Valuation, Valuation, it’s a rage across the Nation…..

So I just finished a tour of another country, meeting about 700 entrepreneurs from medical devices to enterprise software, with a couple of chip companies thrown in for balance. During the Q&A session there was a lot of discussion around benchmarking deals there to Silicon Valley deals, and can a better valuation be won here? So at the risk of getting it wrong, let me make a stab at that--I think fund economics work in a way that requires an A-round investor to buy about 20% of your company--generally they will want another such investor in the deal, so expect to sell 40%. It doesn’t really matter how much either side negotiates around the deal, at the end of the day they all end up looking something like this magical 20% rule because that’s the only way that the economics of the venture fund will make sense.

Now outside the valley a lot of people think about VC more like the stock market--so the feeling is that once a VC invests, they disappear to go find other deals, and their equity is locked in, plus they get paid dividends over time. In reality what happens, is a B-round comes, and the A round VCs invest again to minimize their dilution. The lead B investor will likely insist that the ESOP is re-upped back to 20%, and that will come out of the A-round VCs.

I need to explain this much better in another posting because it’s the source of enormous confusion, especially in other countries, and I think is at the crux of the adversarial approach to Valuation discussions. The point of this posting is to share an epiphany I had when taking a deal to the partners for approval to go to term sheet.

So what happens in these meetings? Generally there is a formal voting system that requires each partner to either love or hate the deal (on a 1-5 scale, there can be no 3s); but before that all the partners look for a fatal flaw in the company, i.e. something that would kill it in the market and make it too risky an investment [more on that later].

The prime topic of discussion is not valuation--actually its ESOP--if it’s big enough, who else needs to be on this bus and how big a stock budget will we need to attract them. This has all been thrashed out already between the CEO and the partner leading the deal, but its important to second guess based on experience of the other partners with other companies in that space.

Another topic is, can we really add value to this deal--again, its been thrashed out a month or more before when the deal first came to the partnership, but it’s good to review one last time. Do we really understand this space, can we add to the success of this deal?

A number of other issues come up, and then it’s deal structure. How risky is the market looking forward--under the current economic uncertainty a number of areas could be tough. IT spending will decrease and it will get harder to build startup revenue, so a B-round deal will likely suffer in valuation because the investors know they need to carry the company longer to get through the coming rough patch.

If there was a previous round, it’s likely that that VC isn’t terribly affected by valuation of this one, provided he is investing pro-rata, because the new money dilutes the old. If valuation goes down, his pro-rata gets a greater percentage to compensate; if it goes up, the original investment is worth more to compensate. What he does care about is the dilution due to ESOP increase because that comes mostly out of him, but at the same time he knows the company needs to attract more talent.

So here’s the rub, if the ESOP keeps getting topped up with each round, then the Team who build the company gets minimal dilution (or the company grows rapidly and the shares owned by each member become much more valuable) – so ironically, the VCs dilute themselves. Does this worry them? Of course not, because the pie is getting bigger. I am convinced that this is the only way to look at valuation, from either side. If we are obsessed with the percentage we end up owning a lot of nothing. If the company is really successful whether you own 20% or 30% you still make money and the fund succeeds, if it fails, owning 90% isn’t going to help much.

My epiphany came when my partners voted the valuation up, and nuked the milestone tranching the deal – this was a deal with some history and potential performance issues. When VCs tranche a deal, i.e. fund part now and part later after the company hits a pre-determined millstone, it’s highly unlikely they will ever use the milestone or withhold the second tranche--they are just trying to ensure the team is really 110% focused on the issue that defined the milestone.

The fact is that markets change and the team is the only element that can respond, so a milestone drafted today is probably meaningless in 18 months. So why have the milestone if it isn’t really going to help, and is more likely to put investors at odds with the team? The VCs voted in favor of removing it because they wanted to align themselves with the Team--this alignment is critical for a successful partnership going forward to build the company together. Likewise, making the valuation a little higher can remove weeks of wasted time negotiating, and turn what would have been hard feelings from the Team, into feelings of support and aligned interests--what is that worth?

I’ve been through a really bad turnaround where I was brought in by Intel to triage one of its companies. The problem in that deal was misalignment between investors, and between investors and Team. It nearly killed the company. In contrast, when I ran Lightbit, we navigated through tech nuclear winter, and the VCs (Mayfield & Accel) with whom we had been brutally honest and built a strong trust helped us carry the company (of course, many of us stopped taking salary for a year as well ;-) ).

Next Time – Typical deals (or the second part of valuation)