In Part One of this series on launching a venture in the Ed-Tech market, I reviewed the steps one might take in building a fresh team and preparing to seek outside capital for the business. Now, I would like to move to the funding piece of the game, and particularly the art of identifying a proper valuation in the world of venture capital.
A friend of mine was telling me a story over lunch the other day about a guest lecturer in his entrepreneurship course (he attends a rather notable MBA program in Manhattan). Without revealing too much detail, this gentleman had himself an early-stage venture with a grand vision and little traction to show for it, but a few VCs were sniffing around like a young Lagotto Romagnolo catching its first whiff of ectomycorrhizal fungi. Said guest lecturer boasted to his crowd, “Before my first meeting, I valued the company at somewhere between $5-7 million. I went in there, chest-puffed, and told them, ‘this thing is worth $100 million.’ By the end of the conference, I secured a $50 million valuation.”
My buddy recalled the details of the story in the same manner I would evoke a Tom Brady two-minute drill: twinkle in the eye, giddily tripping over words, drool slowly cascading down the chin--utter intoxication. To him, this apparent swindling seemed to be something akin to the entrepreneurial dream: I HAVE A $50 MILLION DOLLAR COMPANY!
He sat back enraptured in entrepreneurial lust - I, in turn, sat back twisted in investorial disgust. Is this really what is being taught at elite business schools??? How could it be??? I quickly began rethinking the idea of my own B-School application this coming Fall (unless you would have me, Stanford. Pretty please accept me?).
Too often in this venture capital world do people get caught up in the euphoria of the equity raise, the idea that, by enlisting a team of investors that put a high valuation on your company, you have won. In fact, it is quite the opposite. What a high valuation really means is you now have even higher benchmarks to pursue and even greater pressure from your investors, Board of Directors, and even your employees. Yes, you are able to maintain a nice ownership percentage of your venture, but at what cost? How well-positioned for future expansion have you truly left yourself? And after all, isn’t that the POINT of venture investment?
Early stage equity raises are rarely, if ever, the last bit of outside capital that will make its way into the company. And frankly, by making the decision to seek outside capital in the first place, you are essentially sealing your fate to raise more money in the future because with VC money comes two unyielding expectations: fast growth and an exit strategy. There is certainly no harm in owning a nice company that builds slowly, stays lean and cost efficient, and over time becomes a cash flow positive business that can hold its own and grab a piece of the market; but if this is your goal, venture investment is not your game.
This is why the art of valuation is at once a tender dance, a romance or seduction not unlike a bird-of-paradise waltzing its plumage with elaborate precision, as well as an exercise in discipline and concrete economics filled with trailing revenues, market sizing, and comparable transactions. The entrepreneur, likely courting multiple term sheets simultaneously from investing groups of varying strengths and weaknesses, and the investor, weighing the virtues of what this company is worth in a vacuum vs. what it may take to close a deal in the real world, glide across the dance floor of negotiation, never getting too close, but never breaking too far apart. This tango is further complicated by the inconvenient truth that venture-stage valuation is nearly impossible - there is no RIGHT answer, though some answers are MORE right than others. And there are certainly WRONG answers.
One thing is undoubtedly true - the best valuation is the one that satisfies both the investor and the entrepreneur. If, as the guest lecturer noted above has accomplished, you are able to swindle a group of VCs and secure a valuation well above the actual stage of your company, you may face a tough road ahead. As previously mentioned, with lofty valuations come lofty expectations. VCs typically like to make sure a company has at least a year (if not two years) worth of capital to support operations upon closing a round of funding. This gives an entrepreneur some breathing room to go heads down and grind, tweak the business model and begin scaling production/distribution/sales/etc. But this capital will dry up, one way or another: either the venture is not taking off as expected and revenues are doing little to combat expenses, or the venture is cruising along so successfully that the entrepreneur should once again place his proverbial foot on the accelerator and increase the company’s burn rate.
With an overly high original valuation, the entrepreneur will find it hard to raise this next round of capital. Sure, you may have swindled that first group of investors, but the next group will take one look at the capitalization structure and quickly realize something ain’t right. You will find it exceedingly difficult to secure that next round of capital as investor after investor is scared off by the valuation, and they will insist on the dreaded “down round,” or a valuation at lower cost than previous funding - something existing investors will push back on with the ferocity of a black rhino in mating season*. Nobody wants a down round.
Of course, all this wooing of uninterested new investors coupled with combating your current investors winds up draining an entrepreneur of his most valued commodity: TIME. They say time is money, and in the world of venture capital, this is doubly true. Time spent negotiating capital structures is time NOT spent selling products, or engaging customers, or recruiting engineers or executives, or even catching a couple extra Zs and coming in fresh and energized. Any way you play it, a lengthy fundraise process is a detractor to the health of the venture.
Perhaps you are lucky enough to have those early investors with the skewed perception of value simply re-up, continue funding the venture at the will of the entrepreneur. But this is rarely the case. Furthermore, the type of investor you want as an angel is typically different from the one you want leading your A round, which in turn is different from the B, and so on and so forth. Early on, you may be looking for more operational guidance - someone that has played this venture game before and understands the concerns of a young company still finding its way and growing its core team. But as things expand and your business reaches new heights, you may want to find a more strategic partner - someone with expertise and distributive capabilities in your given field, someone that can negotiate and empower strategic partnerships at significant scale, someone that can ultimately position your venture for a fortuitous exit. These folks are rarely if ever the same as your early backers. These are the folks you want your business primed to impress. These are the folks that will see an overpriced venture and scoff.
Scoffing = No bueno.
This also applies to a valuation that is far too low, by the way. If a company has raised venture capital and given away too much ownership stake, new investors will take serious issue with a perceived lack of incentive. The idea is that if an entrepreneur does not have enough riding on the ultimate outcome of the company in terms of equity, he will perceive the venture as more of a day job and less of a life passion. As an investor, you want your entrepreneur to live and breathe his company. If his compensation is skewed more toward the paycheck and less toward the pot of equity at the end of the rainbow, he will ultimately not yield the same work product. As my partner Matt often likes to say, “we want entrepreneurs that are on fire.” It is tough to catch the proverbial flame without being properly incentivized through ownership. If a company receives a valuation that is far too low and still has the legs to reach a next stage of funding, the new investors will simply reset the option pool to an appropriate level of incentive, and the investors of old are likely to take a hit anyway.
The entire concept of venture capital hinges on the idea that a young company can leverage old money (and its associated connections/introductions/guidance) to significantly accelerate growth, capture an audience, and grab land. This is a multi-step process with tangible layers of advancement. One misstep can throw off the entire staircase. Valuations by their very nature MUST reflect an accurate portrait of performance to date + legitimate future expectations.
So I plead with you, oh great Business School professors and guest lecturers - quit teaching this crap to the future entrepreneurs of the world.
*Lots of animal sex analogies in this one. I must have been watching Planet Earth in my sleep again last night.