Nosebleed Valuations

So I never thought I would ever have this conversation with any entrepreneur, but here it is. There’s this exciting new Internet company with a brilliant founder, and a sharp business guy and their business is going to eclipse Facebook, Yahoo, and probably even Google ... want in?

Its going really cheap, 100M pre-$, that’s right, this week only 5 will get you 10 ... well 5 actually, 5 million that is ... So my epiphany is this. How do you explain to a passionate entrepreneur that their idea is brilliant, and in fact if it does take off the way we all would like, it will be worth $100M? The problem is that they need the VC money and help to de-risk it and set it up for success in order to get that next valuation. Now most entrepreneurs, like me, are more old school and come a little more cap-in-hand looking for investment--but the new generation of Internet guys have a very different attitude--and lets face it, why wouldn’t they in the hindsight of the incredible price tags put on acquisitions by the Internet giants? Eyeballs, clicks, CPM ... and with so many clicks, probably, eventually, some revenue.

So we all understand Net Present Value, discounting for risk, etc ... but forget that business school argument. It's as simple as this. For an early stage VC to make money, they need to own about 20% of the company in their A-round. There is no magic to this, it's pretty much the benchmark across the valley, and across the world. Now a strategic investor who is getting a lock on a new technology or access, or preferential treatment, will pay a lot higher valuation but wont deliver much, if any, value beyond the money. The 20% number anticipates the VC contributing more capital to the subsequent B & C rounds in an attempt to maintain pro-rata, and reduce dilution. If things go as planned, the B round will be at a significantly higher (multiple of) the A, and the same cash that was invested in A, when invested in B, will buy a much smaller percentage. VCs love that because it means the company has become much more valuable through the A round, and they can attract new, later stage investors whose risk tolerance is lower but who will pay higher valuations for less risky investments.

Anyway, as an entrepreneur I tried to always worry about what milestones I could achieve with the A money, so that I could max out valuation on the B, rather than trying to optimize the A. Its hard enough to attract a quality VC to your business when he's seeing many comparables on a daily basis, without making the hurdle higher by slapping an outrageous price tag on it. Mind you, I am just a hardware guy so what do I know about what’s outrageous pricing for Internet deals.

So once I explained the VC model for funding and the 20% parameter, the sharp business guy said, OK but our valuation of $100M is minimum, so you’ll need to invest $20M to get your 20% ... and it went on. In an effort to make some kind of deal make sense, I proposed that we do the equivalent of investing $5M in an A for something close to 20%, and if they hit their proposed milestone in 6 months, we’d invest another 5-7 for a tiny % to hit 20% aggregate. After taking this to a few friendly VCs and getting a lot of laughs, I learned a new maxim for Internet deals – “its cheaper to fail than ever before” – meaning VCs are doing many more deals in this space by investing $250k to $500k, to test an idea. Most fail, but those that don’t move on to the more traditional $5M A round, still nowhere near a 100M pre-.

Putting it simply, pre-revenue companies (or concept plays) have trouble raising money from banks, it's not like real estate. Conversely VCs thrive on risk and leveraging their ability to reduce it and build great companies with great entrepreneurs ideas. The price for that is selling a greater percentage of your company to get the VC's mindshare beyond their money. I really like these two entrepreneurs and their idea, which reminds me a lot of Netscape, and would love to find a way to fund them (within the bounds of VC mandate and economics). I really like the way they made me rethink the VC model ... its important for us to reexamine our founding principles from time to time to ensure we really do understand them.