As anyone who follow the start-up world knows, valuations for high potential young companies as of late have been trending upward (how's that for an understatement) and are fairly divorced from underlying traditional (ie revenues and earnings) metrics. This is currently true with both "later" stage companies such as Foursquare's $600M valuation and earlier stage companies that are seeing pre-money valuations that are 1.5-2 times what one would expect to see in "normal" markets. As an entrepreneur this naturally sounds like good news, and it largely is, although I thought it might be helpful to share some of the perspectives from the investor side as well as some potential watch outs.
As an investor, when to "pay-up" for a compelling opportunity is one of the more difficult decisions we make on the new investment side of our daily lives. If you do it across the board, you will end up with a portfolio that has sub-par performance, but if you miss out on great companies by being too disciplined, the opportunity cost is exceptionally high. So when confronted with such situations as an investor, some of the things that cross our mind are as follows:
- Is there downside protection in terms of the underlying asset? The best example of this that I recall is a conversation I had with one of my former partners at Greylock in discussing their investment at $500+M value in Facebook. At the time he told me that he was unsure about the upside from there, but that he was sure given the company's user growth, early revenues, relatively limited capital raised to date and the company's strategic importance, there was no way way they were going to lose money on the investment. On Wall Street, they call these asymmetric trades: lots of upside and low downside. While they may not all pay off, it can be a savvy approach for an investor to take.
- Is the amount of capital being raised sufficient to get through important milestones? Even if they long term upside is high, if the capital being raised at a high valuation is not enough to get the company through enough value creating milestones that allow the next round to be at a higher price, it is unlikely to be worth pursuing as the pain of down rounds,the impact on morale and other issues can be painful. Interestingly, this thought process often leads to larger rounds, with more dilution for entrepreneurs, and creates a whole host of risks that come along with too much capital such as lack of focus and unrealistic expectations.
- The last, and perhaps most obvious point, is that as an investor when you are reaching in terms of valuation, it needs to be for the right reasons. At Flybridge, we rank our investments on a host of criteria including the strength of the team, the size of the opportunity, how robust the business model is, whether there are real network effects and how disruptive the approach is. to reach on price, we need to be convinced on all dimensions as the criteria together indicate a strong likelihood of creating a lot of value and that the company can quickly grow into the value being established. The wrong reasons to reach are competitive pressures or investments that are viewed as strategically important for the venture firm's brand. Our LPs don't pay us to win all the time nor do they want us to use their capital to create a perceived halo that comes from being involved in high profile companies.
From an entrepreneur's perspective, raising capital at high prices sounds like a great thing. There are, however, some words of caution that are worth running through having had a first row seat in the last overheated market. The first is to recognize that a successful fund raise does not equal a successful business, so don't believe your own press and take an eye off running the business lest the next round be more challenging than the one you just closed. Second, be careful about pushing your investment partners too far. I remember one company where we were A round investors and they raised a Series B at very high prices and the VC director that came along with that financing was extremely dysfunctional when the business hit the inevitable bump in the road. I don't think he was a bad apple, but rather was under a lot of pressure with his partners having gone to bat for the high price only to have the company do well, but not well enough to justify the valuation. Finally, as alluded to above, reaching on valuation too early implicitly raises expectations that you have for yourself and others (employees and investors) have for the business and this can lead to the pursuit of overly aggressive strategies too early. So the final word is be aggressive, but realistic.