Why Startups Should Raise Money at the Top End of Normal

Posted on Jun 5, 2011 | 54 comments


This article originally appeared on TechCrunch.

2 preamble issues having read the comments on TC today:
1: I know that the prices of startup companies is much great in Silicon Valley than in smaller towns / less tech focused areas in the US and the US prices higher than many foreign markets. I acknowledged this in the article. You can be pissed off, but I don’t set prices. I’m just making the commentary.
2: As expected at least one person accused me of writing this post because I want to see lower valuations. That’s stupid. I can’t control the market. When prices are too high I just pass. Simple. I wrote this because over the last decade I’ve seen a destructive cycle where otherwise interesting companies have been screwed by raising too much money at too high of prices and gotten caught in a trap when the markets correct and they got ahead of themselves.

I said both in the article but felt compelled to provide a statement up front for the skimmers.

I have conversations with entrepreneurs and other VCs on a daily basis about fund raising, the prices of deals, how much companies should raise, etc. I’ve stopped talking about this as much publicly because it’s such a heated, emotional topic where the points-of-view are strictly subjective and for which the answers will only be revealed in the future.

I’ve decided to take all of my private conversations and subjective points-of-view on the topic and make them public in a keynote speech at the Founder Showcase in San Francisco on June 15th.

I thought I’d post on one of the topics before hand. It’s the one bit of advice I find myself giving most frequently these days, “raise money at the top end of normal.”

Huh?

Here’s what I mean. There is an inherent value that any company has. On a public stock market that is the value that investors place on future free cash flows of the business discounted to today’s date to account for the time value of money. The more mature the company and industry, the easier it is to predict its future. When investors are feeling confident about the future they tend to bid up the value of public companies due to an increased perception that the future cash generated by the company will appreciate. The price of public stocks change instantly in reaction to news that is perceived to affect the future value of that company.

Every day shareholders vote on the value of the company by buying or selling shares. There is no price movement without one person agreeing to sell the stock and other agreeing to buy it. Stocks that have a lot of people trading are said to have a lot of liquidity, which basically means it’s really easy to get into (buy) or get out of (sell) the stock.

Private markets for stocks are the opposite. They are pretty illiquid. If you invested in the first angel round of a startup company it is usually very hard to sell your stock – usually for many years if ever at all. So how exactly are prices determined?

There is no great science to it. The earlier you invest the higher the chances the company won’t work out and thus you pay a lower price than later-stage investors. As an investor you’re trying to pay the appropriate price for your perceived risks of the company succeeding and protect yourself in the event that it isn’t quite as valuable as you had hoped. As the risks below get eliminated the higher the valuation investors are prepared to pay.

Over time some “norms” have emerged in pricing based on investors risk / return profile. The obvious thing that investors think about is making a financial return on the investment they made in your company. Early-stage investors in technology startups are only looking for growth-oriented companies that can achieve an “exit” someday – either via selling your company to a larger company or via an IPO. The former is much more likely than the latter. So investors have to have some general sense of what companies that are similar to yours ultimately sell for in the private market place via an M&A transaction and they have to have some sense of valuations on public stock markets to be able to back into what their potential returns on your investment might be in the event of an IPO.

For example: If you were to invest $41 million into a company (and one could assume that you owned between 33-50%) then the company is worth $82-123 million at funding. As an early stage investor you’re often planning around 10x your investment at the time your write your first check so in this case you’d be going into your investment expecting an exit of $800 – $1.2 billion. Then you can do a little bit of research and find out that very few companies ever achieve this valuation in a trade sale so you’re clearly gunning for an IPO. You’re unlikely to want to make this sort of investment with the product or the market not yet validated. The risk wouldn’t be appropriate.

Ah, but you say that for a normal-sized angel check or A round check one shouldn’t worry about the ultimate exit because he or she is getting in really early and at a cheap enough price so who cares whether one pays $5 million pre-money or $15 million pre-money – you just have to make sure you back really big companies. Well, obviously if you knew that in advance it would be big of course that would be true. But the reality is that you’re faced with two problems: 1) the earlier the stage the riskier and thus more write-offs so you need to have enough ownership percentage in your winners to make up for the losers and 2) the earlier stage your check the more likely the company will need many more funding rounds behind you and thus you face dilution.

So rounds tend to be “range bound” where the top end of the valuation spectrum often being done in boom markets (i.e. 2007, 2011) and for the hottest of companies and in bad markets for fund raising (2003, 2008) prices test the bottom end of the range.

There is no such thing as a uniform price. It is highly dependent upon many factors: experience of the team, type of opportunity (a big biotech or semi-conductor A round is likely to look different from an Internet A round), geography, etc. So the ranges you would expect can be highly imprecise. But to help with the explanation I’d like to put down some markers of typical Internet pre-money valuations done in major US markets (San Fran, NY, LA, etc.) while acknowledging that San Fran deals are often higher valuations due to increased competition amongst investors.

There is no value judgment in my putting up these numbers nor am I negotiating with anybody. I’m just pointing out my gut feel for approximate ranges of deals that I’ve seen with Silicon Valley having the highest valuations, NY / LA / Boston / Boulder / Seattle having valuations in a slightly lower range but comparable and sometimes significantly lower prices in markets that don’t have a healthy venture market. These are not scientific, just anecdotal and just trying to provide some transparency for entrepreneurs on what I’ve seen the market. And of course there are always outliers.

Prices have definitely gone up in 2011 as depicted in the anecdotal chart below. Again, prices are expressed as pre-money valuations.

For me I think that investors have got to accept the new reality in pricing if they want to remain competitive in markets like we’re seeing now. As ever, prices still determined by: quality of team, quality of product / market and competitiveness of the deal.

So when I advise entrepreneurs on fund raising I often say that it’s OK to try and shoot for the “top end of normal” for the market conditions. So in 2011 as a startup company if you can generate lots of demand you can definitely raise an A round of capital (say $3 million) at a $7 or 8 million pre-money valuation or slightly higher whereas just two years ago you would have struggled. That’s fine. That’s the deal you get when you’re raising in a good market for startup financing.

What I caution entrepreneurs from doing is raising money at significantly ABOVE market valuations. I’m a VC so I have an obvious bias. But that’s not where this is coming from. I’ve been preaching the “don’t get ahead of your inherent valuation” message for nearly 10 years. I raised my A round at a $31.5 million post-money valuation with no revenue. It was early 2000. That was market. I saw this kind of pricing when I first entered the VC market in 2007. We had companies pitching us that had almost no revenue at all and they were raising $10-15 million in capital at a $40-50 million pre-money valuation. I should also point out that while they had built their products they had limited market traction.

We passed on all of these deals and often tried to discuss the possibility of more modest amounts of capital raised and at more realistic prices. It’s hard to stop a train. One company which was raising at $40 million pre-money wrote a comment about me in a public forum saying something along the lines of “Mark worked really hard to understand our business and was very detail-oriented. But he and his firm were just too cheap on valuation.” Fair enough. But he sold within 3 years for not a huge price after having raised more than $20 million. Another firm we saw tried to raise $15 million at a $60 million pre-money with similar metrics. They did an inside round, spent a bunch of money and then went through a fire sale of the business less than 2 years later.

Here’s the problem. If you haven’t figured out product / market fit and therefore still have a highly risky business you run great risks for getting too far ahead of yourself on valuation. If you raise at a $40 million pre-money on what would in normal times have been a $15 million valuation you’re fawked if the market corrects and you need another round. To any prospective investor you look like you’ve failed even before your first pitch. Even if you have an interesting story to tell most investors won’t want to go through the brain damage of doing a “down round,” which creates tension between them and early investors.

Finally, even if they could bring themselves to offer you a major down round, the more sophisticated investors know it’s fool’s gold. They get a cheaper price, they wipe out much founder stock value and they reissue you new options. You’ll take the money – what choice do you have? But 6 months later you’re not working past 10pm. 1 year in you stop catching early morning flights. Within 2 years your evenings & weekends are spent planning your next business. And the CEO they would hire to come in and run the business when you go would always be a mercenary.

So my advice: go ahead and ask for a valuation that 2 years ago wouldn’t have been likely. Use competition to make sure you get a fair price. Raise a slightly higher round than you would have previously but keep some amount as a strategic reserve. Make sure that when you need to raise your next round of funding that you are able to show an uptick in valuation that is important for new investor confidence and to maintain great relations with your early investors.

Increase price. But unless you’re already a well-known technology heavyweight be careful about raising above the range of prices that are normal for a bull market. If you’re hot, don’t raise above normal. Raise at the top end of normal.

Other topics I’m going to cover at the Founder Showcase on June 15th:

  • Why I believe convertible debt with no cap is wrong for your investors
  • Why convertible debt WITH a cap is wrong for you
  • How much money should you raise?
  • When should you start talking with investors?
  • Why you shouldn’t stack too many brand names into a round
  • Are we in a bubble?
  • and more.

Hope to see you there.

  • Anonymous

    Words of wisdom there.  We raised at 10%-15% higher than market before the last boom and then got creamed b/c we were raising in a down market with a ‘hairy’ cap table.

    Be interesting to see the next few years.

    _XC

  • http://twitter.com/dariusvasefi darius vasefi

    Mark, I read the TC article and felt you explained the qualifications clearly but still get such comments – go figure… 

    On the valuation side how much of a difference does it make on either side if you’re up or down a couple of mil if you build a successful company?  If you have a good fit between the investors and founders and see yourself being able to work with them for 4-5 years or more then the number should not be a determining factor – if it’s fair as you mention.  If not a “good” fit personally and decision is based on the numbers mainly chances are good something will go wrong and everyone loses.

  • http://bothsidesofthetable.com msuster

    Hair is the death of companies in a down market. For sure.

  • http://bothsidesofthetable.com msuster

    Much more important to have a good fit than a perfect price IMO.  And raising at a high price that is 20% above historical is manageable. 100%+ and you can be forked.

  • http://www.aaronklein.com/ Aaron Klein

    Great post, Mark. We’ve purposely kept our cap table pretty conservative under the same thesis you state here.

    Can’t wait to hear you in person at Founders Showcase…hope we get the chance to say hi.

  • http://bothsidesofthetable.com msuster

    Thanks, Aaron. I should be hanging out a bit so come by and say hello and remind me of this conversation so I can place the context (although with Disqus I tend to “know” who people are more than I otherwise would.

  • http://www.aaronklein.com/ Aaron Klein

    will do!

  • http://twitter.com/dariusvasefi darius vasefi

    Sure, I personally would take a good partner over a higher valuation (or any valuation for that matter).

  • http://polidigital.org Joshua Ansell-McKinnon

    I am one of the people who is doing all I can to not get funding…But I know giving up equity can equate to acceleration and growth in business.  

    Bubble?…YES! in internet tech.  

    I think we need to get more young entrepreneurs excited about growing low-tech companies.  Maybe I am weird or missing something.  Tech is sexy, but there is lots of demand for low tech products…Food?

  • http://anyessays.com/ Help with essay

    Amazing article. Thanks for the post. This is very straight forword and helps to improve your skil set.

  • http://twitter.com/eltonjain Elton Jain

    @msuster:disqus : each day when I start my lunch I open the sides of your table and check if there is any new article. If someday there isn’t any, my lunch gets boring. Today am happy :-)

  • Dave W Baldwin

    On the money.  I wrestled with doing the spreadsheet stuff deciding to follow my gut being overly conservative.  Figured it better to speak with someone who could appreciate that understanding how you look at that matched with strategy vs. speaking to someone who wants to see the off the chart.  Those who look off the chart probably become distracted easily anyway.

    Thouyou can’t predict everything, don’t you think the strategy should reward the seed as much as possible? The party I will be conferring with over the next month has been burned where he was seed and then the taggers got in at the same price and/or sweeter. I’ve got that worked out in game plan, but his saying that must mean a lot of Angels get burned that way.

  • http://www.sethlieberman.com Seth Lieberman

    Mark- this is a great post and thanks for sharing tons of insight.  For those not able to make it to SF next week (me) perhaps you could elaborate on the tradeoffs you think appropriate between valuation and deal terms.  As we all know, the devil is in the details and valuation (wherever it is) is not the end all be all.

  • http://www.researchandcompare.com Alex Murphy

    Mark – Great post.  I have some thoughts:

    We should want valuations to be lower … across the board.  We often fail to realize that one of the worst situations to end up in is a down round.  The number one reason for a down round … the prior valuation was too high.

    When a company is valued to high in a funding round, it distorts the pricing of options for the employees which can affect moral down the line.  Although risk is lower as you move from product market fit to scale, you are still risky.  Kudos to Groupon for their hyper growth, but they lost $400 MM last year at a 42% Gross Margin.  What happens when the 2000 clones start to erode their margin, and FB and Google start to get traction … their loses will go up.  What happens to the investors that buy the publicly traded stock in a company that fundamentally isn’t making big margins and doesn’t have an infrastructure that is truly defensible?  It just isn’t good for the ecosystem end to end.

    Bringing that back to the start up entrepreneur, the only positive that comes out of high valuations is that you keep a higher percent of the company … which is only true if you don’t stumble.  Look at Pandora and the many others where the founders lost a significant percent of their company because of a misstep or a change in the macro environment.  The market for a company may be a $2 MM raise on an $8 MM pre today for Product Risk today and a $1.5 MM on a $4.5 MM pre for Market risk in 12 months for your next raise.  A better plan may be to keep expectations low, make sure that you are testing your hypotheses take less capital at lower valuations and try to manage your growth along the way.  Interested in your opinion.

  • http://sushrutmunje.com/ Sushrut Munje

    Brilliant and an informative post, sir.

  • http://twitter.com/AminPali Amin Palizban

    very informative. how long do you think the “bull” market condition is going to last for?
    should a company that ideally should raise series A in 6 months (after gaining traction & product-market fit) raise money today to take advantage of the market condition?

  • http://www.justanentrrepreneur.com Philip Sugar

    The problem is how people perceive the pre-money valuation and the amount of the investment when nobody is taking money off the table.  People view it as if people were taking money off the table.

    I would argue that the pre-money valuation is just a number on a piece of paper setting the split and the amount of investment is the amount of money you are going to be forced to spend and then return at astronomical rates of compounding interest.

    People view it differently.  They view it as how much I’m worth and how much we’re getting.

    If you view it that way its crazy not to get as high as possible.  Taking a hypothetical: I can raise  $5M at $20M pre, or $20M at $80M pre.

    If at the end you own 20% in each deal and you view pre-money valuation as what you’re worth, in one case you think you’re worth $5M and the other $20M.   Mark is trying to take $15M off my plate!  Honey, you’re not worth shit until somebody buys that common stock certificate you own for cash.  Its just some ink on a piece of paper.

    So as you point out, if you spend that $20M and don’t have a ton to show for it you will find out what a down round (best case scenario) feels like or worse find out what preferences mean in a fire sale.

    The thing to remember is you aren’t taking anything off the table, so the valuation doesn’t mean anything from the perspective of how much somebody will buy common for, and VC money doesn’t stay in the bank for rainy days, it is spent, and then must be returned.

  • http://byJess.net Jess Bachman

    Those are some interesting charts Mark.

  • http://blog.sixstringcpa.com Geoffrey

    Love the approach you took to analyze the problem @philsugar:disqus - interesting. 

  • http://blog.sixstringcpa.com Geoffrey

    @msuster:disqus really impressed with the preamble approach. You coalesce existing feedback and give it back to readers upfront. It saved me time from having to read both sets of comments over lunch.  

  • http://www.researchandcompare.com Alex Murphy

    Preferences are the king here.  It would be good to layout what happens in the scenario that Phil is laying out in the event that the company needs to come back to the table but can only get a $30 MM pre.  What is the likely scenario?  What happens to the founders?  What is likely to happen when this situation happens and the founders are shown the door.  

    When the market get frothy, it is really easy to forget what it is like when it sucks.

  • http://blog.sixstringcpa.com Geoffrey

    @amurphy59:disqus nice comments. I do not have experience with a down round. I do, however, have previous experience in private company valuations – including valuations for ESOPs. I tend to agree with you that employee morale can definitely be impacted by the ‘valuation’ of private company stock. Again, nice analysis & commentary. 

  • Dave W Baldwin

    For humor’s sake.  I don’t do much with Linkdn, but came across this fresh entry today:

    A firm claiming big investors are moving into emerging fields- “As we gain our first 5,000 contacts (investors?) in 2008.”

  • http://www.justanentrrepreneur.com Philip Sugar

    There is a reason VC stock purchases get closed with 200 page deal books versus a trade of cash for certificates.  

    How about a $30M sale?My viewpoint has been called “the close fisted entrepreneurs point of view”I’m all for high valuations.I just always have to point out, that unless you are taking money off the table that valuation is purely hypothetical and subject to massive change.  I had a broker once come up to me and exclaim how much this one person must be worth because she just raised $40M, could he get an introduction.I knew the terms of the deal: it was a 3x multiple participating preferred that got done because she had a gun to her head and needed the money.  In the end not pretty.I know tons more people that took their shares multiplied them by the valuation number to calculate their net worth that ended up with nothing on the deal than those that made lots of money. No tears it’s the nature of the beast and the journey is better than the destination, a pre-money VC valuation is just one step on a long road.

  • http://bothsidesofthetable.com msuster

    low tech is fine. You need to do what you’re passionate about. I grew up a tech-head so it’s what I think about.

  • http://bothsidesofthetable.com msuster

    true. terms matter. what matters more is the quality of the investors. I’d much rather take a lower prie and work with a mensch than a higher price and run the risk of getting screwed later in a tough economy.

    I have written about terms before, including a detailed video. Here’s a link http://www.bothsidesofthetable.com/2010/07/22/want-to-know-how-vcs-calculate-valuation-differently-from-founders/

  • http://bothsidesofthetable.com msuster

    “if you don’t stumble” is the key line that most people miss. most business stumble at one time. even costco & starbucks were near bankruptcy in their early years. It is unrealistic to expect you will be facebook or zynga.

  • http://www.researchandcompare.com Alex Murphy

    We just had a start up XLR8R event here in DC this weekend and one of the sessions was about funding your start up.  The point was made that your company isn’t really worth anything until someone offers to buy it from you.  You did a great job of summarizing the point that the investments and associated valuations are simply ways of determining how you will split up the proceeds if that happy day comes with a transaction.

    The ecosystem needs realistic wins from the beginning all the way through to the end.  Boom and bust volatility creates an unhealthy investment environment which is bad for all involved in the long run.

  • http://bothsidesofthetable.com msuster

    raise as early as you can. when the money is flowing, it’s flowing. when it stops it’s total constipation over night. Nobody can predict when the music will end.

  • http://bothsidesofthetable.com msuster

    Valuation matters but within a narrower concept. I wouldn’t encourage taking too low of a valuation because future ownership is future ownership. But raising at too high of a valuation becomes a problem if you have any missteps or if there is a market Black Swan.

    Based on your comments I’d say we’re in agreement other than wording.

  • http://bothsidesofthetable.com msuster

    How about us getting ours out this week!

  • http://www.researchandcompare.com Alex Murphy

    yep, everyone stumbles. Start ups are like infants, first learning how to crawl, then to walk. It takes patience and persistence and willingness to get back up when your nose lands on the ground. Just like infants, every business has to pick themselves back up and keep on improving.

  • http://bothsidesofthetable.com msuster

    I don’t even know what that means …

  • Scott Kriz

    As an entrepreneur, I believe that a good fit is more important than both the pre-money valuation AND getting funding in general. If you are building a compelling business – you should be able to find a good fit. If you are having trouble doing that but are still passionate about the business – I would bootstrap it.

  • Dave W Baldwin

    Sorry- it is today’s post yet talking of their going for their first 5,000 contacts in 2008 not “working with the…. we gained in 2008″.

  • http://www.justanentrrepreneur.com Philip Sugar

    I think I worded it poorly.  Keep as much of your company as you can, my point was right now I see a lot of people believing in their valuations and therefore wanting as big as one as fast as possible, regardless of what makes sense from a development perspective.

  • http://twitter.com/peteskalla Peter Skalla

    Mark, I’m interested in the topic of convertible debt with/without cap you’ll be covering June 15th.  I put some thought into the inherent problems of convertibles and hit on a ‘safety valve’ optional conversion to common I think nicely addresses the issues.  Would be interested in your critique or input (or anyone else’s).

    Terms schematic (PowerPoint):  http://bit.ly/ln2uxO

    Term Sheet:  http://bit.ly/iMVBb3 

  • http://declandunn.com Declan Dunn

    Mark your headlines (and posts) are just so good, raise money at The Top End of Normal (instead of the Bottom End of Weird in my mind).  The charts here are great, wish I had them when in DotCom times when everything had to be a billion dollar company…just looking back and at current bubbles, these valuations are what a few will make, and those who take on the valuation take on the chore of proving it, and those who don’t take on the same goal. 

    To me it’s a possibility that the time presents, though no matter what the time you should define your business your way, not following bubbles or how much you think you can value something. Thanks for helping me understand it more from the investor’s side than my own startup mind.

  • UmarAfridi

    Great read – we’re just getting into looking for funding and these kind of posts help immensely

  • http://www.meratvforum.org T.v Serials

    I know that the prices of startup companies is much great in Silicon
    Valley than in smaller towns / less tech focused areas in the US and the
    US prices higher than many foreign markets. I acknowledged this in the
    article. You can be pissed off, but I don’t set prices. I’m just making
    the commentary.

  • http://twitter.com/AminPali Amin Palizban

    thanks for the advice. i will start the process of raising money for http://www.7Geese.com ASAP . first step is to review your blogs on pitching :)

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  • http://blog.ideatransplant.com Jan Schultink

    Great post, and looking forward to the June 15 keynote with answers to some big questions.

    A small question. If the market is willing to pay crazy valuations and you are a poor founder offered all these dollar bills, why not raise a ton of money, at exuberant valuations, but put the cash you don’t need in the bank and skip that next down-round? It is hard to say no to all those $$$s.

  • Gary

    Great article, thanks Mark.  Selfishly, I hope your next post is about Convertible Notes both with and without caps (hint hint), because we have used this structure and are contemplating raising more with the same terms!

  • http://www.facebook.com/profile.php?id=715091955 Alison Murdock

    Looking forward to your talk next week and especially re when you should seek investment. A few commenters mentioned bootstrapping it until you find the right investor. With all due respect to your job as an investor, there’s a lot to be said for being really scrappy until it’s blindingly obvious that you need to raise money. Depends on the type of company one is creating, but many can be done leanly and cheaply to show traction and proof of concept. I don’t think enough is written about bootstrapping and its merits.

  • http://www.smallbusinessbible.org Small Business

    Very knowledgeable I must say, your diagrams represents a lot more clear picture.

  • http://www.ibla.us Meganlisa

    Having spent time on this issue from the investment banking side (fire sales, recaps, telling someone you can’t help them raise capital, period, because no one will pay more than their last round, and the like) I agree with pretty much everything you said.  I recently wrote on my blog about the current valuations (ibla.us) and said that ski high ones leave little room for execution risk.  So if all works out fine; if not the terms for funds can be tough.

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  • http://www.openviewpartners.com Scott Maxwell

    Mark, really nice thoughtful article.  I would add that it is really important for the investors and founders to be as aligned as possible with the financial incentives and valuations that turn out to be excessive or expectations that are not met can create a lot of misalignment. 

    The alignment comes into acute focus at both financial and liquidity/exit events when institutional investor rights could prevent a company from completing a financing or liquidity event (but the founders believe that they have a good deal worked out). 

    While I have not directly experienced in an issue like this, I am hearing about these issues coming up more frequently lately…it comes up as the investor saying something like  “I know that you want to sell and that you think that you have a good price, but we are not going along with it because we need a much higher price.”

    This has been an issue forever, but seems more frequent these days and I suspect will become a larger issue as the bubble inflates more and ultimately deflates or burst (yes, I said bubble :)

    We talk about this a lot in our investment discussions (both for our initial investment and in follow up rounds for companies that we invest in), as alignment of interests/expectations is one of the keys to a friction-free company build and ultimate exit.

    Scott Maxwell
    OpenView Venture Partners