The Illusion of Startup Valuations
Start Thinking Like an Investor: A Framework for Early Stage Valuations
Early stage companies face a barrage of challenges. And one of the leading challenges is fundraising. When I meet with companies as an advisor or potential investor, we invariably find our way to a discussion around the current norms for investment valuation and terms. Regardless of the amount of open source material available on the subject, it still presents itself. It’s one of the reasons I created a project called Venture.Fit to improve understanding of venture mechanics and increase industry transparency.
I believe the root of this questioning revolves around three things:
- The opaque nature of private capital markets: How do I know I am getting a fair value?
- The competing tensions and incentives between founder and investor: Can we trust each other?
- The lack of founder understanding of investor fund management and dynamics: Why do Investors seem to want so much of my company?
I am going to layout my particular view into these tensions and attempt to shed some light on the subject. While there is no magic formula for valuation, my hope is that you leave with a framework that provides boundary conditions and insight to the continuum of potential valuations.
The Market Trumps All Guidance
Over the last years there has been an incredible amount of ‘open sourcing’ of venture mechanics. Early thought leaders like Brad Feld, Fred Wilson, and Mark Suster have published numerous article on fundraising. I highly recommend Brad Feld and Jason Mendelson’s book, Venture Deals, if you are looking for a long form and in-depth guide to investment terms. In addition you can search through AngelList, Mattermark, PitchBook, and Qoura to gain insights on investment structures and terms. And while you are at it you can reach out to your local investor base, other founders, and seasoned venture attorneys.
But all that guidance has limited impact, if you are staring at one lonely term sheet after months of combing the fundraising trails. The hard, cold truth is that other than minor modifications or the willingness to walk away from a deal, you are largely consigned to the offered terms. While that may sound disheartening, there is an opportunity for Founders to overcome this condition by better understanding the realities of valuation motivations.
The Confusion around Valuation Discussions (a.k.a. Investors are from Mars and Founders are from Venus)
You may have seen this quite simple formula:
PreMoney Valuation + Investment Amount = PostMoney Valuation
and possibly this one:
Investment Amount / PostMoney Valuation = Investor Ownership
Assuming a positive exit that overcomes all of the preferred terms for downside scenarios, these formulas largely define the outcomes of ownership for the Investor, in a given investment round [Note: not for the Founder though].
What is interesting, is that many Founders tend to think in terms of Pre Money Valuation first. In fact, that is normally how the question is framed to me: “What’s the typical valuation for a company of my stage raising round type X?” That is interesting to me because, in my experience, most Investors tend to think in terms of ownership and investment amount first, with Pre Money as a mathematical by-product or artifact of that calculus. An Investor is typically optimizing around how much of the company it needs to own for a given investment amount, to support its fund return rates, structure, and goals. That is also why most Investors seek external dilutive events for the round, e.g. stock option pools or convertible notes, to occur Pre Money.
So when a Founder and Investor negotiate in terms of Pre Money Valuation, each party is deriving its counter-offer from differing perspectives, which is a likely source of tension or confusion for the Founder. Re-framing the Founder’s valuation question to, “What is the typical ownership an investor needs to support its target fund return rate, given our company stage and desired investment size.” might lead to a shared view of the investment that reduces tension and assists the Founder in self-selecting for a conventional venture financing pathway. It could also minimize a frequent Founder reaction to an investment offer, “Is that Investor crazy, our company is worth way more than $X, just on the IP or work to date.”
Try On These Investor Shoes
I can possibly hear a Founder response to that heading, “Oh yeah, I feel really bad for an Investor sitting on top of lots of money leading an exciting and cushy life, while passing judgement on the validity of an opportunity with the wave of a hand.”
While there may be some threads of truth to that statement (but not many if you are a seed or angel fund), I would suggest considering the following Investor realities:
- Investors Have to Raise Capital from: LPs
- Investors are Accountable to: LPs
- Investors That Don’t Have Great Returns are ‘Fired’ by: LPs
Limited Partners, LPs, are the entities that invest in and provide the capital for venture funds. Investors act as fund managers and typically contribute a very small percentage of the fund’s capital. And unless an Investor is part of one of the top 10 storied fund platform franchises, that exceeds industry return rates year over year while beating back LP investments requests for its next fund, an Investor goes through a grueling and protracted fund raising process that can easily take over a year.
Part of the fundraising process involves presenting a investment plan and outcome waterfall, typically over a 10 to 12 year horizon, that describes the expected statistical return outcomes and timing for a given fund and portfolio size. This analysis provides a framework for investments and is used to demonstrate a notional return rate to LPs that justifies the risk profile for the venture asset class.
Most of these plans attempt to portray a balanced view where many of the investments will return nothing, some will return low single digit multiples, and one or two will be the home runs, even venturing into unicorn level exits. Based on the pedigree of the Investor team and appeal of the fund’s investment thesis, LPs will place an investment to be managed by the Investor team.
And in a surprising twist, many LPs will keep a close eye on Investor decisions and interim performance. Exciting discussions can take place around why an Investor chose to invest $Y in exchange for X% of company Z when that LP is seeing different valuations in other funds it is invested in, or maintains personal insights and concerns with related market directions. And mid way through a current fund, Investors often begin the fund raising process (actually, Investors are always raising capital) for a subsequent fund. If the current fund is not successful in approaching or meeting the desired return rates, it is unlikely that the Investor will be able to raise another fund.
The Investor’s Dilemma
With this backdrop of Investor fund dynamics, it can be useful to consider a paradox of early stage investing: an Investor must simultaneously believe each startup investment has the potential to result in the one or two home run outcomes that will largely drive the promised fund return rates, while pricing that investment based on a weighted probability that the company will likely not return any capital.
To complicate matters, the opportunity cost and likelihood of identifying numerous companies with these magic characteristics often limits the practical size of a given investment fund portfolio. So, does the Investor: place an investment with the first opportunity at hand? Close a competitive deal by offering an attractive(higher) valuation (and convince Investment Partners this makes sense), and hope this is definitely the one? Or, just wait for a “better” opportunity to come along.
The Founder’s Dilemma
An early stage Founder raising capital is doing so to build and deploy a product. Slowing that process can present risks from first mover advantage to securing critical team members. But shouldn’t a Founder seek to maximize the amount of ownership of the startup post any financing round?
One of the best ways to accomplish that is to create a competitive bidding environment, which also happens to be one of the most difficult things to achieve. Funds exhibit rational and irrational behaviors, and can sometimes get caught in the herd mentality or Fear Of Missing Out on a hot sector. But there is a practical upper limit to valuations, where bad things can begin to happen:
- Investors are pushed beyond a fund’s natural investment criteria and return rate floor, creating the potential for strong oversight and mis-aligned incentives
- Implied unicorn valuations for subsequent rounds can become dangerously difficult to justify with operational results, resulting in down rounds and negative market signaling
- High valuations, at early stages, reduce the potential market of new investors willing to accept the risk of achieving exits that justify the valuation
At the other end of the spectrum, an exceedingly low valuation can disincent Founders and early employees and create its own set of signaling to the market place. If you find yourself in discussions with an Investor willing to take a Founder and Option Pool to dangerously low levels, I would suggest quickly seeking alternative sources of capital.
Does it Really Matter?
With all the hand wringing and optimization of valuation it is important to consider the round in the larger context of a notional series of financing and outcome scenarios. The follow diagram depicts summary excerpts from the venture.fit platform, comparing an identical series of capital raises ($52.5M total with a $750M exit) and varying only the Pre Money Valuation of the Seed Round by $1M (and implicit with that is a corresponding change in Investor ownership).
As seen above, a $1M change in Pre Money Valuation results in a 1% delta in Founder ownership at exit. Going back to the point in time of the Seed Round, a $1M change in valuation, with a 3% percent delta in Investor ownership, can feel like a large movement against a $1.5M raise. But is it worth optimizing and negotiating over one percentage point of outcome, occurring 8 years down the road?
A Framework For Valuation
A valuation is book-ended by two strong constraints: 1) a floor that maintains equitable Founder returns to keep the team incented and allow for a valuable Stock Option Pool to attract employees; and 2) a ceiling that maintains Investor return multiples that support the investment fund’s target return rate, in the context of a weighted average risk profile of portfolio outcomes, and future company capital raises. By considering a transparent and comprehensive analysis of return outcomes and the capital lifecycle of a startup, there is room for a more reasoned valuation discussion between early stage Founders and Investors.
If you are interested in detailed analytics of fundraising scenarios with return profiles for investors and founders, you can sign up for the early access waitlist at venture.fit.