How Different Perceptions of the Odds of Success Lead to Disagreements on Valuation

Investors and entrepreneurs often disagree on the valuation of early stage companies. Many people have written on this question. I don't want to repeat them. Instead, I want to focus on a key issue that I think gets short shrift in the discussions - different perceptions of risk.

To understand this concept, I need to first explain how investors make money by financing startup companies. Investors make money because the value of the companies they back ends up being worth more, on average, than the money they put into the companies.

The investor's return is determined by four factors: what the company sells for when it goes public or is acquired; how much of the company the investor holds at that time; how long it takes to get to that exit; and the probability that the exit will occur. The higher the value of the business at exit, the more of the company the investor holds, the shorter the time horizon to exit, and the greater the odds of an exit happening, the more an investor will make on a given investment.

I will leave discussion of the exit value, time horizon, and the dilution of the investor's ownership to another post or other authors and focus on the probability of a successful exit. The higher the probability of an exit, the higher the valuation of the company should be, all else being equal.

The problem here is that investors and entrepreneurs often have very different perceptions of those probabilities. When the entrepreneur first comes up with his or her idea and begins to pursue it, the odds of a successful outcome are very low. There's technical risk, the chance that the founders won't make a product that works; market risk, the possibility that no one will buy it; competitive risk, the odds that the startup will beat others serving the same market; and financing risk, the chance that the founders will not be able to obtain all the funding they need to pursue the opportunity.

Several sources of information - data on angel investments from the angel performance project, anecdotes from investors, records of venture capital firms, and so on - indicate that a money-making exit occurs in about one-in-ten businesses backed at this very early stage by accredited investors.

Sophisticated investors take those odds as given. They assume that they will make money on one-in-ten of the companies they back at this stage and lose money on nine-in-ten of them.

The entrepreneurs in whose businesses these investors put money are not diversified across a portfolio of ventures with an average probability of success of 10 percent. The founders are each starting a single company.

Each of the entrepreneurs that the investor backs assesses his or her chance of success at far higher than 10 percent. In fact, research shows that each entrepreneur thinks that his or her venture will succeed with a 50 percent or higher probability, while assessing the odds of success of other people's ventures at the 10 percent that the investors estimate.

The Source of Startup Valuation Differences?

Now I am sure you see the problem. If the investors assess lower odds of success to ventures than the founders, the investors will value the businesses lower. The gap in valuation will often lead deals to break down.

Odds Photo via Shutterstock

This article, "How Different Perceptions of the Odds of Success Lead to Disagreements on Valuation" was first published on Small Business Trends