Valuations and Founders

When highs bring lows

There is a strong trend of high valuations for startups right now that was captured by Sam Altman in his recent post on valuations. Altman identifies one reason for the trend in the increasing supply of money to startups from new types of investors. These investors are competing with traditional VCs in the space. He also sees three consequences resulting from this trend:

• The established model of VC investing based on special access and information asymmetry is failing.
• VCs are increasingly trying to differentiate themselves through soft value adds, such as services.
• Term sheets for VC investments are realigning in favor of founders.

I agree with much of what Altman has said but believe he misses one important reason for the rise in valuations and fails to spell out three challenges for founders:

For starters, I believe accelerators such as Y Combinator or Techstars are an important factor for the rise in valuations. This doesn’t mean that accelerators are bad (my company is a Techstars Boston 2012 graduate and I am a big fan). The value instilled in accelerator companies from exposing founders to seasoned entrepreneurs, professional investors, and strategic partners is invaluable. Startups today have more sustainable business models and scaling strategies than 10 or 20 years ago. But accelerators have been instrumental in organizing the supply side of the market. Herds of startups are presented on demo day, generating a feeling of scarcity and a fear of missing out among investors. This drives higher valuations and larger rounds of funding for startups.

If higher valuations generate larger rounds, they also, as Altman notes, drive spending for startups. This is problematic for a number of reasons. First, founders flush with cash often grow their teams too early without a real need, causing not only a high burn rate from personnel cost but also a lack of focus. End of the day, a larger team doesn’t necessarily mean more progress. The point of Lean Startup is that we do not know our end goal, so we have to learn. Realistically, how quickly can we learn? Also, do we need to learn everything from scratch?

Second, startups tend to spend time and money on marketing early on because they feel compelled to be seen in a competitive space. The problem here is quantity versus quality. Increasing traffic, Facebook likes, and Twitter mentions are all great when you are ready to scale, but in the early life of a startup your biggest challenge is to qualify traction. Numbers can help you answer some questions, but numbers can’t answer all questions and too many numbers may hide the real lessons you need to learn.

Finally, high valuations set many founders up for failure in later rounds. There is an important assumption when you raise capital that isn’t always clear to founders in their “vision round.” Even though raising $1.5M on a $10M pre-money valuation for the seed round seems awesome, you will be measured against different metrics in your next round. For your Series A you need to prove that you have a real business model and can create actual behavioral changes among customers. Doing this successfully is necessary in order to raise more money at a higher valuation next time and, if you fail, you are faced with a flat or even a down round. While seed rounds are plenty, the Series A crunch is real. Metrics for later rounds have been elusive (but see recent post by Rob Go) with more good companies around for investors to pick from. So, make sure you don’t spend your money before you have the metrics.

In the end, as Altman points out, frugal companies tend to win. For founders, the challenge is to understand how much money you really need to achieve your goals and to make every dollar count. The cost of technology is closing in on zero, so you should consider hard the costs of personnel, data acquisition, and the time you need to learn product/market fit before you raise money.

For investors in early stage startups, the biggest value-add to founders in my view is driving focus. Value add services may be helpful to startups in many instances, but there are always professionals that can help fill the gap. Only investors can hold founders accountable to real progress and focus. Some examples of how investors can help their founders include:

• Lead the founders to focus on providing customer value rather than developing new features.
• Help the founders distinguish between finding early adopters that believe in the product vision and happy-eyed users that have no real problem to solve.
• Make sure the founders understand customer purchasing-drivers and decision-making processes to keep sales cost low.
• Ensure the founders focus on making customers successful with their product.
• Encourage founders to learn from others’ mistakes by introducing them to peers and leaders.

And yes, do show up to monthly investor meetings.