The ‘Take On:’ series sees the Seedcamp Partners, Reshma and Carlos explore various topics throughout the world of Startups and Early-stage Investment. During each episode they’ll speak with members of the Seedcamp family to hear their views; including the Seedcamp team, our Investors, Mentors, and Startups.
For the second podcast in this series, Reshma and Carlos look at what investors look for in other investors to syndicate with, but also what founders should look for in investors, when actively fundraising. They discuss:
why choosing your investors is like choosing a family
what an amazing investor looks like
what type of investor might be most suitable for your startup
why the size of your investor’s fund is worth considering
the pros and cons of working with specialist vs generalist skill-set investors
why an investor’s deal experience is important
how to tell if an investor might not be suitable for your startup
One question that I often get from founders is what ‘tier’ a prospective investor is. As in, what differentiates their prospective investor over another as ‘better’ or ‘worse’, relatively speaking, and on what basis.
Just to clarify, although there is no formal ‘ranking system’ for the tiers of investors, generally speaking, every investor sort of knows where they ‘rank’ relative to others or at least relative to the top investors. The best funds, generally known as ‘Tier 1 investors’ are the most in demand, and then, the tiering is largely subjective from that point onwards as to whether a fund is Tier 2, or Tier x, so there isn’t a huge benefit to spending too much time trying to actively find the ‘objective’ rank of an investor.
That said, what IS worth exploring is what differentiates the better ‘tier’ investors from the rest. Below are the seven attributes that I believe differentiate ‘the best from the rest’.
As you seek out potential investors, keep an eye out for these variables, the more of these your prospective investor has, the likely better off you will be as a founder.
1) Has a great network – the biggest value-add, in my opinion, that an investor can bring to the table, is their network. The larger their network, the more doors they can open for you. Nothing beats a direct intro to someone you need to meet.
2) Has a great brand-name – this helps with the network, but having an investor with a great brand name, either as an individual or fund, can help not only open doors indirectly (as in not requiring an introduction), but also to provide your startup with instant validation to potential customers, partners, and new investors.
3) Has sufficient levels of capital to support you – Although different investors have different strategies around this (eg. an Angel rarely can follow-on as much as an institutional fund), it is generally a good thing to have an investor who can invest in your company throughout the lifecycle of your company.
4) Has sector expertise – One way that investors can differentiate themselves as a top tier investor from the usual suspects is by having focused experience in your sector. For example, an investor could be a generalist Tier 2 fund (remember that this is subjective), but as an ecommerce investor they may be a Tier 1, great if you are a ecommerce company, but just ok if you’re a fintech company. This is because they will likely have a large network (see point 1 above) in their sector of expertise.
5) Has deal experience – You will go through a lot of unique and stressful situations during a fund raise. It really helps to have someone who has gone through the process before and can help smoothen things out between all parties involved if needed.
6) Isn’t burdensome – An excellent investor does not burden the founder during the investment process with unnecessary or unusual diligence requirements for the stage your company is in. For example, a company that is very early stage will likely not have much to be ‘diligenced’, if an investor is requiring you to have an accurate version of what will happen in your company 5 years from now and you started your company three months ago, question whether they truly think the information you will give them has any likelihood of being true (and whether you think they’d make a good investor for you).
7) (Lastly, and most importantly) Has a big vision – Good investors on your board will help you by working with you on best practices for company building, but great investors will help you by helping you set the right vision for your company. The better investors help you think big because they think big themselves. This means not only having an attitude of can-do vs can-not, but also having the experience on how to coach you through this type of thinking.
Now, keep several things in mind, however, after reviewing this list:
1) There are many new investment funds and or individual angels that come to the ecosystem and therefore may not have an established brand name, but have great networks and experience. Don’t dismiss them prematurely, however, do ask others that they’ve worked with what it’s like to work with them.
2) Although founders that have done well and gone on to join a fund can be awesome people to have on your board, however, investors don’t have to have been founders themselves to be great investors. Experience as investor, having done many deals and knowing how the best companies operate, can count for a lot, so look for a blend of all attributes in your investor and not just look for a founder-turned-investor that can empathetically relate to what you’re going through, but provides little beyond aged anecdotes about how they did things.
3) If you’re ever stuck between two potential investors, really really consider that the person that will be working with you on the board will help you define many things about your company over the coming years. Choose wisely and ask yourself who you would rather work with long term, you wouldn’t want too chose someone on a brand name alone, but causes you hair loss, heart burn, and emotional stress on a regular basis.
I hope this helps you in your quest to find your potential investor.
Updated Post on Nov 11, 2013 – See bottom of post for updated notes.
When looking to plan for your company’s growth strategy or to go fundraising, it’ll serve you and your company well to break down what you need to do in terms of projected milestones. Technically speaking, I believe a milestone is a future ‘marker’ within your company’s stated growth trajectory.
Therefore, milestones, in the context of startups, are effectively points in time along the company’s timeline prior to a future event or goal. These points in time are usually defining points in a company’s history… such as a key hire, a product launch, a certain number of users, a retention rate, first revenues, first profit, etc.
Rather than the goal itself (an example goal could be to create a successful, cash-self-sufficient company, that provides tangible value to its customers and is floated on the public market), milestones are a subset of ‘the goal’. As such, milestones of any size can be created throughout the lifetime of your company as it progresses to your company’s ultimate goal.
Milestones are important from a fundraising point of view because they can define whether a company is caught with little to show to potential investors at the point of fundraising or with a strong showing of what the company’s been able to accomplish to date.
Lets, for example, look at the following points in a company’s history (I’m making the timing up for example only, don’t assume these are ideal timings):
Month 3: Minimum Viable Product
Month 5: Private Beta Launch
Month 8: Key Hire
Month 11: Public Beta Launch
Month 12: x% daily growth rate in subscribers
If a company knows how much money they need at all points in the timeline (see the article on how much money should I raise), then the question is which is the best milestone to fundraise on?
From an investor’s psychology point of view, risk is what is being managed. Minimization of risk while not losing an opportunity to invest in a hot company is the balance game that all investors play. Investors are constantly trying to find the least risky point to invest in a company relative to what they afford to invest (valuation) and the ability for them to invest (there is space in the investment round for new investors).
As such, the best time for a company to fund raise is either right before the completion of a key milestone or right after the completion of key milestone but before too much time lapses right after its completion such that there isn’t a sustainability of the reached milestone.
Let me explain. First, let’s look at the psychology of investing right before a key milestone is completed:
If an investor feels confident that the company is on track to hit its milestone, the investor knows that once the company succeeds, the company will inherently be more valuable to the outside market because it has been meaningfully de-risked by some amount. As such, the investor wants to ‘get in’ on the deal right before ‘launch’ for example, so that they can get a specific valuation while the company is still a little bit riskier, but not overly so.
This makes sense and is therefore quite simple to understand, but only companies that can instil confidence in potential investors of managing growth post milestone completion, generally get investors rushing to get this done. However, it’s a great for a start-up to be in, because generally, for things like a product-launch milestone, it is easier to control than say, a specific user growth rate.
Now let’s look at the psychology of investing post a key milestone being completed:
If an investor feels like he wants to ‘stall’ to see if the company is completed, or the number of users hit, etc.… then he is trying to effectively fully de-risk the investment before committing cash. However, he knows that being playing the cards this way, other players will also be on the table quite quickly because the company is not only attractive to him, but also to many others that were standing by the sidelines waiting to see what the company would do (relative to their risk profiles as in, this doesn’t mean that late stage investors, for example, will change their mind to invest in your company). Therefore, the investor in question wants to get in before the company is too valuable for them to invest in.
Therefore, the art of picking milestones is trying to determine which ones are the key ones to focus on.
As a rule of thumb, these are the biggest ones:
Human Resources – Hiring key people that will make a huge impact on your organization (not just employees for workload purposes, but like a shit-hot marketing person, for example).
“In terms of team growth, I believe there are other significant milestones, where organization changes happen roughly every doubling in size: founding team (usually 3 -5) expands to 7 -12, expands to 25-30, expands to 50-70, then above 100 and beyond. More often I see companies do quick jumps rather than continuous growth, and the jumps are always followed by significant growth management challenges.”*
Product – Product launches vs. version releases
Market – Market validation. As in, first customers, or first paying customers, etc.
Funding – Maybe some money being committed to a round that the investor in question can lead or participate in.
You can break these down into smaller and smaller ones if you’d like, but that’s where you start having to make judgement calls as to what is meaningful and what is not.
Other examples of milestones include*:
Proof that you can work together as a team, usually historical evidence
Proof that you can build something, i.e. working prototype
Proof that it’s useful to someone – first users and clients
Proof that you can talk to investors – every financing round, even small ones
Proof that you can talk to audiences – 100k users or 1M users or 10M users…
Proof that the initial team is able to attract talent – key hires are C- ad VP- level professionals, which will drive your growth further. Every startup will eventually need a functioning management team consisting of CEO, CTO, COO, VP Sales, VP Marketing, and possibly some others depending on what you’re building.
Proof that ecosystem agrees with your ideas – bringing respected industry advisors or partnerships on board
Proof that there is market – $1M annually
Proof that you can manage your finances – cash-flow positive operation
Proof that you can scale – $10M annually
Proof that the market is big! – $25M annually and beyond
Just keep in mind, milestones are all about moving from one stage of risk to the next. As you start planning your fundraising strategy, you want to make sure you time it so that you have ample time to fundraise so that you are in control of which milestone your company hits when. You just want to make sure your fundraising strategy uses these milestones to your benefit and not get caught between them and stranded for cash.
You should raise as much money as you can, but at least enough money for you to accomplish your next most meaningful ‘validated’ milestone + some buffer funds to help you spend time fundraising afterwards. This means you should look at a variety of points across your company’s timeline to see which can be made into meaningful milestones.
Whichever country you are in, you will have different fundraising challenges depending on the mix of individual and institutional investors. In a country where the funding comes mostly from individuals, you will likely not be able to raise substantially large rounds, in countries where you have access to organised groups of individuals, you’ll have access to larger rounds, and in countries where you have access to many institutional investors, you will likely be able to raise the largest rounds.
If you want to go for really really big, you should go to the geography where you can get that meaningful amount. Otherwise you will be underfunded, regardless. Keep in mind that in those markets, costs of running startups are going to be higher, so you need to include that in your plan…hiring star coders, for example, in the USA is very very hard these days.
In markets where you are not going to be able to raise the appropriate amount you need up front, try and articulate your requested amount this way: “This is what I need [big number], but this is what I can accomplish [milestones] with this [smaller number]”
An assortment of United States coins, including quarters, dimes, nickels and pennies. (Photo credit: Wikipedia)
Raising money for your startup is never fun. It takes time, distracts you from developing your product, is fraught with emotional ups & downs, and doesn’t have a guaranteed outcome. Frankly, many founders would rather go jump into an icy lake than take another fund raising meeting where they aren’t sure what they should say to ‘convince’ an already hesitant investor to open their purse strings and invest in their company.
So, back to the main question… how much money should I raise?
The flippantly short version of the answer is, “as much as you can”… but in some cases, more isn’t necessarily better. Although you should raise as much money as your company needs to achieve major proof-points/milestones, overfunding a company can also have its drawbacks.
Let me explain this last point before going further on the ‘how much money should I raise’ question:
Many founders are obsessed about raising as much money as possible all at once because well, if you do raise a big war chest, then that’s one less problem you need to worry about. However, with a large amount of money come several potential problems:
1) With more money usually come more investment terms and more due diligence. It is probably a fair statement to say that the more money involved, the more control provisions an investor will want as well as more diligence to make sure that their money isn’t going to be misused.
2) A high implied post-money valuation. In order to accommodate a large round, investors need to adjust your valuation accordingly. For example, if your business is objectively worth 1 million, but you are raising 2m, unless the investor plans on owning 66% of the company after investment, they need to adjust the valuation upward (I’ll abstain from giving ranges for now). Having an artificially higher valuation prematurely can put a lot of strain on a startup if things don’t go well and then later need to raise money again, as it increases the likelihood of a subsequent round being a down-round (when you take a negative hit to your valuation) or rather, other new investors passing on the deal in the future because it is ‘too expensive’.
3) A propensity to misuse ‘easy money’. You could argue this point from a psychological point of view if you wanted, but suffice it to say, I know many VCs that believe that over-funding a company leads to financial laxity, lack of focus, and overspending by the management team. Perhaps it is lingering fear over the hey-days of the late 90’s were parties were rife, and everyone got an Aeron chair, but the general fear with overfunding a company is that it will be tempted to expand faster than it can absorb employees into the culture, integrate new systems, or expand real-estate needs without substantially disrupting the efficient operations of the company.
4) A last one, which is hard to really quantify and happens only to very few startups, is the media’s reaction (positive or negative) to how much money you’ve raised relative to what you have. Think about this story, although very rare, it’s what the effect of what too much can cause.
Ok, got it, overfunding can be bad… too much money can be a bad thing, but if you said I should raise as much as I can, where do I start and what is the ‘magic’ number to ask for then?
Alright, let’s look at this question from a different point of view, as I mentioned in my previous post on how an investor evaluates your financial plan, an investor (depending on their areas of focus) may not necessarily know what the exact figures your business will need to grow to its next major milestone, but rather, the investor will rely on your ability to communicate this on your financial plan for the investor to then make a decision on whether your accurately understand your cash needs or not. Tied to this cash need is an implied understanding of your company’s milestones.
Let’s define what a milestone is before proceeding:
A milestone is a quantifiable achievement, be it in terms of product development, team expansion, or market adoption of your company’s value proposition.
Your financial plan will likely be a series of chronologically organized milestones. For example:
Month 6 – Hire UX guy to optimize app
Month 8 – Launch mobile app
Month 10 – Start charging on the mobile app
Month 11 – Hit 10,000 users
Month 12 – Launch partnership with key distributor
Month 18- Hire CMO
These are all milestones. Some more important than others, and frankly an investor will likely want to talk to you about the importance of each one of them to get a feeling for which ones are the key ones to focus on to determine if your business is going to ‘take off’.
The reason for this is simple, the best time to go fund raising, is RIGHT BEFORE or SHORTLY AFTER the successful completion of a key or series of key milestones. For example, right before a key milestone, you can woo new investors with the promise of how successful you will be at the completion of the milestone and basically you convince them that if they don’t get into your company by investing now, that they won’t have a chance after you’ve achieved the milestone because many others will also be interested and the competition will be stiff (remember, investors don’t want to lose out on potentially hot deals). Shortly after achieving a key milestone is also a good time to try and convince investors because you’ve effectively accomplished a major thing (like launching a product), which de-risks the investment for them, but they can still get in the company before it ‘takes off’. Frankly, the worst time to go fundraising is when your last major milestone has grown stale and the next one is too far away to be de-risked. So, this is why it is key to know your milestones, and when they are happening.
Parallel to this milestone timeline is the ‘cash timeline’. As in, how much money, in aggregate, you will have spent to get there. So using my examples from above:
Ignore whether this is a realistic example for your business for the time being, but I’ve assumed a 10K cash burn on this example up to the end of year 1, and then starting in Year 2, I’ve assumed 20K monthly cash burn. If you don’t know what your monthly cash burn is, you’re in trouble. Monthly Cash Burn is a KEY figure to know before meeting any investor.
As you can see, an investor could choose any of the milestones above to focus on for your cash needs. The idea is simple, fund your company through the achievement of major milestone(s) (to reduce investment risk and to see if your company has any traction before putting more money in) and then go fund-raising for more money, hopefully on a strong note, where you will have met your timelines and expected outcome (be it market traction, or successful completion of your product, or hiring of the appropriate person).
For example, an Angel investor (someone that usually invests from their own money) typically can’t invest millions, so their investments tend to be less than 300K. However, they’ll want to make sure your business is going somewhere before putting all their money in, so it’s likely they’ll want to come in early to give you enough cash to achieve something plus a little extra to help you fund-raise after, but also to see how you achieve the milestone before putting in more. So, perhaps this Angel may opt for funding you through month 10 with your requirement of 100K plus a few more for fund-raising. This would get you through your product’s launch and give you a couple of months to see how it goes in terms of market traction (all the time you will be speaking to new potential investors) so that you can have something strong to talk about for fundraising purposes.
Alternatively, an institutional investor (one that invests other people’s money as well as their own), say a VC fund, may see that your company has some real potential in what it is trying to do, sees that you have a plan that requires 100K to launch before you start trying to monetize, but with their experience of seeing your kind of business having to do a few pivots before getting the launch product 100% right, think that perhaps the best quantity to give you based on your calculations is about 500K for about a year to a year and a half. This should also give you some breathing room to work on achieving your various milestones rather than having to focus on having to be constantly in fund-raising mode.
So now you are probably asking yourself, how is it that some investors have different perceptions of how much money I need and wish to give me? Effectively, how much money does an investor ACTUALLY think I need vis-a-vis what I ask for?
Your exact calculations may have said that you needed 100K to launch your product, but an experienced investor may have seen various companies like yours and seen that there are usually mistakes done along the way that consume cash without quantifiable progress towards the agreed milestone (you may have learned something, but you may be delayed in your launch because of some screw up). Because of this, investors some times include ‘buffers’ into the number they offer you in a deal. This buffer could come from the various sensitivity analysis the investor did, such as, what if the company is delayed in launching their product by two months, or what if the company can’t find that key employee, or what if the company can’t start charging for their product for an extra few months, or what if the product needs a pivot, or what if people aren’t willing to pay what the company expected? All these things will affect the cash flow of the company and because of them, the investor may assume some or all will occur, leading to the company needing more money than was planned by the founder. Effectively, your 100K in a perfect execution timeline, may actually be 250K after some minor delays and mistakes, and with the extra cash the investor in my example above gave you, you now may have enough cash to go fund-raise without having to panic about having to get cash in ‘yesterday’ or be constantly in fund-raising mode.
Keep in mind that this larger amount an investor may be willing to give you will also affect your valuation range, too much and it ‘inflates’ the valuation range your company sits in (as per my point number 2 in the intro), so an investor won’t give you ‘excessive’ buffer so that it forces the company to be ‘overpriced’ for them and for the company’s future. Inversely, hopefully you can also see where an investor may deem a company to be ‘underfunded’ if it doesn’t have enough money to get to where it can achieve a meaningful milestone(s) upon which to go fundraising with a strong foot forward for future investors to be attracted.
In conclusion, raise as much as you can but understanding your monthly cash burn and map out your company’s important timelines and the cash you will realistically require to achieve them. Then have an engaging conversation with your potential investors as to how much they think you need based on their experience. As a rule of thumb, try and raise enough money so that you have time to go fund raising after you’ve accomplished your next key milestone(s). In a future post I’ll discuss how much time you should set aside for fundraising, but to make the rule-of-thumb complete, add AT LEAST 6 months to the amount of money you need for your next milestone to include time to go fundraising.
Hope this helps
Update 1:
A friend of mine emailed in and mentioned that perhaps there was a difference in how investors from different geographies look at this issue of how much they want to invest in a company up front, and yes… I would agree with that statement, but the point of my post is merely to provide the reader with a ‘framework’ by which to approach the question of how much to raise, not so much to answer the multiple varied ways that investors might look at the amount required and subsequent fundraise amount. For example, some investors may choose to just want to back the team and thus will just give them an amount that they think startups typically get for the stage the company is in, and others will give an amount of money merely to exclude the investor competition from winning the deal from them!
However, I believe the framework I’ve mentioned in this post can help a founder assess how much money they may need for a period of upcoming time no matter the risk averseness (or not) of the investors they meet with. Whereas a bolder investor may not really focus on minor milestones, but rather just focus on a larger one such as ‘grow the network’ and for that the amounts invested is done with far less due diligence and far more quickly, a more risk averse investor will probably be more specific about what you plan on accomplishing with his money.
In the end, the most important thing, is to be keenly aware of your cash needs on a month by month basis, so that if the question comes up, you know how much you plan on spending and by when. You should also focus on raising enough money in your timeline so that you also have time to accomplish your key milestone(s) before going fundraising again, and lastly you should include enough buffer in your last fund raise to help you through your next fundraising period post-milestone. If you meet an investor that wants to invest a lot quickly, great, if you meet with various investors that are more risk-averse, at least you won’t get caught not understanding your execution plan. If you want another rule of thumb, many Early-Stage VCs will look at the next 12month to 18month worth of cash needs + a buffer to estimate the cash needs of a company. Add to that 6 months of additional cash burn and you have a rough starting point for a ‘headline figure’ from which to start discussions.
One of the most frequently asked questions at any startup event or investor panel, is “how do investors value a startup?”. The unfortunate answer to the question is: it depends.
Startup valuation, as frustrating as this may be for anyone looking for a definitive answer, is, in fact, a relative science, and not an exact one.
For those of you that want to cut to the summary of this post (which is somewhat self-evident when you read it) here it is:
The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.
Whilst this statement may capture the bulk of how most early stage startups are valued, I appreciate that it lacks the specificity the reader would like to hear, and thus I will try and explore the details of valuation methods in the remainder of my post with the hopes of shedding some light on how you can try and value your startup.
As any newly minted MBA will tell you, there are many valuation tools & methods out there. They range in purpose for anything from the smallest of firms, all the way to large public companies, and they vary in the amount of assumptions you need to make about a company’s future relative to its past performance in order to get a ‘meaningful’ value for the company. For example, older and public companies are ‘easier’ to value, because there is historical data about them to ‘extrapolate’ their performance into the future. So knowing which ones are the best to use and for what circumstances (and their pitfalls) is just as important as knowing how to use them in the first place.
While going into the details of how these methods work is outside of the scope of my post, I’ve added some links that hopefully explain what they are. Rather, let’s start tackling the issue of valuation by investigating what an investor is looking for when valuing a company, and then see which methods provide the best proxy for current value when they make their choices.
A startup company’s value, as I mentioned earlier, is largely dictated by the market forces in the industry in which it operates. Specifically, the current value is dictated by the market forces in play TODAY and TODAY’S perception of what the future will bring.
Effectively this means, on the downside, that if your company is operating in a space where the market for your industry is depressed and the outlook for the future isn’t any good either (regardless of what you are doing), then clearly what an investor is willing to pay for the company’s equity is going to be substantially reduced in spite of whatever successes the company is currently having (or will have) UNLESS the investor is either privy to information about a potential market shift in the future, or is just willing to take the risk that the company will be able to shift the market. I will explore the latter point on what can influence you attaining a better (or worse) valuation in greater detail later. Obviously if your company is in a hot market, the inverse will be the case.
Therefore, when an early stage investor is trying to determine whether to make an investment in a company (and as a result what the appropriate valuation should be), what he basically does is gauge what the likely exit size will be for a company of your type and within the industry in which it plays, and then judges how much equity his fund should have in the company to reach his return on investment goal, relative to the amount of money he put into the company throughout the company’s lifetime.
This may sound quite hard to do, when you don’t know how long it will take the company to exit, how many rounds of cash it will need, and how much equity the founders will let you have in order to meet your goals. However, through the variety of deals that investors hear about and see in seed, series A and onwards, they have a mental picture of what constitutes and ‘average’ size round, and ‘average’ price, and the ‘average’ amount of money your company will do relative to other in the space in which it plays. Effectively, VCs, in addition to having a pulse of what is going on in the market, have financial models which, like any other financial analyst trying to predict the future within the context of a portfolio, have margins of error but also assumptions of what will likely happen to any company they are considering for investment. Based on these assumptions, investors will decide how much equity they effectively need now, knowing that they may have to invest along the way (if they can) so that when your company reaches its point of most likely going to an exit, they will hit their return on investment goal. If they can’t make the numbers work for an investment either relative to what a founder is asking for, or relative to what the markets are telling them via their assumptions, then an investor will either pass, or wait around to see what happens (if they can).
So, the next logical question is, how does an investor size the ‘likely’ maximum value (at exit) of my company in order to do their calculations?
Well, there are several methods, but mainly “instinctual” ones and quantitative ones. The instinctual ones are used more in the early-stage type of deals and as the maturity of the company grows, along with its financial information, quantitative methods are increasingly used. Instinctual ones are not entirely devoid of quantitative analysis, however, it is just that this “method” of valuation is driven mostly by an investor’s sector experience about what the average type of deal is priced at both at entry (when they invest) and at exit. The quantitative methods are not that different, but incorporate more figures (some from the valuation methods outlined) to extrapolate a series of potential exit scenarios for your company. For these types of calculations, the market and transaction comparables method is the favored approach. As I mentioned, it isn’t the intent of this post to show how to do these, but, in summary, comparables tell an investor how other companies in the market are being valued on some basis (be it as a multiple of Revenues or EBITDA, for example, but can be other things like user base, etc) which in turn can be applied to your company as a proxy for your value today. If you want to see what a professionally prepared comps table looks like (totally unrelated sector, but same idea), go here.
Going back to the valuation toolset for one moment… most of the tools on the list I’ve mentioned include a market influence factor , meaning they have a part of the calculation that is determined by how the market(s) are doing, be it the market/industry your company operates in, or the larger S&P 500 stock index (as a proxy of a large pool of companies). This makes it hard, for example to use tools (such as the DCF) that try and use the past performance of a startup (particularly when there is hardly a track record that is highly reliable as an indicator of future performance) as a means by which to extrapolate future performance. This is why comparables, particularly transaction comparables are favored for early stage startups as they are better indicators of what the market is willing to pay for the startups ‘most like’ the one an investor is considering.
But by knowing (within some degree of instinctual or calculated certainty) what the likely exit value of my company will be in the future, how does an investor then decide what my value should be now?
Again, knowing what the exit price will be, or having an idea of what it will be, means that an investor can calculate what their returns will be on any valuation relative to the amount of money they put in, or alternatively what their percentage will be in an exit (money they put in, divided by the post-money valuation of your company = their percentage). Before we proceed, just a quick glossary:
Pre-Money = the value of your company now
Post-Money = the value of your company after the investor put the money in
Cash on Cash Multiple = the multiple of money returned to an investor on exit divided by the amount they put in throughout the lifetime of the company
So, if an investor knows how much % they own after they put their money in, and they can guess the exit value of your company, they can divide the latter from the former and get a cash-on-cash multiple of what their investment will give them (some investors use IRR values as well of course, but most investors tend to think in terms of cash-on-cash returns because of the nature of how VC funds work). Assume a 10x multiple for cash-on-cash returns is what every investor wants from an early stage venture deal, but of course reality is more complex as different levels of risk (investors are happy with lower returns on lower risk and later stage deals, for example) will have different returns on expectations, but let’s use 10x as an example however, because it is easy, and because I have ten fingers. However, this is still incomplete, because investors know that it is a rare case where they put money in and there is no requirement for a follow-on investment. As such, investors need to incorporate assumptions about how much more money your company will require, and thus how much dilution they will (as well as you) take provided they do (or don’t ) follow their money up to a point (not every investor can follow-on in every round until the very end, as many times they reach a maximum amount of money invested in one company as is allowed by the structure of their fund).
Now, armed with assumptions about the value of your company at exit, how much money it may require along the way, and what the founding team (and their current investors) may be willing to accept in terms of dilution, they will determine a ‘range’ of acceptable valuations that will allow them, to some extent, to meet their returns expectations (or not, in which case they will pass on the investment for ‘economics’ reasons). This method is what I call the ‘top-down’ approach…
Naturally, if there is a ‘top-down’, there must be a ‘bottom-up’ approach, which although is based on the ‘top-down’ assumptions, basically just takes the average entry valuation for companies of a certain type and stage an investor typically sees and values a company relative to that entry average. The reason why I say this is based on the ‘top-down’ is because that entry average used by the bottom-up approach, if you back-track the calculations, is based on a figure that will likely give investors a meaningful return on an exit for the industry in question. Additionally, you wouldn’t, for example, use the bottom-up average from one industry for another as the results would end up being different. This bottom-up approach could yield an investor saying the following to you when offering you a termsheet:
“a company of your stage will probably require x millions to grow for the next 18 months, and therefore based on your current stage, you are worth (money to be raised divided by % ownership the investor wants – money to be raised) the following pre-money”.
One topic that I’m also skipping as part of this discussion, largely because it is a post of its own, is “how much money should I raise?”. I will only say that you will likely have a discussion with your potential investor on this amount when you discuss your business plan or financial model, and if you both agree on it, it will be part of the determinant of your valuation. Clearly a business where an investor agrees that 10m is needed and is willing to put it down right now, is one that has been de-risked to some point and thus will have a valuation that reflects that.
So being that we’ve now established how much the market and industry in which you company plays in can dictate the ultimate value of your company, lets look at what other factors can contribute to an investor asking for a discount in value or an investor being willing to pay a premium over the average entry price for your company’s stage and sector. In summary:
An investor is willing to pay more for your company if:
It is in a hot sector:investors that come late into a sector may also be willing to pay more as one sees in public stock markets of later entrants into a hot stock.
You have a functioning product (more for early stage companies)
You have traction: nothing shows value like customers telling the investor you have value.
An investor is less likely to pay a premium over the average for your company (or may even pass on the investment) if:
It is in a sector that has shown poor performance.
It is in a sector that is highly commoditized, with little margins to be made.
It is in a sector that has a large set of competitors and with little differentiation between them (picking a winner is hard in this case).
Your management team has no track record and/or may be missing key people for you to execute the plan (and you have no one lined up). Take a look at my post on ‘do I need a technical founder?‘.
Your product is not working and/or you have no customer validation.
You are going to shortly run out of cash
In conclusion, market forces right now greatly affect the value of your company. These market forces are both what similar deals are being priced at (bottom-up) and the amounts of recent exits (top-down) which can affect the value of a company in your specific sector. The best thing you can do to arm yourself with a feeling of what values are in the market before you speak to an investor is by speaking to other startups like yours (effectively making your own mental comparables table) that have raised money and see if they’ll share with you what they were valued and how much they raised when they were at your stage. Also, read the tech news as sometimes they’ll print information which can help you back track into the values. However, all is not lost. As I mentioned, there are factors you can influence to increase the value of your startup, and nothing increases your company’s value more than showing an investor that people out there want your product and are even willing to pay for it.
Hope this helped! Feel free to ask questions in the comments.
