The Valuation Game

One of the things I learned early when I started investing was that valuation in the Midwest was typically a lot lower than it was on the coasts.  The reason for that was basically supply and demand related.  On the coasts, there was a lot more money chasing fewer deals.  There were a lot more deals to choose from as well, but the ones that were good enough to get a check stayed around the same percentage.

When you look at statistics on funding, it’s roughly the same year over year.  Around 3000 deals get funded by venture capitalists, and around 66,000 deals get funded by angels.  You can go deeper and look at the breakdowns from series to series, but trust me when I tell you as you move from Series A to B to C, the volume and velocity go down but check size goes up.

I am noticing an uptick in the valuation entrepreneurs want to get here in the Midwest.

This is concerning to me for a number of reasons.  Probably the first thing someone will say is that I am totally biased, and just want to get more blood out of a rock because I am on the investing side of things.  However, one of the things I always tell entrepreneurs is not to raise any money from venture capital or angels if they can.  When entrepreneurs bootstrap, it’s better for them in the long run.  I have seen people bootstrap for years and sell their company walking away with a nice return for themselves and the employees of the firm.  I have also seen it the other, way.  Entrepreneur raises money too early and at too high a price and it dooms the company.

Here is the important thing:  Valuation and corporate finance are a strategy for growth just like good product market fit and other strategic issues. It’s not only about the money.

If you take the Venture Deals class Brad Feld and Jason Mendelson do online, you learn a lot about valuation.  It’s a great class and I would urge anyone involved with funding entrepreneurs or being an entrepreneur to take it.  The companion book they wrote about the class is great as well.  But, there is an online exercise on valuation with spreadsheets in the class that should open everyone’s eyes to how all the parts work together to create a return for everyone.

This sounds so apparent but I think a lot of people miss it.  Valuation isn’t created by the number you get on the first round.  It’s created at the margin by the step ups in valuation you get between rounds.  In an extreme example, Facebook’s seed round was done around $6M and they all did pretty well.

Valuation is a number pulled out of thin air. It’s negotiated.  There are a lot of factors that go into it.  If you are a successful entrepreneur and starting a new company, you will get a higher valuation.  You have about a 16% better chance of being successful again.  In startup land, that is a lot.  A lot of entrepreneurs focus on the market size and try and sell their valuation because of it.  That’s not the way to look at it.  It’s about where the company is at the time-not how big the market is.

I think that AngelList is starting to have an effect on valuations.  Entrepreneurs see where other companies are raising and are putting those numbers into their pitches.  However, I also don’t think a lot of companies outside of Silicon Valley raise a lot of the capital on AngelList.  Funders Club recently put their returns out into the atmosphere.

FundersClub’s 2012 fund held a 2.3x unrealized net multiple and its 2013 fund held a 3.2x multiple.   There aren’t any exits.  
FundersClub’s multiple for realized exits is 1.1.  Successful VC funds typically try to return 3x after fees.  Putting money into companies at too high a valuation destroys that multiple.

Charlie O Donnell of Brooklyn Bridge Ventures advises to not raise so much money.  He also did some great work here on calculating venture capital returns.  He writes:

If prices are 2x higher, then we’re looking at high teens returns for just the seed round’s returns, and mid for the whole ball of wax if you follow on.

Seed round returns are particularly sensitive to exit valuation–because what might seem like a million bucks here and there is actually a lot on a percentage basis.

So, if I can get everyone down from $5mm pre-money to $3mm pre-money, now I’m netting my LPs above a 40% return.  If I’m forced to pay $7mm pre-money for all the same deals, we’re looking at sub 20% returns.  Don’t even talk to me about paying $9mm pre.

I don’t care if you raised money to build your product at $6M, and now you want to raise at $10M just because you have a couple of customers.  I don’t care if someone wrote you a check at a super high valuation.  They are an unsophisticated investor and don’t know what the hell they are doing.  I also don’t care if you ego needs a number.  Fit the valuation number with where the market is.

At the same time, if the company is really really good, investors need to get comfortable with the valuation that is outside their comfort zone.  If a company is on the edges of the investor’s comfort zone, they shouldn’t pass simply because of valuation.  That can be a fatal mistake.  They are missing out on potential returns.  At the same time, today’s “sure thing” probably isn’t.


6 thoughts on “The Valuation Game

  1. Good one.

    Valuation is what you can get, nothing more.

    Two comments:

    -The idea that there is a local Chicago or NY venture market that works under different valuations is fast if not now a myth. There are differences of course is company running cost, but a great idea is just that.

    -Bootstrapping is a bitch. Plain and simple.
    Bootstrapping with any sort of hard goods inventory is an impossibility.

    I’ve done this a bit and honestly capital constraints or moreso going out for capital after you already should have market proof is a rough way around the block. Not a fan.

    1. I should have added this to the post. If a startup comes out at a really high valuation, they better have the top AND bottom line revenue to prove that valuation out based on standard industry metrics. Otherwise, the seed round looks a lot like a PE round.

      1. good point.

        most of us get what we can as if you need the capital you need the capital.

        i don’t think it is that common for startups to shut down because the capital was too expensive.

        you take it if you need it in most instances with of course the exceptions.

    2. I also agree, on the differences between markets. However, most seed funds and professional angels usually only invest within a days drive. At some point, geography does matter.

      The reason for seed funds is that they are very limited in how many deals they can do-and they are constrained by their management fee costs. It’s expensive to travel all over the place to add value to a company, and sit on a board.

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