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  • Peter Lee - Baroda Ventures 7:22 am on June 11, 2009 Permalink | Reply  

    Valuation optimization vs maximization – what is the real goal? 

    One of the most confusing and misunderstood concepts to entrepreneurs is around valuation – not only in how it is determined (that is an entire post itself which I won’t try to tackle right now) but more importantly, what should the goal be?

    I think for entrepreneurs who haven’t been been through fund raises already, the first and obvious reaction is the get the highest valuation possible and if you do, you’ll have “won the battle”. I guess it makes sense that this viewpoint is commonly held – in many other areas of negotiations, auctions, grades, sales deals, etc, the goal is to get to the extreme (either lowest or highest) and the closer you get, the better you did. Its how they got to where they are now – by winning and excelling in everything they did. They view the “valuation negotiation” with a VC just another competition to win.

    So, why isn’t this the right approach for entrepreneurs? (and the answer is not because I’m the VC writing this and I’m trying to convince you to take a lower valuation – but good try!). The reason is because a) the funding is a financing event, not an exit (the exit is when its decided whether you win or lose) and b) the prior valuation has a significant impact if and when another financing round is required. The exception to this is if this is definitely the last financing round the company will need before exiting – and even this has it pitfalls when it comes time to exit (see my earlier post about entrepreneur and investor alignment specifically regarding exits and the VCs need for high returns and a multiple on their investment).

    For the entrepreneur, the financing event and resulting valuation merely puts a number on the company value which then affects the percentage ownership the founder has in the company – but this doesn’t translate to real money that the owners can walk away with (I’m sure those of you who were at startups during the dot.com bubble but didn’t exit before the crash can relate to this quite well…). Its paper wealth. Funny-money. Remember 100% ownership of nothin’ is still nothin’…

    Valuation becomes a real issue for those companies that need to raise another round of financing (this may be where many of the entrepreneurs who raised money in the last 18 months before the market crash last fall start to perk up…). A high valuation (which 12 months ago seemed like a huge success) is now feeling like a huge albatross – a heavy burden on the company that may stifle their ability to raise money from an outside investor. This occurs because the prior round investors want to be rewarded for putting money in earlier through getting a higher “step-up” valuation in the next round. The new investor is often wary of companies with valuations too high as their expectations for a smooth round getting done is put at risk as they worry about spending a lot of effort for a down round that gets resistance or just gets done by the insiders (prior investors). In a startup, momentum is very important on how the world perceives your succes. When things continue to be on the “up-and-up” across all areas of the business – great team is built out, revenues increase, customer base grows, metrics improve….and valuation continue to rise round-after-round, everyone is happy.

    Now, just to be fair, on the other side of the table, it isn’t in the best interest of the VC to drive to the lowest valuation possible either. This is because if the founder/entrepreneur doesn’t have enough of an ownership stake in the company (especially after several financing rounds), there is a real risk that the founder may leave if he feels like the reward for staying isn’t big enough vs doing something else (starting another company, taking the big corner office at a cushy large company job, etc) – remember, being an entrepreneur is hard work and people need to be rewarded for their commitment.

    Somewhere in the middle between a valuation so high it risks future financings and a valuation so low it dis-incentivizes (I know this isn’t a word but it should be….) the founders is the optimal valuation. For the entrepreneur and VC, the goal should be to find a fair valuation for everyone. The entrepreneur/VC relationship is a long-term one, often 5+ years. Raise these concerns with the VC and get it on the table so both of you see each other’s perspectives and motivations. Its a good initial step in a very long journey that will ultimate be in both of your best interests. Remember, “winning the war” is the goal – exiting the company so that both you and your investor makes money through an exit. The fund raises and valuations are just a step along the way towards the final goal.

    As this topic can be a bit confusing, feel free to sign up for my office hours to discuss at greater length.

    [Update: 6/19/2009 Thanks to Ben Kuo at SoCalTech for the posting. ]

  • Peter Lee - Baroda Ventures 7:29 am on June 5, 2009 Permalink | Reply  

    Seeing Eye To Eye – Entrepreneur and Investor Alignment 

    Having seen many different start-up situations from both the VC side as well as the start-up side, the importance of investor and entrepreneur alignment is often under-estimated in its impact on everyone involved.

    For inexperienced entrepreneurs, this issue is not well understood and often leads to some of the biggest areas of disagreement and tension between the entrepreneur and investor. While there are numerous areas where this can occur, I’m going to focus on one where I find the most tension and misunderstanding of the issues. Exit options, VC fund sizes, VC/entrepreneur alignment, and founders’ outcome (in a future post, I will address some of the other issues such as CEO/Founder replacement, VC fund raising cycles and LP ).

    Before diving into this discussion, for those of you that are less familiar with VC fund economics, some background reading may be helpful. The first is more of a VC industry analysis by Fred Wilson of Union Square Ventures and the second dives more specifically into the economics of an example fund by Josh Kopelman of First Round Capital. These issues are well understood by VC’s as that is their industry and reflects directly on their own personal economics as it relates to carried interest in their fund (i.e., think about a sales persons understanding of their own compensation/commission structure and how it affects their own motivations and economics).

    So, how do the different fund sizes affect VC and founder alignment? Lets first look at it from the VC side and take 2 examples – a large fund of $400-500M and a smaller fund of $50-100M. If you read the background material and/or already understood VC economics/dynamic, there is a difference between how partners at each of those funds will look at exit sizes that are considered worthwhile/successful/attractive. Much of this really boils down to the amount of time each partner has to sit on boards and work with their companies if they consider themselves active investors. With the number of boards that can reasonably be held by one partner in the 6-8 range, this limits the number of investments he can make, which then dictates the average amount of money he typically needs to put into a particular investment, and ultimately drives the need for the size of exit he needs to make the economics work for the fund and himself. In the 2 example fund sizes, obviously larger funds typically need to put in more money (often $10-15M per company) and thereby requiring large exits (in the multiple hundreds of millions per company minimum) vs a smaller fund (often $2-5M per company and with exits in the sub-$100M range reasonable from a fund and personal return perspective). The constant here is that both investors have the same amount of time and bandwidth and will typically do the same number of investments per fund. For an entrepreneur, it is fairly straightforward to see the differences between the 2 types of funds just based on fund size and number of investing partners.

    Now lets take a look at it from the founder/entrepreneur’s perspective where there is also a wide range of “personal economics” that matter. To simplify, I’ll just use 2 examples – an entrepreneur who is looking for a large personal exit (one that will make him $25-50M ) and an entrepreneur who is looking for a moderate personal exit (one that will make him $5-10M). Often this is largely based on their personal economic situation at the time (i.e., an already successful entrepreneur who has had his first good exit and put away $5-10M in the bank vs the entrepreneur who maybe has seen modest success with less than $1-2M put away).

    Given these two perspectives (VC vs entrepreneur) and the different fund sizes and entrepreneur exit size preferences, this is where investor and entrepreneur alignment becomes critically important in “Seeing Eye To Eye.” Putting my consulting hat on and analyzing this using a 2×2 matrix…


    In the matrix, the green represents good alignment, the yellow represents ok but keep watch, and the red represents where I see some of the larger disagreements. The matrix explains the basic situation for all 4 combinations so I’ll just focus on the yellow and red areas as the green areas are fairly self-explanatory and straightforward.

    Yellow – Smaller VC fund, Smaller exit need, Entrepreneur looking for large personal win $25-50M. While there is some misalignment here, this is actually a less common situation and often doesn’t become an issue in practice. The reasons are that many entrepreneurs looking for big exits often have already had one hit and have plenty of personal funds. They often use their own money to self-fund the business initially and often don’t need a small amount of outside money but go straight for a much larger Series A from a larger VC. In addition, even for smaller funds who do invest early with these entrepreneurs, if the company is doing very well, those investors are happy to bring in larger VC syndicate partners who have deeper pockets and can fund to a much larger exit. The smaller VC will get a good bump in valuation and is happy to leverage their investment to go for the big exit that the entrepreneur and new VC seek.

    Red – Larger VC fund, Larger exit need, Entrepreneur looking for moderate personal win $5-10M. This is where I see the most misalignment, conflicts between VC and entrepreneur, and the primary focus of this post. The conflict occurs in many different situations – whether a company is doing well or not. When companies are doing well, they often have opportunities to exit earlier from incoming acquisition offers. For an entrepreneur who has an opportunity to exit a company at $50M and thereby allowing the entrepreneur to personally make more than $5-10M, this often isn’t big enough to interest the VC who can block the exit and push the company to go for higher exit size (but often a much higher risk to the company). Other areas that this occurs is when determining whether to grow/expand quickly vs getting to profitability. For an entrepreneur to reach his objective, slower growth but getting to profitabilty faster can be the best option, but for the VC, growth over profitability is often the objective thereby require more spend and often leading to more financing rounds diluting the entrepreneur….and these disagreements occur when the company is doing well so generally everyone is happier and want to work together. The misalignment get much more contentious when the company is not doing as well.

    Given the varied perspectives of different VCs and entrepreneurs, founders should make sure they understand this dynamic (as the VC will definitely be experienced and understand this well). Ultimately the VC/entrepreneur relationship is a long-term partnership (you may be stuck together for 5+ years). Make sure you go into the relationship understanding each others motivations and goals – it will make for a much more productive and less contentious relationship.

    • Charissa 10:57 am on June 5, 2009 Permalink | Reply

      I love the chart and breakdown of aligning with investors-its really helpful as I’m in the process of seeking funding. I agree that its important for the entrepreneur to do their research and make sure the VC or Angel is funding in their space and the amount that they fund is in alignment with the entrepreneur’s needs!

    • Jose daVeiga 11:52 am on June 8, 2009 Permalink | Reply

      This is a great article. Got me thinking on other permutations – from the entrepreneur’s viewpoint only – of course. There is that one instance where small investors think they have to behave like big ones and things get to a point of open conflict when the company is not doing well from their standpoint of “we are big”. Unfortunately this is usually compounded by an attitude that is hands-on also based on assumptions and hearsay about what the “big guys” do. Of course I am talking about money that thinks it’s smart and isn’t. Is the yellow really a problem? I would always be happy with an over-achiever. I think the problems, from a VC standpoint are great(er) when it’s in the Red. On another hand, as I said, I can think of a permutation of this entirely from a entrapreneur’s standpoint which would in some ways be very much a mirror of this one – the idea being that all companies run into trouble and the higher percentage of troubles are those caused by the hardships on the way to success….

    • Will Chow 3:58 pm on July 18, 2009 Permalink | Reply

      Every professional investor has a clear goal for their exit size, but I think many entrepreneurs do not. Starting something is attractive often because it is about discovery and excitement, which runs counter to something as clear and tangible as the exit. IOW, I think a cause for the misalignment is that entrepreneurs often don’t have a well-formed exit target, making exit alignment a desirable but oft-ignored goal. My personal feeling is that there are many entrepreneurs (especially the geeks, probably) that either don’t want to think about their desired exit (doing so can be distracting, hubristic, and stressful) or simply don’t have one (ok, I’m not one of the latter, but definitely yes on the former). After all, there are a lot of motivations to do a startup, besides exit size. But that doesn’t mean you can’t get more closely aligned. As an alternative, VCs can (and do) probe along related angles, to understand what is driving the entrepreneur: e.g., do you want to change the world (or are you happy to just have some happy users)? You may not get number out of him, but if you try hard enough, you should be able to figure out which box he falls into.

  • Peter Lee - Baroda Ventures 4:05 pm on May 30, 2009 Permalink | Reply  

    My version of the elevator pitch – a 100 story highrise with multiple stops along the way 

    In meeting with entrepreneurs, especially those that I haven’t met or heard about before, I often ask them to give me the 5 min overview of the business before we dive into any details or the formal presentation deck. I typically ask for this before I ask for the entrepreneurs backgrounds – for reasons which I’ll get into shortly.

    The commonly heard 30 sec or 1 min elevator pitch is ok when an entrepreneur is pitching a customer or for PR or other audience that isn’t looking at the business holistically but is only interested in 1 or 2 aspects of the business. For a VC though, it is just not enough time to cover the information to get me interested. In the 30 sec or 1 min pitch, there is barely enough time to cover the market and product let alone competitive differentiation, business model, industry trends, financing plans. and key metrics such as customer acquisition and average revenue per user. The entrepreneurs’ ability to convey the business concisely in a compelling manner is a huge indicator of their understanding of the business as well as how they will think and act when running the business. What surprises me is how many entrepreneurs are so bad at this.

    In a startup, one of my favorite sayings is “you can do anything, but you can’t do everything.” With limited time and resources, entrepreneurs must cut through the clutter and focus their time and attention on the most critical issues. A founder or CEO who can’t explain the key aspects of his business concisely and rambles on about un-important details worry me that he will behave similarly when running the business.

    The 5 min overview should be a mini version of the entire pitch but forces the entrepreneur to really hone in on the most critical aspects of the business that will influence its success or failure. Like Mark Twain’s famous quote, “I would have written a shorter letter, but I did not have the time,” the ability to quickly and concisely explain the business indicates to me that the entrepreneur has really thought about and understands his business.

    The reason I ask for the 5 min pitch before the entrepreneurs’ bio is that I actually like to judge the attractiveness of the business independent of the team. When I hear the bios of the founders first, it obviously sways me (which it should) as I hear the rest of the business. While the fit/capability of the team is paramount to my decision, I find it is better left until after I understand the basic premise of the business so that I can really assess the business purely on its own merits. After this, hearing the entrepreneurs’ backgrounds allow me to then assess their ability (and hopefully their clear advantage) in executing on the business.

    In VC, when I am assessing the “fundability” of a company, I find that out of the many many factors that can influence the business, it generally boils down to 2 or 3 critical issues that make the decision. If these 2 or 3 issues are negative and all of the other issues are positive, it still kills the deal for me. The best 5 min elevator pitch is the one that has done this work for me.

    Now…once you have me hooked on the business and then the team, we can have a productive meeting getting into the presentation deck and questions about the details of business.

    • Zev Posner 8:37 pm on September 21, 2010 Permalink | Reply

      If you have a great idea and BP with a great URL to match – how do you get a good team to help you identify revenue – execute etc… ? if you think you are weak in that area – as for the 5 min pitch – it is the hardest one to do but if you cant you are not ready for the game!

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