In this climate, one of the more talked about issues in the venture community surrounds the way in which investors determine pre-money valuations for early stage businesses. With little or no revenue traction, an incomplete management team, and immature technology, most early stage companies have to sell the promise of growth and market opportunity in order to justify a decent valuation. It’s a tough sell in good times. In times like these, it’s darn near impossible. With fewer exits of significance and public markets still closed, VCs are increasingly back-solving from a reasonable exit value to get a pre-money valuation that makes sense. If 90% of exits are sub-$100 mm acquisitions, and the goal of any early stage investment is to get a 5-10x return, post-money valuations on most Series A investments need to be less than $10 mm. This is a reality that still hasn’t caught up with a lot of entrepreneurs.
So this is bad news for entrepreneurs, right? I’m not so certain… one of the most important outcomes of these more reasonable valuations is that VCs get larger ownership in companies. Once most VCs have characterized the risk in a deal and the money has been wired to the company, they turn their attention to the opportunity – how big could this company get? What kind of return could we see here? With larger ownership stakes, the VC has more confidence in the potential return they may see. That triggers a natural tendency to work harder for and on behalf of that business. A 5% ownership stake in a company makes it hard for the VC to really visualize a great cash-on-cash return. But make that stake 30%, and you can visualize that return – you think about it when you come in every morning, you spend that extra hour helping out where you can, you engage at a higher level. So while it might seem painful to accept a smaller than expected valuation, smart entrepreneurs use this to their advantage – it helps them engage with their investors at a deeper level, they can expect more from those investors and they can expect a stronger follow on commitment from those investors. Short term dilution can sometime translate into more stability in the investor base, a greater likelihood of success, and a happy investor base willing to invest in the entrepreneur’s next great idea.
Stay tuned…
{ 3 comments… read them below or add one }
Lance Weatherby 05.13.09 at 7:55 am
Logical article though being a successful entrepreneur/startup often has little to do with logic. : ) Here’s the rub. If the angels own 30%, the VC owns 30%, and there is a 15% option pool that leaves the founders with 25%. Assume there are three with 8% ownership each. Then take this simple math take into consideration most of the deals that I am hearing about are more along the lines of 40% so the three founders are holding 5% each. And the VC has liquidation preferences. A 5% ownership stake with liquidation preferences makes it even harder for the entrepreneur to really achieve a great cash-on-effort return.
I am being a little extreme to make a point but my general advice to entrepreneurs these days is don’t raise venture money in 2009 unless you absolutely must.
Greg Foster 05.13.09 at 9:03 am
I definitely think there are a lot of start-ups that think they are ready for VC and really aren’t. I agree they should wait. For those that are ready, the problem with waiting til next year is that a) there will continue to be contraction in the VC industry meaning fewer dollars to go around and b) I think there will be a glut of deals in the market with so many folks not wanting to raise money this year. 2009 might actually be a good year to raise money if you have a quality company.
Paul Freet 05.13.09 at 7:03 pm
I doubt many entrepreneurs will delight in the knowledge of their investors being more motivated while they are less so.
Today, in a VC backed company, just like in 2002, common stock is essentially worthless. Understand the reality of that and work to build a great success regardless.
Accept the harsh truth. In this economy, it is either your company or a VC-backed company, but not both. Entrepreneurs and investors need to stop pretending it is otherwise. So, think long and hard about why you are raising money.