tl;dr Startup risk allows for the potential for reward. Valuation only increases on mitigation of risk.

“Out of clutter, find simplicity. From discord, find harmony. In the middle of difficulty lies opportunity.”

― Albert Einstein

Startup are valued based on the overall market opportunity discounted by the risk associated with achieving a successful outcome. Therefore, valuation increases as the market increases or as risk is mitigated.

Successful companies level up. The team, product, business and process improve. The common successful venture backed path can look like a series of risks that are mitigated.

Stages:

1. Seed - product market fit
2. Series A - build team and business
3. Series B - scale the business
4. Series C - profitability
5. IPO - liquidity

These phases are made up of a variety of risks that vary across companies and markets.

Let’s take a look at risks that exist, examples where the risk determined an outcome and the questions VCs ask.

Risks:

• Execution / team risk - Google Video vs. YouTube - the incumbent with the benefit of vastly superior resources fell to better execution. Is this team uniquely able to execute on the opportunity?
• Technology risk - OnLive. ultimately failed due to the inability to create a desktop visualization technology with low enough latency. Can the right product be built?
• Business model risk - WebVan in 1999, Exec recently. At scale, will the unit economics support the proposed business?
• Financing risk - Everpix and Canvas. How much capital is required to get to a positive outcome? Will this be a category that can easily find follow on capital?
• Market timing risk - Friendster vs. Facebook. Too early and too late is just as bad as being wrong. Why now?
• Market adoption risk - Plancast. Will the market resonate with the product? Will the company suffer from a lack of product market fit, startup competition, or strong incumbents?
• Market size risk - Mochi Media. Is the market large enough to sustain growth and have a material impact on the fund?
• Scalability risk - Sonar. Growth is the only thing that matters. For enterprise is there a repeatable sales process, for consumer are there distribution channels with sufficient volume to create a big business?
• Legal risk - Aereo and Outbox. Are there IP, copyright, or other legal risks that have a material impact on the business?

Fund Raising on Risk Mitigation:

I’ve often had friends ask when to raise their first round of financing. The answer depends on the level of risk associated with the project. In many cases, former engineers and product managers with strong track records of building and shipping successful products do not need to build a MVP to generate investment interest. For these men and women, the risk isn’t whether they can create a product but can they create a business. This is demonstrated by generating traction. The valuation these teams can command wont change based on a product and as a result raising pre-product is ideal.

Conclusion:

Startup valuations are determined by a discount on the market opportunity due to risk. Startup valuations have step function increases with the mitigation of material risks discussed above. The best time to raise a round of financing is at these step function increases on risk mitigation.