This is a post by Carlos Eduardo Espinal and Scott Sage. Carlos is a Partner at Seedcamp, an early stage mentoring and investment program based in Europe. Scott is an Associate at DFJ Esprit, a leading cross-stage venture capital firm that invests from seed to late stage in European technology and media companies.
Historically, when deciding where to base their first US office, a European startup’s decision basically came down to the Bay Area or Boston – depending upon which customer segment they were serving. Up until recently, New York was nothing more than a fly over state or, at the very best, a satellite office with a small sales team.
So why are some of Europe’s hottest startups now opening up their first US office just on the other side of the pond in NYC? Why are investors increasingly coming to NYC to find the newest and most innovative start-ups? These are the questions that we’d like to address in this post.
To begin with, let’s look at the main reasons why start-ups are finding establishing a presence in NYC increasingly attractive:
New York is closer than Silicon Valley for European investment and start-up hubs such as London, Berlin, and Paris. Naturally, this proximity leads to reduced time zone pressures for distributed teams working on projects together via VoIP
New York has its own strong and vibrant start-up ecosystem which helps new companies feel right at home as well as find support from those that have tackled similar problems already
New York’s large immigrant pool allows newly arrived companies to readily find cultural similarities between their home countries and groups within NYC.
There are great academic resources in and near New York, which helps for both training as well as for hiring talented staff
New York is also close enough to Boston’s start-up ecosystem and top-tier academic institutions that it is not unheard of to have people take short flights or trips for both investment discussions and hiring decisions.
New York has some of the world’s leading VC firms and angel investors
New York is a very important media, fashion, finance, and advertising hub for the world. This allows companies to be close to key partnerships
New York has a mature set of key start-up service providers such as legal firms, which the ecosystem needs for transacting investments.
Due to these compelling reasons, we believe investors are increasingly taking notice of start-ups that are based in NYC or moving to NYC from Europe.
However, it’s best to hear why NYC is so important from Entrepreneurs directly. In the words of some founders, NYC represents a key hub because:
“New York and London are deeply connected as financial centers, most of our partners operate in both locations from our perspective. The predominance of financial technology companies in the region maintains a pool of resources with deep understanding of finance. Also this maintains an ecosystem of financially oriented Angel Groups and VCs.
“There is an extremely fast-growing start-up culture that is increasingly attracting more talent from the top schools in the country located in the NY to Boston region and away from other industries. It has been much easier to attract talented interns from Ivy League schools like Princeton for us. The start-up scene is also very diverse and seems to be in perpetual party mode.”
“If your clients are media and advertising agencies or publishers then it’s the only place you need to be. I mean, pretty much everyone in these industry, who is not based in NY (or doesn’t have an office there) is a niche player; NY is trying hard to beat SV in attracting start-ups, so newcomers from Europe that chose NYC over Silicon Valley are praised (which can give you easy PR).
“Everything works 24/7 (food, Fedex’es, subway), which is in sync with how startups operate, and time difference (especially to London) is bearable especially for the early birds. I would say that if someone has figured out their business model, has the product, engineering team somewhere outside of NYC and targets agencies, publishers or finance companies then NYC is a great place to come to scale the business.”
In conclusion, we believe NYC has become a key hub for European start-ups looking to maintain a link back to their mother country and wishing to manage distributed teams while having great access to the resources that the North-eastern corridor of the USA has to offer. Additionally, we expect to see an increasing number of cross-Atlantic investments occurring over the next years which will bode well for the European start-up ecosystem overall.
[Disclosure: Bilbus, Campalyst and Erply are Seedcamp portfolio companies, StrikeAd, Conversocial and Redkite are DFJ Esprit portfolio companies]
ABOUT THE AUTHORS
Carlos Eduardo Espinal is a Partner at Seedcamp, an early stage mentoring and investment program that engages start-ups through monthly Seedcamp Events, where entrepreneurs present their companies, network, receive mentoring, and compete for investment by Seedcamp. Yearly, Seedcamp invests in about 20 companies. Scott Sage is an Associate at DFJ Esprit, a leading cross-stage venture capital firm that invests from seed to late stage in European technology and media companies. Members of the DFJ Esprit team have experience of investing in over 200 companies and generating strong returns for investors through building valuable companies alongside the founders and management teams.
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
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.
You are about to go meet an investor… you’ve read on the web and heard differing views from people on whether you need a financial plan… some say you don’t, it’s a waste of time as its all made up numbers anyway… others say, you absolutely need a financial plan… so you walk into an investor meeting full of anxiety as to whether not having something is going to reflect poorly on you or if what you’ve created (if you did create something) will be crap in the investors eyes… so what to do?
The financial plan, for most tech-focused early-stage founders, is probably one of the most dreaded bits of the investment pack to send your prospective early-stage investors. The variety of opinions online don’t help either as they just confuse the matter…
Do I need one or do I not need one?
If I build one, how do I know it is ‘right’?
If I build one, surely the investor will know that my numbers are all “fake” and just slash them all in half?
Let’s face it, as much as we’d like to think we can predict the future with all sorts of fancy extrapolations on growth rates… but we can’t… Considering that most people create financial projections based on assumptions of what needs to happen for an upcoming month’s worth of operating events to happen and then project from there for x number of months or years, you effectively create a series of increasingly improbable chronological events with the last event (month) in the series being effectively a function of the compounded set of decreasing probabilities, all of which are asymptotically approaching zero percent in their likelihood of happening “according to the plan”.
What’s my point? Well, that your financial plan isn’t worth much from an accuracy perspective.
So what then? If my numbers are crap, why bother with whole financials nonsense?
It is in its forensic analysis of your thinking behind the model, however, where an early-stage investor really gets a feel for how you think and how you want to direct your company in the near future. Next, it is in how your cash will be used efficiently to accomplish the mutually agreed goals.
Before we continue further, I want to clarify that I’m not going to discuss how it is that you should format your financials, or explain basic accounting principles, or how financial statements work. There are plenty of resources online that can help you with that. Rather I want to explore how an early-stage investor (well, at least myself) forensically reviews the financial plan of an early stage startup (vs. a later-stage startups where there is a historical performance record already there and with multiple years of budgets and actual figures).
So what do I mean by conducting a forensic analysis of company’s financials?
Well, I certainly don’t mean it in the sense of reviewing the financials of the startup from a post-mortem basis, but rather reviewing them with the same level of scrutiny on ‘reasons’ why things may have occurred or may occur as one sees on TV shows like CSI. Effectively, I’m looking for what are the cause & effects of each of the numbers and what are the key assumptions behind them, with emphasis on the word “assumptions”. The verbal discussion with the entrepreneur’s financials will focus entirely on their assumptions and the reasoning behind them.
When an investor is discussing numbers (which may be entirely wrong from a future-perspective) with an entrepreneur, if the entrepreneur shows a solid understanding on why the numbers are there, having a clear view of the market dynamics in which their company operates, with realistic customer acquisition assumptions, realistic hiring plans, effective use of marketing budgets, appropriate expenses for a growing company, it can have a HUGE impact on establishing the necessary credibility of competence an entrepreneur needs to inspire confidence in the investor. The opposite, seeing a financial plan with current month revenues/expenses projected five years into the future assuming linear or exponential growth in all aspects of the organization and then stated with a confidence of ‘this is what we realistically expect to happen’ can be both demoralizing for an investor if not outright humorous.
Let me share with you a little secret: With a few exceptions, you will always know your industry and its numbers better than any investor will. However, an experienced investor will ask you the right questions to ascertain whether or not you know your industry well enough to increase the probability of your own company’s success. As such, really do your homework… by homework I mean, don’t just go out and build a product and hope there will be customers. If you take the Lean Methodology approach, for example, as soon as you have customer validation, make an effort to understand the market dynamics of that customer… how many of them are there? What is their concentration? How do you reach them? Are they locked in with a competitor with some sort of monthly or annual contract? Do they buy in a cyclical pattern? Do they prefer to buy online or only from salespeople? Do they need help with setting up your product or can they use it as is? What are they generally willing to pay for other similar services? How is the market growing? Mind you that in some circumstances the ability to ‘charge’ money of your customers may not be deemed the real potential for revenues at first (think Twitter 3 years ago), but again it is how you articulate the future value that matters.
If you take all those questions and research them, what you will find are key components of what will make up the assumptions on your future revenues (or value creation objective). Perhaps your customers are only willing to buy your product during the holiday season, so you will have a hard time with cash coming into your company during the off-season. Financials that didn’t take that into consideration would look to an investor as somewhat unrealistic, not in the numbers, but in the market dynamics of your product. Take other assumptions for example, if you can only reach your customers via another party (perhaps a distributor?)… As in you aren’t directly selling to your end customer, how does that affect the time until you get cash, and the amount of customers you get all at once (or lose all at once)? How long are your customers likely to stay within your service (churn)?
Again, all of these examples are about doing your homework on how your company will operate within its industry and how it will acquire customers. The better you can explain the reasons why a number in your financial model is based on a realistic set of assumptions, the better off you will be. But look at it another way… while you are doing this exercise, you will realize whether there is actually a business that can make money (or other method of value creation) or not. For example, if you do the analysis and find that in the sector you are exploring people aren’t willing to pay and that many other competitors are giving the product away for free, and that there aren’t many opportunities to inject ‘advertising’ as a supplementary source of revenue, you may have just saved yourself a serious amount of wasted energy!
Which brings us to the next part of the homework: the understanding of your company’s expenses. If you have found a market where your product is actually capable of generating some sort of value (note again that I’m not necessarily focusing on “revenues” because there are many ways investors define what “value creation” is, whether it be a growing user base or actual sales) the next part is how do you spend your money to match that customer growth. When do you hire new sales people (and how many sales people do you need relative to a customer sale?), when do you bring new servers online, spend on marketing, spend on new offices, laptops, etc.. Obviously the types and amounts of expenses vary from company to company, but what matters here is how they map to what you are trying to do and whether that mapping is realistic (what is your customer acquisition cost?). For example, if you have a marketing charge of $500 one month, is it realistic to expect that next month your customer sign ups will increase by 500%? Well, as I said before about the “little dirty secret”… I have no flippin’ idea, but I will expect you to tell me how the $500 will equal 500% in customer growth and I will basically evaluate the credibility of your answer. If you answer, I will buy $500 worth of flyers and pass them out, you can rest assured that I will not believe your 500% figure, but if your team’s background has a track record of low-cost viral marketing campaigns, and your answer is basically a version of that… well guess what, I might just find it plausible. I may be exaggerating the bit about having ‘no flippin idea’ as most investors will have seen enough of what works and doesn’t work to call BS, but again, if you can walk an investor credibly through your assumptions, it will do wonders for the confidence you create.
Lastly and most importantly, is the review of how the expenses map to the revenues as far as cash flow is concerned. The lifeline of a company is how much cash it has before it either dies or needs to go fund-raising again. As such, investors not only want to know how much a company needs in terms of cash to execute its vision (perhaps the subject for an upcoming post), but also on how that cash is being used. If there is a huge mismatch here or there isn’t enough time for you to reach your company’s next point of tangible progress (a validation point), this may be a point worth discussing. Much is joked about how an investor will take your revenues and cut them in half, actually an investor may outright eliminate your revenues from the overall sensitivity analysis he is doing to get a feel for how much cash your company would burn on a monthly basis at time x in your plan (you should know your current monthly burn number by heart, by the way). This is because if your company has to do a pivot or something else goes wrong, this will not only accelerate the cash drain relative to your plan, but also have an effect on when the company needs to go fund-raising again and an investor needs to take all of that into consideration as part of the investment analysis.
In summary, do your homework before you build your financial model, but definitively go through the exercise of building one. It will be hugely helpful in helping you identify how your business may need to grow in order to adapt to the sector in which it operates and how you may need to spend money in order to achieve your goals. Most importantly however, by being prepared with a thorough understanding of why everything is there within your model, the less anxious you will be when meeting potential investors… and remember, you may not know all the answers, such as how much money will it cost you to acquire a new customer, but even if you at least start with a reasonable assumption, confess that you aren’t sure about it, and then play around with a range to see if things work, that is also helpful to the investor for them to get a feel for how you can evaluate uncertain circumstances and adapt accordingly.
In my recent post on how an early-stage investor values a startup, I talk about how market comparables were the closest guide to how early-stage investors value a startup vs. any other methodology. However, I feel like I left one question unaddressed. Namely, why are there valuation discrepancies for comparable companies across the world (more specifically at investment stage rather than exit stage)?
The answer has to do with liquidity of deals, the localized risks for investors, and the supply of investors.
As I mentioned in my last post, there are various factors that can come into how an investor values a startup, but using market comparables from deals done in the USA doesn’t always incorporate all the risks that are prevalent in the specific geography where the company and investor in question operates. Furthermore, the availability of capital in any geography will also affect how an investor gauges his own risk/reward ratio when pricing deals.
I’m going to talk about this point abstractly and without incorporating the argument of the global nature of internet-based businesses (they do have some localization risk still, but less so). So, for example, startup exits for investors in certain developing economies will happen less often than say, in Silicon Valley. This has to do not only with the number of companies coming out of the country, but the universe of potential buyers for these companies in that geography.
This affects that risk an investor takes, as he is less likely to get that 10x that I mentioned in my previous post. Therefore an investor seeks a ‘discount’ to take on a deal in order to have a portfolio of deals where there is the possibility that one will be able to exit in spite of whatever market conditions exist locally. Add to that the fact that the investor may be one of very few investors, and therefore can command this discount more forcefully than if more competition existed (once enough investors exist, market pricing becomes more stable and in parity with other larger markets).
Think of it this way… If you’ve been on tourist holidays to resorts abroad, you’ll have noticed that things that are generally cheap(er) back home are notably more expensive at the resort store. This higher cost is due not only because of the transport cost to the resort, but also the cost of holding them there in inventory without knowing if anyone traveling to the resort will buy them. If the seller doesn’t include a higher premium on these items, he will not break even considering the high scrap-age risk he must take on inventory not-bought, and if there aren’t any other stores around, the store doesn’t have to compete on price either, but can continue to seek profit under the circumstances.
So, the point of this post is only to highlight why in certain parts of the world financing can be more difficult to get, but also why it can be priced differently than equivalent deals elsewhere.
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.