The delicate art of fundraising and valuations
By Justin Hall December 5, 2014
- To investors, a valuation is intended to maximise positive returns on their portfolio
- To entrepreneurs, it is the literal quantification of their hopes and fears
VALUING an early-stage company can be a sensitive issue, for both entrepreneur and investor alike.
Early-stage entrepreneurs might not have much in the way of revenue, traffic might have plateaued, and their website might not be much to look at right now.
But they were the ones who stayed up through the night when their database servers crashed; they were the ones who subsisted on ramen noodles for weeks on end so they could put more cash into marketing; and they were the ones who suffered the indignities of being rejected by yet another potential investor because they didn’t have enough traction.
READ ALSO: GrabTaxi’s US$250mil round: The pressure is on
Yes, valuing an early-stage company can be painful.
To investors, determining an appropriate valuation is nearly always a financial decision, a calculation intended to maximise positive returns on their portfolio.
To entrepreneurs, a valuation is the literal quantification of their hopes, fears, and their indomitable, unassailable stubbornness. The process of financially quantifying the unquantifiable can be tremendously difficult, even traumatic, for founders.
When fundraising, their immediate urge might be to place a large price tag on their company. This protects their financial interests by reducing their degree of dilution, while giving sufficient justice to the sheer number of sacrifices they’ve made to help grow their startup from 0 to 1.
Oftentimes, this price tag is beyond what others – especially investors – might consider reasonable or fair for the startup.
While a large price tag might seem an indication of success, founders would be wise to remember that fundraising is a marathon, not a sprint. And sprinters can stumble long before they get to the finish line.
Fab.com was once valued at US$1 billion, and now it’s barely worth US$15 million; Digg, the would-be rival to now ubiquitous Reddit, was once worth US$164 million before eventually being sold for US$500,000 … and who can forget Webvan’s famous implosion at the turn of the century?
But because it’s so easy to understand, and perhaps because it’s the simplest proxy of their time and effort, founders will often push that number as high as possible.
This is misguided for the following reasons:
- Pushing a higher valuation does not always translate into better overall terms for the entrepreneur. An investor can easily exchange a high valuation for more opaque, harder-to-understand terms such as high liquidation preferences or participation on equity, or exorbitant discounts or interest rates on debt, to justify the investment’s price tag. In many instances, the terms can come out more positively for the investor.
- A high valuation can impede the close of a current raise. For your typical early-stage entrepreneurs, the startup is operating in the red from day one. When they start to raise funds, it’s a matter of life and death for their company. Having a valuation that is considered above the norm can dramatically slow the process of finishing a round, as investors will naturally take far longer to approve a deal if they’re not comfortable with the price tag.
- Most importantly, a high valuation can sink you when you need to raise again. Most startups will need to raise at least three rounds of funding before they become self-sustainable. A high valuation in the initial round will, by necessity, affect the valuations in every subsequent round. But investors, both existing and new, will always want to see a bump up in valuation every time the company raises funds. The alternative is a down-round, whereby the price per share is lower than in previous rounds. This is an absolute red flag to investors. If entrepreneurs ask for too high a price in their current round, they must grow enough to justify at least a moderate bump up on that valuation when they raise again, otherwise they’re dead in the water.
They should do the exact opposite:
2) Determine what would be an appropriate level of dilution. This doesn’t mean giving away 50% of your company; this means giving enough to entice investors while giving you enough ownership of your company to keep you involved even after several more future rounds (and subsequent dilutions).
3) Establish a valuation based on that number. For example, you need US$500,000 to survive 18 months, at which point you’ll raise again. You believe a reasonable dilution given the stage of your company would be 20%. Hence, your pre-money valuation would be US$2,000,000.
4) And don’t forget to understand what your local market can support. If you are raising a US$5,000,000 seed round in a region where a typical seed round is literally a tenth the size, then you simply will not raise.
Early-stage investing is more art than science, but it doesn’t necessarily need to be that way. Entrepreneurs can and often will change investors’ minds if they reasonably and precisely explain why their startup should be valued at a certain price.
Establishing a trusting, working relationship with investors, especially at the outset, goes a long way in creating outcomes beneficial to all sides.
Valuing an early-stage company can be painful. But it doesn’t have to be.
Justin Hall is an associate at Golden Gate Ventures, an early-stage fund based in Singapore. A former Rakuten Network manager and scholar at NUS, he sources investable early-stage technology companies from South-East Asia. You can reach him via Twitter at @JVinnyHall.
Reaching out to investors, and the cold email
Startup consolidation and the recipe for regional success
To SEA’s Goldilocks startups: Consolidate or die
The ‘Delaware model’ and why Singapore is kicking butt
For more technology news and the latest updates, follow @dnewsasia on Twitter or Like us on Facebook.
Author Name :
By commenting below, you agree to abide by our ground rules.