The Valuation Trap

With the Linked In valuation hovering around $7 billion in the public market, I thought it would be appropriate to discuss how the private market is currently valuing pre-revenue companies.  In doing so, maybe I can help a few early stage entrepreneurs avoid what seems to be a more and more common financing pitfall.

A lot of people have written on the issue of early stage valuations, and I’m not going to try and explain how we, as investors, go about placing a precise value on something with no revenue, no operating history and, occasionally, no product. Suffice it to say, it is as much art as it is science.

In addition, because this post runs the risk of sounding incredibly self-serving, I thought I would make one point up front: I cannot think of a single instance where I have not made a seed or early stage investment solely because I could not close a reasonable gap in valuation.  When you are looking at companies at the very start of their life cycle, the real value creation is in front of them. As long as both the investors and the company recognize this fact, there is almost always a compromise to be found.

With that behind us….

Despite what anyone says, the largest single factor in pre-revenue valuations is the marketplace in general.  Good old supply and demand economics. Depending on where we are in any given economic cycle, there is always an “acceptable window” within which the vast majority of company valuations fall. Where any given company lands within that window is determined by unique and extenuating factors like size of the opportunity, the experience of the management team, intellectual property, etc…

What I am seeing today, however, is far more seed and series A stage deals with valuation asks that fall well outside of the market window.  I don’t mean valuations that are on the high end of the spectrum, or just outside the window.  I mean valuations that are 2, 3 even 5x what the market is currently supporting.

This phenomenon is partially the result of general market dynamics — most notably the overall rising tide.  Its no secret that the venture market is once again frothy.  A few big exits have reverberated through the marketplace and, as a result, the valuation window is inching upward.  This is natural, and to be expected.  Success breeds confidence.

In addition, the web 2.0 generation of entrepreneurs is well into its second cycle.  In other words, many founders who built successful companies in this current technology cycle are on to their next venture.  They are able to demand higher valuations — and rightly so.

In a strong market, there is also more competition for deals.  As a result, vcs tend to be more aggressive in their courting of prospective investments. At times, this behavior can lead entrepreneurs (particularly first timers) to feel slightly over confident in their ability to attract capital.

Finally, without making a sweeping generalization, my own observations have led me to the conclusion that “brash” is in among a certain subset of the start-up community. Ten years ago, it was cool to be geeky (Bill Gates was the standard bearer).  Five years ago, there was a shift towards detached intelligence (i.e., the the casual confidence of Steve Jobs).  Now, we seem to be living in the Mark Zuckerberg era.  Think big, be confident and don’t take “no” for an answer.

Anyway, regardless of the drivers, we are seeing more and more “bold” asks out there from pre-revenue companies, including valuations that, by any measure, are far outpacing the rising market.  The result, rather predictably, is that these companies are taking longer to get funded, and if they do, it is often at significantly lower numbers then where they started.

So why do it?  Why make the big, bold, and usually unrealistic ask? When I pose the question to entrepreneurs, I often hear some variation of “why not?” After all, there is a chance they will be successful, and if not, they have made sure that no money has been left on the table.

Well, here are a few thoughts on why not:

1.  By asking for a valuation that is outside the scope of reasonable, you are telling potential investors that you either don’t know, or don’t care about, the rules of the venture capital game.  This is a dangerous signal to be sending to potential partners who make a living playing by those rules.

2.  At the end of the day, you are probably bluffing.  If you go back to those investors with a significantly lower number, you have already begun to erode the most crucial element to any investor/entrepreneur relationship: trust.

3.  Even if you manage to get a deal done at a high valuation, you have also managed to greatly increase the likelihood of a future down round. One of the keys to long term financing success is the ability to show strong, steady growth. The early years are sure to include a few hiccups, stumbles and pivots. By setting a high hurdle for the next financing, you have limited your strategic flexibility. Have a long term view, and set your company up for success. Mark Suster wrote a great post today where he encouraged entrepreneurs raising capital to shoot for the “top end of normal” so as to avoid this very predicament.

4.  Time kills deals.  While you are focused on your fundraising efforts, your competitors are building their business, investors are becoming interested in other deals, and markets are changing.  Less time equals less risk.

We’re in a market where hot deals are getting done, and getting done at decent valuations.  At the same time, the investment community is still spooky, and deals perceived as cold, stale or flawed, are dying on the vine. Therefore, be smart about your valuation. Ask for what you deserve, set yourself up for success, but get it behind you. There is real value to be created.

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