Why you should take money at the maximum of a normal level.

Almost every day I talk with entrepreneurs and other venture capitalists about fundraising, about the prices of transactions and stocks, about how companies should take money, etc. In fact, I try to talk less and less about such things in public, because this is such a hot and emotional subject, where there can be a lot of points of view and they are all strictly subjective, and most of the questions are answered only by time.

Nevertheless, I decided to collect all the private positions in one topic and publish them in one place, as well as present them as a performance from the stage on June 15 as part of the Founder Showcase , held in San Francisco.

One of the topics I will raise right now. This is a little advice that I often give to start-up entrepreneurs: “take money at the maximum of a normal level”.
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That's what I mean.

Each company has a certain value. In public securities markets, this value is determined by the value that investors attach to the future values ​​of free cash flows , discounted to the current date, to obtain a time value of money . A rather simple fact arises from this complex formulation: the older the company itself and the area of ​​economy (industry) in which it operates, the easier it is to predict its future.

When investors are confident about the future of a company, they inflate its value due to the growth of perception, the subjective feeling that the future profits of this company and the industry will be appreciated by other investors. Therefore, the capitalization of publicly traded companies changes almost instantly, reacting to news that can change the future valuation, that is, the profit, of this company.

Every day, shareholders vote for the value, that is, the value of the company, by buying or selling its shares. There will be no price movement until one person agrees to sell the stock and the other agrees to buy it. Traditionally, shares of companies that a large number of people trade in are called liquid - which generally means that it is relatively easy to get into the company (buy shares) and get out of it (sell the shares).

Private, or closed, securities markets are the opposite. They are rather illiquid. If you invested during the angel round in a young company, it will usually be very difficult to sell the shares you received as a result - as a rule, it takes several years if you can sell them at all. So how are prices determined in such events?

There is no complex science here. The sooner you invest, the higher the chances that the company will not get anything out of the way (your risk is very high), plus you should not forget that you pay much less money per share than investors at later stages. As an investor, you are trying to pay an adequate price for the perceived risks during the growth of the company - its path to success, as well as to protect yourself the extra expenses that arise if you, for example, overestimated the company (after all, it still cannot assess itself). As these risks decrease, the company's valuation increases, its value, as well as the amount of money investors are willing to give.

Illustration No. 1, vertical vector: cost estimation . Vector horizontally: time . From left to right, risks: product risk, market risk, growth risk, monetization / competition risk .

Over time, some standards based on the risk of investors and the return on investment profile appeared in the valuation of companies. The obvious thing is that every investor is thinking about how to increase their own investments made in one or another company. People who invest in early-stage technology start-ups are looking for companies that are focused on rapid growth and are able to make a “way out” once - either to allow the giant operating in the same industry to devour themselves, or to make an initial offer (the notorious IPO). And the first, as a rule, more likely than the last. For this reason, most investors have certain ideas about which companies, similar to yours, usually participate in merger-acquisition transactions, and they also have, or at least should have, an internal ability to evaluate their profits in that If your company still makes an initial listing of securities.

Consider an example: if you had to invest $ 41 million in a company (again, suppose that your share in this case would be in the range of 33% to 50%), then the estimate of the value of such a company would be in the plane of $ 82-123 million. As an investor at an early stage, you usually plan to increase your initial investment (to exit) 10 times, compared to the amount on the first check, so you will expect the company to exit from $ 800 million to $ 1.2 billion. Then, after a little research, you find that literally a few companies have ever been bought for such a sum of money, so your investment is made in a one-to-one IPO. It is unlikely that you want to make such an investment in a product, or a market that has not yet consolidated (that is, it does not have strong positions in the economy), so this risk will not be acceptable to you.

But after all, if there is a statement that with the average amount of funds (the amount on the check) in the angel, or the first (A) round of investment , you should not worry about withdrawal, because if you climb into a share really early and at a low price - then what difference do you pay $ 5 million according to preliminary estimates or $ 15 million according to preliminary estimates - the main thing is that you invest in really large / fast-growing companies? Well, it is obvious that if you know in advance that the company will be big, this statement is an unconditional truth. But the reality is that you will immediately have to face two problems:

1 . The earlier the stage, the higher your risks and the greater share you will have in your pocket in order to win back at the expense of the losers (note: the law of the financial market is this: when someone wins, someone loses) .
2 The earlier stage you finance, the higher the likelihood that the company will need several more investment rounds, which will blur your share in the company.

Illustration No. 2, vertical vector: round / cost estimate , horizontal vector: time . At the peak: hot companies / booms , at the bottom: medium-sized companies / failures .

Each round will be assessed in a certain range, limited by floating levels, where prices at the peak characterize the most successful companies in the industry or the overheated market (2007, 2011), and the bottom prices do not describe the most successful years for investing (and looking for funds) (2003 , 2008).

Do not forget that there is no such thing as a “universal price”. The cost of each investment depends on many factors: team experience, type of business and industry (such as Round A of a semiconductor or bio-fuel company will be very different from Round A of an Internet company), geographical location, etc. Therefore, the range that you can expect will never be accurate. But in order to explain this in more detail, I will show examples of typical preliminary estimates of Internet companies in the largest markets in the United States (San Francisco, New York, Los Angeles, etc.), not forgetting that in San Francisco deals are usually made at higher valuations due to close competition between investors.

Illustration number 3: a normal market - neither bearish nor bull. Vector vertical: rounds / cost estimation . Vector horizontally: time . After the curly brackets, the amount of funds received by the company at different cost estimates.

This is my value judgment and I did not conduct any negotiations with anyone before putting the figures on the illustration. I show the approximate price range that I saw in the estimates of the value of Silicon Valley companies, as well as New York, Los Angeles, Boston, Boulder and Seattle. The figures are based on my personal experience, and I'm just trying to clarify the perennial question of entrepreneurs about what is happening in the market. Plus, there are always exceptions - they should not be forgotten.

In 2011, prices clearly increased, as shown in the chart below. The amounts are expressed in preliminary estimates of the cost, that is, before the investment.

Figure 4: bull market prices. Vector vertical: rounds / cost estimation . Vector horizontally: time .

Personally, I believe that investors need to accept the objective reality of how pricing is happening today in order to remain competitive in today's market, in the current environment. As always, prices are determined by standard factors: the quality of the team, the quality of the product or the market, as well as the competitiveness of the transaction itself.

Therefore, when I tell entrepreneurs that it is quite normal to try to shoot at the “maximum of a normal level”, I speak about the current market. In 2011, as a startup, you can generate huge demand, and you can certainly get, say, $ 3 million in round A with a preliminary estimate of $ 7-8 million, or even higher, which just a couple of years ago seemed fantastic. Today it is normal. This is what happens when you raise funds in a healthy and good market to finance your company.

What I warn all entrepreneurs against is getting money at valuation levels that are deliberately higher than they really are. I myself am a venture capitalist, and you might think that my logic is dictated by this very fact, but in reality this is not so. I have been preaching the idea that it is not necessary to stay ahead of my current estimates for the past 10 years. I received the first funds at a post-investment valuation of $ 31.5 million, in the financing round A, even without profit. It was the beginning of 2000. It was the then market. I first saw such estimates when I first entered this market in 2007. Later, many companies came to me that did not have a profit, and they all received $ 10–15 million with a preliminary estimate of $ 40–50 million. It is worth noting that although they had a product, they all operated in a limited market.

We have always ignored such transactions, although we often tried to conduct a dialogue about investing a smaller amount, with more realistic estimates of value. But to stop the train is very difficult. One company raised money at a preliminary estimate of $ 40 million and one of its representatives wrote about me in a public forum that: “Mark worked very hardworking and tried to understand our business, and also scrupulously treats all the details. But he and his company simply did not appreciate us. ” Well, that's fair. But they sold their business in less than 3 years, not for very big money, almost immediately after they received another batch of investments of $ 20 million. Another company in our field of vision was trying to get $ 15 million at a preliminary estimate of $ 60 million, with similar dynamics. They held a closed round, spent a ton of money and soon sold the company, which existed for less than 2 years, immediately.

That is the problem. If you do not have a tangible product or market, you still have a very risky business, and you are doubly risking, overestimating your own value. If you receive money at a preliminary estimate of $ 40 million, although on a normal, non-overheated market, you would not be worth more than $ 15 million - you will get% $ ect, because the market will be adjusted and you will need another round. In this situation, for any investor you are already the loser. Even if you have a super interesting story, most investors will not want to listen to this murmur because of a potential " down-round " (when later investors invest at a price lower than the original ones, that is, the cost estimate falls).

Finally, even if they agree to this, in order not to lose their money at all and will offer you such a round themselves, a smart investor will always know that this is “fool's gold”. He will receive a lower price, will tear you to pieces taking huge stakes, because make you give up on most of your own business. And you take this money - do you have a choice? In a maximum of 2 years, you will be planning to create the next startup. And the CEO, whom they will have to hire in order for the business to function somehow, will most likely be a mercenary from another industry. In general, you understand.

Therefore, here is my advice to you: go and look for money in assessments that a couple of years ago seemed unlikely. Use market competition to understand your fair (this does not mean real , it means fair ) value. Get more than you could or did before, but be sure to leave some of the money as a strategic reserve. Make sure that if you have to go through another round, you will be able to show the rising value of the company so that the new investor feels relaxed and maintains good relations with earlier investors.

Raise the price. But as long as you are not a very well-known technology giant, such as Facebook or Twitter, beware of ratings outside the normal range, normal for a bull market. If you are popular, do not take "like everyone else." Take on the maximum of the normal level.