Why Founders Shouldn’t Care About Valuation
If you’re a founder negotiating a venture or angel investment, and valuation is what’s keeping you up at night… this post is for you.
I’ve invested in 32 pre-seed startups over the course of my 13-year career as an angel investor. And now, as the founding partner of the Berkeley SkyDeck Fund, I am investing in 120+ more over 2 years. And I know all too well that the vast majority of founders, endlessly, obsess over the topic of how much their startup “is worth”.
“How much is my startup worth right now?” — Every startup CEO, ever.
My message to them is: stop. You’re focused on the wrong parameter.
I understand why it happens; it’s the top line number that shows up in Crunchbase and Pitchbook, and you can use it to explain to your nervous husband + mother why your efforts and sacrifices as a startup CEO have all been worth it. After all, you’re not a unicorn unless you’re valued at $1 billion.
I’ve even heard some accelerators lecturing to their startups that the identity of their early investors don’t matter, it’s only dilution that matters. (SMFH)
And besides, it’s the first topic your investors tend to focus on as well — if they care, then you should care too, right?
Wrong. And in fact, I’ll try to convince you “surrendering 40% of your valuation” can be the right decision for the founder. But before discussing why you should not care about valuation, let’s start by first understanding why investors should care about valuation.
The Investor View
First, for the purpose of this discussion, I’m going to conveniently sort professional angel investors + venture investors into a single neat bucket, ignoring the wide range of variation between different groups. This analysis applies to anyone who objectively cares they’re doing a good job with their venture investments, rather than simply pursuing the life-long passion of seeming important and appearing on panels.
Investment fund managers view investments through the prism of a portfolio. Even the most highly concentrated investors will still end up with 12–16 bets in the course of a given fund, and some (like my Berkeley SkyDeck Fund) will end up with more than 120+ investments.
The success of any individual startup is certainly important, but for the fund as a whole, success is ultimately quantified as either internal-rate-of-return (IRR) (sometimes presented as the slightly less meaningful — but easier to understand for the arithmetically challenged — TVPI).
When a fund manager tries to prove to himself (or more importantly, to their backers / investors) that he’s been doing a good job, he does it with IRR. Venture as an industry has a (pretty mediocre) IRR of ~16% over the past 15 years (tracked by groups like Cambridge Associates).
Fund managers only have a reason to exist if they’re able to consistently and meaningfully beat that number. And to make that happen, valuations absolutely matter. (As a minor aside… some misguided, often junior managers actually view their portfolio in a slightly different way, which I’ll save for a future post in my series of posts on venture from the point of view of a hedge fund manager.)
By way of example, let’s look at my own angel investments from 2006, when I first began my career. My overall angel portfolio from that vintage (10 companies) had a TVPI of roughly 2.99 (adjusted for hypothetical fees), which places me in the top 5% of all venture investors from that era.
As you can see from the above graph, a 2.99 TVPI places me in elite company, which makes me a credible and attractive manager in the eyes of potential investors in any venture fund. (No, I’m not fund raising — I’m just saying.)
How did I achieve that number? Well, partly because I was fortunate enough to invest in TubeMogul in a seed angel round, with a pre-money valuation of $5mm. When they IPO’ed almost 8 years later, I cashed out with a roughly 14x return.
And so, my single investment in TUBE accounted for almost half of the overall portfolio TVPI (1.4 out of 2.99).
If I had instead invested in TUBE at a higher valuation, let’s say $10mm (in today’s market, that would have been close to market)… I would’ve only had a 7x return, and all else being equal, my TVPI for the portfolio would have been only 2.3. Still pretty good, but would’ve barely made me top quartile.
And let’s say I instead found TUBE at an over-hyped accelerator Demo Day, and in a moment of impulse invested at a $20mm pre… well, then I would’ve only had a 3.5x on this deal. All else remaining equal, my TVPI would’ve been 1.94, and I would’ve only been barely above average!
And this is just in the context of one deal; you can imagine if I was equally loose with valuations on the other companies I invested in (I have 3 other exits in this portfolio), the overall TVPI would’ve been dramatically worse.
In other words, for a venture investor, valuations are everything. It’s the only way we can justify our existence. It’s the only reason one of us deserves a spot at the Tesla Supercharger, or should have a membership at the Battery. And to be successful at our jobs, we can’t compromise.
I’ll also quote a piece of wisdom from an old coffee trader on the floor of the NYBOT that I used to work with during my previous career as a quant fund manager:
There’s only two things we ever get to control; the price we buy at, and the price we sell at. Make sure the price we buy at is the right one.
The Founder View
Now, let’s think of the same issue from the point of view of the founder.
You probably don’t have a portfolio of startups; you’re working on a single vision (unless you happen to be Elon Musk), and all of your energy, dreams, fears are stored within the confines of this single entity.
If investors care about valuation, then shouldn’t you? If they’re negotiating for as low of a valuation as possible, then shouldn’t you automatically push back and ask for the highest valuation possible?
My answer is, emphatically, no.
Let’s not take it to extremes; obviously you want to raise at market rates, and you want to minimize dilution. Selling shares in your company is not so different from selling cabbage at the farmer’s market- you have a limited supply, and you sure would like to have the highest price possible.
But if presented with two investors, one of whom gives you a meaningful premium on your valuation, which one should you pick? Far too many founders these days are automatically picking the one with the higher valuation — and that’s a mistake you might one day regret. (Alternatively, many founders are passing up term sheets and delaying their raise until they find the dream investor who meets their target valuation.)
Let’s go back and do a concrete (grossly simplistic, but hopefully informative) example.
Imagine you’re raising a seed round; one investor has offered you $2mm on a $7mm pre (let’s call this the cheap scenario), and another has offered you $2mm on a $10mm pre (let’s call this the AWESOME scenario). If you visualize these two termsheets in front of you, I suspect most of you will choose the AWESOME scenario out of hand.
But let’s think about what happens when you exit this company with a $200mm acquisition, in 5 years.
The Cheap Scenario: the founders end up owning 78% of the company after the seed round. (The math here is $7mm/$9mm, or 0.777.)
Assuming 2 more rounds of funding which dilutes you by 30% each time, you end up with 38% of the company.
With your $200mm exit, your take is worth roughly $76mm. Congrats, and remember to invite me to your house party. Now, what about the AWESOME scenario?
The AWESOME Scenario: the founders end up owning 83% of the company after the seed round. (The math here is $10mm/$12mm, or 0.833).
Assuming 2 more rounds of funding which dilutes you by 30% each time, you end up with 41% of the company.
AWESOME!!! By taking the pre-money valuation that looked 43% better on paper ($10mm vs $7mm), you end up with 3% more of the company at exit! This translates to a take of roughly $5mm ($81mm rather than $76mm).
Congratulations, you’ve made an extra $5mm! (Yes, I’m being sarcastic about making an extra $5 million dollars!)
Now, don’t get me wrong… $5 million dollars is a lot of money to anyone who’s not a professional athlete, and I certainly wouldn’t scoff at it. But when I think about the utility function of ending up with $76mm or $81mm after almost a decade of hard work… do you really care? Would you really scoff at the $76mm exit as being inadequate?
If you’re like most of the founders I know, you’d be ecstatic with the $76mm exit. You’ll still end up with the same economic freedom (i.e. cars, houses, TechCrunch feature articles) you’re looking for! And so very clearly, that’s precisely what you should be optimizing for.
GET TO THE EXIT. That’s really the only thing that will decide your ultimate happiness, and that’s what you need to place as your highest priority. If the “cheap” investor at $7mm- valuation gives you a better opportunity of building the right product, of picking the right market, of finding the right customer, or of raising the next round… if it increases your probability of getting to the exit by even a small percentage, you should take it.
If we go back to the earlier analogy, your investors aren’t just shoppers buying your cabbage — you’re inviting them back home to help you cook it. If you’re deciding between me or Thomas Keller as customers for your cabbage, pick Thomas Keller. If instead it’s between me or Thomas Keller investing in your startup, pick me.
Ironically, many of the founders I know aren’t even conflicted because of a $7mm vs $10mm pre… they spend hours, days, weeks consumed with something as trivial as a $7mm vs $7.5mm valuation. If nothing else, I hope this article saves them nights of heartache.
Spend your nights consumed, instead, with the question of who’s going to help you succeed in your business; who really understands your model? Who has other successful investments in your space? Who’s ready to make customer introductions on your behalf? Who groks your technology and has suggestions on how to improve it? Who’s first name starts with the letter C, and last name starts with the letter T?
Owning even 100% of a failed startup will give you little satisfaction beyond cocktail party chatter; whereas owning even a smaller percentage of a startup that ultimately succeeds, and exits, will grant you material wealth beyond imagination.
The founders at Berkeley SkyDeck hear this lecture roughly 10 times per cohort (sometimes I get stuck on repeat), and I only hope that means they end up with the right seed investors, which ultimately boosts the probability of success for all of us.
(And I admit this is a shameless plug for the “right” seed investors who’re tired of over-paying for quality startups, to find us at Demo Day on May 15th.)
