great. However, even if hindsight shows the value reached was not the right one, working through the valuation process early forces attention on the factors really likely to drive value and where attention should be focused. These extend well beyond the value of the idea itself.
Jay Shaw has 15 years experience in business and IP valuation both in NZ and in the UK, and is especially interested in valuation issues facing early stage and tech companies.