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- Friends rarely make the best business partners
- A smart entrepreneur’s guide to choosing the right VC
- Choosing an investor is like choosing a spouse (but with less romance)
- Not much difference between angel investors and VCs anymore
- What to do if your startup is suffering founderitis
- How risk and failure drive entrepreneurial success
- Beware of the revolving-door venture capitalist
- Getting an investor to move from “not now” to “yes”
- Talk to your venture capitalist before you crash and burn
- Entrepreneurs need to know when to call it quits
How unrealistic expectations scare off investors – and ways to avoid common valuation pitfalls
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When a new company is launched, the odds are heavily stacked against the entrepreneur. For tech entrepreneurs, those odds are even steeper.
Research shows that more than half of all new businesses fail within four years. For technology companies, fewer than 40 per cent survive that same timeframe. Despite these daunting statistics, new tech firms continue to emerge – and that’s a good thing.
Entrepreneurship drives innovation and shapes Canada’s future. The country’s competitiveness and economic resilience depend on our ability to create, adapt, and build. Yet most start-ups will eventually need to raise capital, which almost always involves assigning a value to the company. Valuations can be a source of frustration, disagreements, and, at times, outright failure.
Consider some familiar phrases from entrepreneurs defending unrealistic valuations:
“We don’t want to give up 30 per cent of the company.”
“This is a conservative estimate.”
“But Facebook …”
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One example can highlight the challenges of overvaluation:
Two entrepreneurs were pitching their pre-revenue tech company, which had unquestionably impressive technology. Several large firms had already expressed interest in their products. Over a few years, they had raised $3 million across two funding rounds to perfect the technology. Now, as they prepared for commercialization, they valued their company at $40 million.
The meeting ended quickly. While the technology risk had been reduced, the company still faced significant execution challenges. For pre-revenue investors seeking a tenfold return, this valuation required the company to reach a $400 million value within five years – a stretch by any measure.
Investing in pre-revenue companies is akin to playing scratch-and-win. Fewer than one in 10 investments succeed. To balance these odds, early-stage investors demand significant returns. For entrepreneurs, that means presenting a realistic valuation is essential to attract the right investors and build lasting partnerships.
If you’re considering investing in early-stage companies, take your time. The learning curve is steep, and many early-stage investors lose substantial sums before understanding how to evaluate opportunities. Once you invest, expect to commit at least three times your initial amount to maintain your ownership percentage during follow-on rounds. Diversification is critical – investing in at least a dozen deals can improve your odds of hitting a tenfold winner to offset other losses.
Let’s look at a more measured approach. Most mergers and acquisitions (M&A) occur at valuations under $30 million. Suppose your tech start-up achieves $1 million in annual sales. At that point, you sell a 50 per cent stake for $1 million to fund growth. The company is still losing money, but its traction is evident, and it has several years of patent-protected market differentiation ahead.
Two years later, you complete another $2 million round, selling an additional 50 per cent stake as the company reaches profitability and sees rapidly increasing sales. This values the company at $4 million. As the founder, you still hold 25 per cent of the business, now worth $4 million.
From here, the focus shifts to scaling and exiting within four years, targeting the busy M&A range of $25 to $30 million. With a clear implementation plan that aligns everyone’s interests, the company is well-positioned for a successful acquisition.
Every company’s path is unique, but mapping your path before raising capital is critical. Seek advice from mentors who have built similar businesses. While the final decision is always yours, hearing from experienced voices can sharpen your strategy.
Build as much value as possible before taking on external capital. Start with the end in mind – define your exit strategy, work backwards and determine how much capital will be needed at each stage. Research similar companies that reached specific revenue and earnings thresholds and exited at comparable values. This approach helps justify your valuation to investors and ensures you attract the right partners.
You may discover that this exercise significantly reduces your expected ownership percentage. But remember, it’s far better to own 10 per cent of something exceptional than 100 per cent of nothing.
Tech start-ups today face increasing scrutiny, particularly in a post-pandemic world where resilience, adaptability and clear market fit are essential. While AI, blockchain and other emerging technologies dominate the landscape, investors remain focused on proven products, sound execution and realistic growth plans. Entrepreneurs who focus on building value methodically, with clear goals and strong strategies, give themselves – and their investors – the best chance of success.
Warren Bergen is the author of Swagger & Sweat, A Start-up Capital Boot Camp.
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