Warning — We’re about to geek out!
It seems obvious to me that small startups follow different rule sets than larger companies. For example, small startups enjoy “Tuesday beer pong” and establishing their “world headquarters at the desk under a co-founder’s bunk bed.” I think of startups existing on a scale from quantized particles to microscopic elements to macro-scale ecosystems. For example, in the early stages of a startup it is hard to tell if a startup is an actual entity or just a bunch of energy being released into the microcosm. My uncertainty principle of startups suggests that the more accurately you state the current valuation of your company, the less accurately you can guess how fast it will grow. In fact, your startup is much like Schrodinger’s cat; it exists as both dead and alive until you observe it with a funding round.
The value of your startup is bounded by the upper price that investors will pay and the lower price you’ll accept. I imagine both investor and founder as Dr. Evil starting the negotiation and meeting at something reasonable:
While syndication and crowdfunding allow startups to treat funding as macroeconomic phenomena following rules of supply and demand, most startup funding exists in a microeconomic bubble. Good investors follow rules of microeconomics, game theory and law of averages to maximize return while reducing risk. In the end, the value of your company is only known when someone hands you money in exchange for stocks. Before and after that moment, the value is uncertain.
The Seed Round:
The earliest stage of funding often exchanges a large number of shares (5–20%) for a small amount of equity. At the earliest stages, investors expect one of two outcomes — either zero return or explosive returns. Anything short of explosive is typically viewed as zero return. At this early stage, relatively few startups are fully validated, so the opportunity is poorly defined. Therefore, seed investments are typically valued based on team. Unfortunately, the dynamics that make a team excel are difficult to measure — not to mention quantify. This is why accelerators focus on team, team and team as their top evaluation criteria.
Angel funding is a bizarre process that often takes too long and typically has no defined mechanics. For any given angel deal, you may or may not get funding after months of talking. I find it useful to view angels as Boolean investors, where the deals are seeded with keys from unknown future times. Because the keys are unknown, you can’t hack the system. The best approach is to find a way to get in front of many Boolean investors and improve your odds. In good times, the odds go up because each investor returns more “funding=YES” statements and more Boolean investors participate. Given that quantized particles are modeled best as stochastic phenomena, the Boolean Investor fits well into the quantized startup environment.
Early Stage Growth vs. Value:
The more you focus on the current value of your company, the less you’re focused on the growth of your company. This is one reason why early stage investments often kick the can down the road with convertible notes. If you state the value now, and you have an unknown growth, you could have a negative round — not good! The convertible note states that the current value is completely unknown in favor of a more predictable return when a later investment happens. Focus on growth, not current value — use a convertible note.
If you don’t know the term Lengevin dynamics, don’t worry — you’re in the majority. You could probably go the rest of your life without hearing this term again. Put simply, Langevin dynamics describe Brownian motion — the way cells bounce around under a microscope. For me, VCs are to Langevin dynamics what Angels are to quantum mechanics. When you graduate to Series A, your value and growth are better understood. Series A startups are governed by friction (or product stickiness), interaction potentials (the team), external forces (the market) and damping constants (market inelasticity). At this stage, startups still behave stochastically, but with much more predictability. This prediction requires understanding the startup and market much better, so Series A companies better be prepared to open wide and embrace the microscope.
All geeky silliness aside, know your startups valuation. Know it before you talk to investors. Know it before you make a plan. If you’re only willing to give up 15% of your company, you can only raise 15% of your company’s valuation. Any investor will want to know what the current valuation is. This is particularly true if they’re getting stock rather than a convertible note.
Until there is revenue, valuation is like black magic. This is why angels often kick the challenge down the road with a convertible note. When you have metrics to show, your startup’s quantum uncertainty reduces. As you grow month over month, the value becomes clearer and clearer.
In the next couple of posts, we’ll provide a few useful hints to help with early stage valuation and considerations when a startup studio is involved.
– In general there are 4 main rounds of funding for startups, Seed Investment, Series A investment, Series B investment, and Series C and beyond. Each round targets specific achievements or objectives for the firm as it grows.
-When valuing your startup, it is easy to run into what is commonly known as the endowment effect. The endowment effect is a psychological behavior which states that we tend to value things in which we own more than someone else would, even if someone else owned the same object. It’s useful to keep this in mind when valuing your startup.
-In case you are unfamiliar with the idea of Schrodinger’s Cat, it is known as a thought experiment devised in 1935 by Erwin Schrödinger. The scenario included a cat that appeared to be both dead and alive at the same time, this is known as quantum superposition.
Originally published on March 17th, 2016 on our previous blog.