In building an early market, the fundamental return on investment is investor risk reduction.
Crossing the Chasm, p. 216
Mature companies are valued by their potential sale price, or their ability to generate cash for shareholders.
Early stage startups have no assets worth selling, and lose money.
The value of an early stage company instead comes from its predicted future ability to generate cash or sell for a high price.
A rough modeling of a startup’s value would look like the following:
P(success): Probability of a successful outcome.
Payoff : Value of a successful outcome.
Progress : Value of IP created, revenue streams generated.
value = P(success) * Payoff + Progress
This is why a newly startup with smart founders but no revenue or product can raise money at a $10M valuation.
The startup has no assets, and has made no progress, but it has potential.
P(success) = 0.1%
Payoff = 10B
Progress = 0
-----------------
Value = 10M
If this startup de-risks key aspects of the business, for example by releasing an product and closing 1M ARR from early adopter users, the value of the company increases dramatically.
P(success) = 0.5%
Payoff = 10B
Progress = 1M ARR, worth 10M at a 10x multiple.
-----------------
Value = 60M
If this startup obtains the same revenue without de-risking the business, for example via consulting work or 1-off projects, the value of the company does not increase nearly as much.
P(success) = 0.1%
Payoff = 10B
Progress = 1M ARR, worth 10M at a 10x multiple.
-----------------
Value = 20M
In the early stages of a startup, the value of your company comes from building proof that you’re likely to succeed.
The quality of your revenue, and the story behind your customers is much more important than the dollar figure itself.