Optimize for value, not for valuation

Speedinvest has completed over 25 seed investments in a little less than 5 years, and that means a lot of deal negotiations. Termsheets are essentially a sales process, where founders try to sell their product (the Startup) as well as possible, and the buyer (the Investor) tries to assess the real value to his or her business, which is, in this case, future returns. The price for the product is the valuation. Naturally, during the negotiation process price is one of the main topics. But the analogy with selling a product clearly ends there. Unlike the price tag on a washing machine or used car, where the future value is subject to simple and well accepted formulae, the future value or returns of a startup is subject to more complex interpretation. It’s a figure so highly individual and incomparable, that there is no golden rule for setting the price.

“Investors are greedy, they want all of my startup!”

We always try to tell founders (during seed-stage deals and also in later rounds): don’t optimize for valuation. Now you could say „Of course, you’re an investor, you want to get as much as possible from my precious company, lower valuations make more sense for you“. Wrong. We want to have a fair share in a successful startup. We don’t look for the lowest valuation, we look for the right valuation. Why? Because the wrong valuation can make or break a startup. What is a fair share? Big enough to make us take good care, small enough that the founders are motivated.

Let’s get into a bit of background. Chances are high that we as a Seed Investor are not the last investor you might have. We’ll invest up to 500k, but you will most likely need more money, depending on your product and the industry you are in. Investors come in clusters or “rings”, much like an onion skin. There is the right investor for every phase, and that means every investor has a different sweet spot and a different valuation range. So getting the right valuation for your startup is an options game, where you have to try to keep as many options open as possible, and then close just the right one.

If your valuation in the Seed phase is too high, you automatically exclude a certain cluster of investors. This is because your current valuation plus the near-term increase based on your traction or progress, will lead to a new minimum valuation for future rounds, and that new valuation might put good investors out of range. And conversely, if your valuation is too low, investors that want to put in a certain sum (because of their business model or investment strategy) will get too many shares (yes, there is such a thing for investors as ‘too many shares’). If founders are heavily diluted in early rounds, future fundraising can be impossible. Investors might decline if the valuation is too low, or worse, just keep you waiting until you “get more traction”. If you fall below that critical sweet spot, you could face the ‘Long NO’.

So valuation is much more a signaling and a targeting exercise than about maximizing a number. A professional investor will want a certain stake in the company to devote the necessary attention, so it’s not only about the ownership, it is also about focus.

But valuation shows how awesome we are

For many founders valuation seems to be a sign of success instead of a means to an end. Focusing too much on valuation is an easy trap: valuations seem comparable at first sight; and everyone talks about valuation. But the very important value brought by the right investors is not so easily assessed. Let’s look at a common example that might show the difference between value and valuation: at Speedinvest, we frequently come across startups that have managed to get Business Angels on board early on. Often they pay enormous valuations in early stages, because a) they are happy whatever the result may be (Roulette), b) they don’t care about the next round (Inexperienced) and c) they will be a minority shareholder going forward anyway, not putting a lot of focus or effort in (Distracted). Would you play Roulette with someone who is inexperienced about the game and easily distracted?

Many founders then wake up in the next funding round, finding out the hard way that no professional investor will pay the valuation increase they expected. The story that “so much has happened since our last round” doesn’t work if you are too expensive for the investor. Down rounds are bad. Very bad. They create the signal that “something didn’t go as planned” and they need a lot of explanation. In this case it is far better to have a nice, easy, upward trajectory. You might show slow growth and get by on bridge rounds for a little while, but at least you are moving consistently in the right direction.

Using valuation as a measure of success is a trap. Paul Graham puts it this way:

„Not only is fundraising not the test that matters, valuation is not even the thing to optimize about fundraising. The number one thing you want from phase 2 fundraising is to get the money you need, so you can get back to focusing on the real test, the success of your company. Number two is good investors. Valuation is at best third.“

So optimizing for higher valuation will

  1. Take you longer, defocusing you from what actually matters, your business
  2. Get you lower quality investors, that will not contribute much
  3. Hurt you in later phases, because of inflated expectations and limited options
  4. Not make you rich.

Looking for the right investor, that helps you get to the next phase, is much more important than anything else. Focusing on raising your round quickly also matters. 2 % more of your startup won’t make a change.

PS: Some words on convertibles.

Convertibles are growing increasingly popular among founders because you can “close the round quickly” and, probably the strongest argument, you don’t need to set the valuation (yet). Both assumptions are wrong.

In fact, no decent investor will forego the process of defining how you want to work together or fail to put that in writing (e.g. investment agreements). So you’ll end up drawing up the same list of terms as you would in a priced round. It looks quicker, but in truth it isn’t.

The benefit of setting a higher valuation, because it’s a cap (upper limits) and has a discount, creates the same signaling problem as above. If your cap is too high, you end up with a down round, with the serious risk of giving away more than you wanted, just because some things don’t go as planned. Floors (lower limits) are pretty uncommon in Europe still, and those would limit the potential damage.

Additionally, if you happen to raise a lot of money with Convertibles with different caps, the math quickly gets ugly and it becomes really hard to tell a potential new investor how big the round actually is and what the valuation will be. All the convertibles add up, thus increasing the round and all of a sudden you are raising a seed round in the millions, with most of the money already spent in the past.

Convertibles are good in two cases only: 1) if you think that you can scale the business substantially in the next months and need some money to get there from your existing investors or potential investors to reach the next financing round or 2) if you are raising some small tickets from casual investors, that don’t want to negotiate terms heavily, are insensitive of valuation and are fine with the instrument. In all other cases, do an equity round. It will save time, work and trouble.

Good reads:

http://jackealtman.com/optimize-for-success-not-equity

https:[email protected][email protected]success-6028afb236a7

http://www.xconomy.com/boston/2015/01/12/seven-surprises-about-convertible-notes-that-founders-should-know/

 

 

 

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