Every Saturday morning, I watch Shark Tank. I don’t think I’ve missed an episode, and have been lucky enough to see several of my friends on the show (some even got deals!).
Almost every entrepreneur that goes on the show gets beat up on their valuation. “No revenue? How can you be worth $5 million?”
Next week is Y-Combinator’s Demo Day. For the past week, many of the conversations I have had in the investor community surround this issue — are YC companies worth the valuations they are asking?
Chris Sacca, a prominent investor, who was also a small investor in my last company responded with a tweetstorm of his own, which included this tweet:
and this one:
Which eventually led to this tweet:
And therein lies the opportunity.
Why Valuation Matters
What Sam and Chris are reacting to not that increased valuations are squeezing out some investors, but that an early high valuation can create undue pressure on the founders in the next round, causing down rounds (where the valuation of the company decreases vs. increases) or find raising money nearly impossible.
Here are the traditional funding rounds:
- Friends and Family: Now often replaced by an accelerator/incubator. Usually a small sum (<$100k) and on a convertible note (debt that converts into equity at a later date).
- Seed: Still figuring out the product. Most likely pre-velocity, and still in the “2 folks and a dog” mode. Usually, mostly angel investors.
- Series A: Have a good idea of product/market fit, now just looking to verify and scale. Usually first institutional investors enter here.
- Series B and on: Clear velocity, now its hit the gas time.
And here is a little secret, you don’t have to go from a seed to an A to a B, etc. You can do an A1, A2, A3, etc. or a bridge round or a debt round. There are a million ways to manage the optics of the fundraise itself.
All of this starts at the original “value” placed on the business.
It is usually done as a “cap on a note,” which is simply the maximum valuation an investor will pay in the next round. (For example, an investor participates in a $10mm capped note. At the next round the company has a “pre-money valuation” (What the company is worth prior to getting additional investment) of $20mm. The original investor will buy shares at the $10mm price, a significant discount.
That initial valuation is seen as the baseline as which to judge all future funding events. In truth, each round sets a new bar.
Maximize vs. Optimize
There are two schools in setting initial valuation: Maximize and Optimize.
Maximize: In this case, the founder believes that their company will be a rocketship. The goal is to maximize ownership. The belief is that there will be no difficulty raising future rounds (of which there won’t be many) at a consistently higher valuation.
Optimize: The founders believe that their company will grow rapidly, but may take time until revenue hits and many multiple funding rounds. The goal is to optimize the investor value versus the money.
(One of the greatest questions in raising money is what is worth more to the company: the cash or the investor.)
For the last several years, accelerators like YC and Techstars have used total money raised collectively by their companies as an indicator of success. It would follow that (at least optically) they put pressure on the companies to raise at the highest valuation possible. Most accelerators take dilutive positions in companies making high valuations early are more valuable. (By the way, I personally know that accelerators push their companies to optimize vs maximize valuations).
Go For The Money, Right?
The valuation (or cap) you initially raise on will set the stage for the rest of your rounds.
Founder 1: First round is $500k at a $2mm pre-money. You do well, and raise the next round at a $10mm. 4x value creation. Awesome. To justify a $10mm pre, the milestones are near, clear and achievable. Angels and institutional VCs are all in play in the second round.
Founder 2: First round is a $1.5mm at a $10mm pre-money. Now, the next round has to be at ~$50mm to get the same 4x value growth. A $50mm valuation does two things: 1) requires significant growth in users or revenue; 2) eliminates most angels and many smaller institutional investors. So now the requirements for success are higher, and the pool at which you can raise from is smaller. This only works if you FUCKING KILL IT.
By shifting the “big” round of $50mm to a later stage, the requirements for velocity and traction are spread out for the founder, reducing the focus on short-term rapid growth.
With the proliferation of angels and early stage VCs, the amount of money available to companies has skyrocketed, but the number of funds doing Series A and later investments has stayed about the same.
That is the Series A Crunch. The bar for getting a Series A has increased. More seed stage companies are failing. More investors are not seeing returns. Angels are investing in other things that have better returns. Funds are reducing their seed investments and focusing higher up the value chain where there is less risk.
For founders this has all translated into “get mine now.” Early valuations are still growing. Founders are taking money off the table much earlier. The focus is often on maximizing founder liquidity rather than optimizing future success of the business.
The Big Failure
The valuation issue at the end of the day is one of trust between founders and investors. On the surface, it appears that a maximized valuation is in the best interest of the founder, while an optimized valuation favors the investor. Because of this, any talk about increased valuations by investors is seen as a ploy to reduce valuations across the board. Founders, having little guidance or direction on this issue get into weird competitions with cohort mates or blog posts for higher valuations. All of this is making entrepreneurship less fun.
Start With Trust
My suggestion? Stop worrying about valuation and start focusing on trust. As a founder, your first mission should be to find investors that you trust. Thinking of it like a marriage is not a platitude, it is a reality. You will not only spend a lot of time with your investors, but be linked to them for the rest of your professional life. Choose wisely.
Once you reach a point of real trust between founder and investor, then discuss valuation rationally. Like most things, don’t get swayed by someone offering high valuations to get into your deal. You should want the investor in at any price first, then determine the price that is fair.
Ask your mentors what valuation they would set for your company. Ask friends who got high valuations how that effected them long term. Same with more conservative valuations.
DO NOT, under any circumstances, look at your cohort mates as the bar to which you set your valuations. Saying that everyone is setting their valuations at $15mm means you should to, is a little following your friends off a bridge.
Be an founder, not a lemming. Figure out what is best for your business and do that. A lot.
BTW: The greatest piece of data that shows how unscientific / ego-driven valuing a pre-seed/seed company is? The fact that by simply being in the SF Bay Area increases your valuation.