Traction

Every business starts as a story. Someone has built a product, a few people use it, one or two have paid, and the founder can describe a future in which many more will. At this stage there are no settled earnings, so there is no earnings figure to price. Whatever a business at Traction is worth has to be reasoned from something other than its profits.

Owners at this stage are usually told one of two things. Some hear that the business is worth whatever someone will pay, which is true and useless. Others are handed a multiple of revenue from a database of venture deals, which looks like analysis and describes other companies. The framework treats the value at Traction as a bet on the business reaching its first earned anchor, and it prices the bet in the open.

A story, tested three ways

The story at Traction is a specific claim: this product solves a problem people will pay to solve, enough of those people are within reach to produce one owner's earnings from closed books, and this team can get there on the money it has. The framework tests the claim at three strengths.

It has to be possible, which means a product exists and is in use and someone has paid or committed to pay. It has to be plausible, which means the path to the first earned anchor can be drawn span by span, with what each step will take, and the cash on hand covers the budget to get there. And it has to be probable, which means businesses like this one usually make it. Before a business has a record of its own, the only evidence of probability is the record of others: the base rate at which businesses of its kind and size survive to a first profitable year, taken from national business-dynamics data.

Any part of the story with no evidence behind it is taken out. Because almost every number at this stage looks forward, each is labelled as an input to a scenario and never presented as a fact. The labelling stops a founder's hopes from turning into a valuation without anyone having decided they should.

Whose value

At most anchors there is a market of buyers to price against. At Traction there usually is not. The people who put money into a business at this stage are particular people: the founder, a friend, an angel investor, a lender relying on a personal guarantee. Each values the business by what it is worth to them, with their own money, their own time and their own appetite for loss. The honest standard is therefore investment value, the value to a named investor, and the work says who that investor is. A market value is computed beside it only when a transaction between unrelated parties has to be priced. Where the number is headed to a court, a founders' dispute, a divorce or an estate, the legal standard governs, and that standard decides whether a discount for illiquidity may be applied at all.

Where there is more than one founder, the founders' agreement carries a lot of weight for a short document. A dispute between founders is the most common way a business at this stage gets valued in a hurry, and the agreement settles most of what follows: what triggers a buy-out, how the price is set and by which appraiser, and where the money comes from. Where no agreement exists, the valuation says so, because the founders are carrying that risk whether or not anyone has written it down.

The value of a bet

With no cash flow to discount, the business is valued as a small set of futures. In one, it reaches the SDE anchor in a stated year with a stated level of earnings, and from that point it is worth what a business at that anchor is worth. In another, it gets there a year late, after more money goes in. In a third, it fails before reaching it, and it is worth what its assets would fetch in an orderly sale, after the costs of selling them and winding down. For a business at this stage that is often a small fraction of what it cost to build, because a product and a handful of customers fetch little on their own. The founder's death, disability or divorce are futures too, and so, wherever there are co-founders, is a co-founder's departure, with probabilities taken from published incidence.

Each future is discounted back to today at a required return set for an investor who can lose everything, and the results are weighted by their probabilities. The probabilities come from the base rate and from the founder's own record of hitting the budget month by month, so the valuation gets better as the record grows.

In the illustration, a business with a 35 percent chance of reaching SDE in three years, where it would be worth $600,000, and a liquidation value of $60,000 if it fails, is worth about $90,700 today at a 40 percent required return. If rebuilding the business from scratch would cost $70,000, the bet on reaching the first anchor is worth about $20,700 above the assets.

Why the bet is not growth

That $20,700 is the part of the value an investor might be tempted to call growth, and the framework refuses to. Growth, in the framework, is what an existing cash flow earns by reinvestment: a business that already earns money puts some of it back and earns a return on what it put back. Counting growth requires a record of returns on capital, and evidence that something protects those returns from competition. A business at Traction has neither. Its movement from first revenue to its first year of real earnings is the business becoming what it claims to be, and the probabilities in the scenarios already carry that movement in full. Valuing it a second time as growth would count the same hope twice. So growth is valued at zero, both today and inside every scenario in which the business reaches SDE, since even there it arrives without the record a buyer would need before paying for growth.

The value comes in four layers, and the fourth is named so it cannot be mistaken for the third. The first is what it would cost to rebuild the business today: its equipment and working capital, and the cost of reproducing the product, the brand, the first customers and the team, each sourced from what was spent. For many businesses at Traction this is most of the value, and the valuation says so plainly. The second is earnings power, the value of what the business earns now with no growth at all, usually small or nothing. The third is the value of growth, zero for the reasons above. The fourth is the option of reaching the first anchor, the probability-weighted value of the futures less the larger of the first two layers. That option is what an investor pays for above the assets, and the valuation carries it on its own line as the least certain number in the file. Where the futures are worth no more than the cost of rebuilding, the option is worth nothing, and the business is worth its assets and its founder's time.

What an offer assumes

The valuation is built before any term sheet or offer is seen, so that the first number on the table cannot anchor it. Every price that arrives afterwards is then run backwards into the assumption it makes, one input at a time.

In the illustration, an offer of $150,000 for the same business implies a 65 percent probability of reaching SDE, holding everything else where it was. Against a base rate of 35 percent, that is 30 points of probability the record has not shown, and the offer is the investor's bet that this business is the exception. It may be a good bet. It is not evidence that the business is worth $150,000, and a founder who reads it as evidence will plan around a probability the record does not support.

The same file names what would show the bet failing before the first checkpoint does. The count of paying customers from outside the founder's circle is watched monthly against the budgeted rate of growth. The cash runway is watched in weeks of cash at each month-end against the budget to the SDE checkpoint. Gross margin on the first product line has to hold at or above its budget, and the budget itself has to keep matching the actual results. Each signal has a level at which the probabilities are reopened, so the valuation moves when the business does rather than when someone next asks.

The checks at the start of the bridge

The checks at Traction are low enough that almost any operating business passes. A product or service exists and someone outside the founding team uses it, which is settled in the first meeting by looking at the product in use. And someone has paid, or has signed something saying they will, which needs one invoice or one letter of intent.

The checks only ask whether there is anything to work on yet. A business that fails them is still pre-product and not on the bridge at all; there is nothing to advise on, and the work is to go back and build. A business that passes is on the bridge from Traction to SDE, and everything after this point is about turning a story into earnings a stranger would pay for.

Traction itself comes in three forms, in no fixed order. A business may have a compelling narrative before it has a product, a working product before it has a market, or early revenue before either is fully proven. Each counts, whichever came first, and by the end of the bridge all three have to have turned into a number.

How a business falls back

A business can also slide off Traction, and the signs are easy to recognize. The budget and the actuals drift apart and nobody revises either, so the story stops matching the numbers. Early users stop using the product, which means the problem was less painful than the story said or the product did not solve it. Or the money runs out before revenue arrives. The first two reopen the probabilities in the valuation, and the third ends it. The framework reads all three with the same checks it uses on the way up, and values a sliding business by the record it has now, whatever record it was expected to build.