The equation of (seed stage) valuation

Books and lawyers will teach you the art of negotiation. This post will not. Instead it will deconstruct the equation behind valuation. It will expose the different elements and weight them. The equation will give you knowledge to optimize your valuation. Knowledge is power. Use it

Most founders want a high valuation. It’s on the last slide of the pitch deck. They meet the investor and pitch energetically. They get to the last slide, pauses and say the big number. They look the investor straight in the eyes. The room turns silent. They think it’s all about being confident. To look like they are worth it. I used to think so too. Now, I know better.

Getting a high valuation is not like a Turkish bazaar where starting high and expecting half pays off. The truth is that valuation is tricky. In fact, it’s downright peculiar.  After 3 years of startup investing and raising funding for about 14 startups, this is what I know:

Valuation is not value

Valuation indicates “value”. It’s a poor choice of word. It has little to do with value. I once talked to founder. He told me that an investor had given his startup a €2 million valuation. He said that he was a millionaire because his startup was worth €2 million. He was wrong.

Valuation is not value. Value is something a buyer assigns to an asset. Investors are not buyers. They don’t want to buy. They want to sell. They are investors. If they wanted to buy, they would want a majority of the shares. They don’t. In most cases, startups don’t have any value. None wants to buy it.

Then what is valuation? Valuation is distribution of shares. It calculates how many shares the investor receives. That’s it. Does this matter? Certainly! But, not as much as founders think.

Only two things really matter: 1) how much influence the founders have 2) how much money founders get in an exit scenario. None of them are a direct function of the share distribution.

Instead, influence is a function of the rights assigned to the particular shares. It’s possible to have large shareholders with limited influence. It’s also possible to have small shareholders with significant influence.

How much money founders get in at exit a function of the price of the company, liquidation preferences assigned to specific shareholders and the amount of shares held. Two of the three elements are detached from the distribution of shares.
Conclusion: valuation matters, but not very much.

What valuation actually is

Valuation is not that important. But founders still want a high valuation. It feels good. It’s a vanity number. It influences the morale of the team, the chance to be featured on Techcrunch and the level support from the family. Valuation is social capital. Human hierarchies are formed by social capital. In that context, valuation is important.
Conclusion: Valuation is primarily social capital

The limits of valuation

Getting a high valuation depends on more than just the haggling. If founders understand what those things are, they can increase their valuation. If founders know which things matter the most, they can maximize it.

What matters and how much below:

The equation of seed stage funding

The first thing founders should know is this: The valuation has limitations. Not because investors have a sense of fairness. But because (institutional) investors have specific investment strategies.

Investment strategies restrict investors. In practical terms, it means that investors aim to own a specific amount of the company and invest within a certain size frame. This mathematics defines the limitation of the valuation. Any valuation not fitting this math is impossible for investors to accept.

At Accelerace Invest we often meet founders who ask for amounts we simply don’t do. The reason is that investors have investors. And the investors of the investor don’t like to see their asset managers go rouge. Many founders don’t know this.
Conclusion: founders should understand the investment strategy of the investor because it governs the limitations for the valuation.

Getting the maximum valuation

Maximizing valuation is basically a function of three things. 1) Performance of the startup, 2) competing funding offers the startup has received (term sheets) and 3) negotiation skills

1) Performance of the startup is a function of A) the historic performance of the startup and B) the future performance of the startup.

2) Influence by alternative funding offers are a function of C) the status of the competing investors and D) the number of competing investors.

3) Negotiation skills are a function of E) the founders own skills and F) the skills of the advisors they use.

Now that we identified the variables, let’s assign the weights.

What is most important? 1) The performance of the startup, 2) the competing funding offers or 3) the negotiation skills?

The obvious answer is the performance of the startup. If the startup makes a ton of money, the company is really valuable. Right? Yes and No. The problem is that some startups get a really high valuation with no significant traction.

The second obvious answer is negotiation skills. Being confident and having the right arguments. Right? In combination with stellar performance, negotiation skills will work in your favor. Without traction, confidence and arguments seems delusional.

What about competing funding offers? Are those important for valuation? Experience tells me that they are. In fact, they often trump everything else. If investors flock around a startup, the game changes. I’ve seen it. It happened to a few startups I helped. Their fundraising were no longer a game between the founders and the investors. It became a game among the investors.

With multiple investors in play, the game turns social. Some investors are friends. Some are not. Some have a low status and other have high status. Played right, this game can work in the favor of the founders.

Founders can get investors to compete, bid and form alliances. Suddenly the main argument for investing can be: “this really well-known business angel or VC fund is investing at this valuation”. Suddenly, the valuation is detached from performance or negotiation skills. It is driven by the game investors play among each other.
Conclusion: competing funding offers are essential for maximizing valuation.

Conclusions made:

  • Valuation matters, but not very much
  • Valuation is primarily social capital
  • Founders should understand the investment strategy of the investor because it governs the limitations for the valuation
  • Competing funding offers are essential for maximizing valuation
Advertisements

The secret equation of startup funding

Many founders walk into investor meetings blind. They know the address and the name of the investor. That’s all.

But they bring a pitch deck and have rehearsed numbers. They pitch, high five and wait for the call back. The phone is silent. Instead they get an email. It’s polite. It says something along the lines of: we think you are really interesting but the timing is not right. Let us talk in another six months.

I have received these emails myself and I have sent them. Lately, I have decided to do it differently. To tell the truth. The truth is that getting funding is not just about delivering an energetic pitch. Unfortunately, many founders don’t know any better. After 3 years of startup investing and raising funding for about 14 startups, this is what I know:

Getting funding has an equation. And few people know it. The equation has clear elements and weights. Those who know the equation can harness it’s power. But before exposing it. Let me put funding into the right perspective.

Resources are the blood of a startup. Founders use resources to create something from nothing. The resources founders need are people and money. Collaborating people are one of the strongest forces of the universe. Humans became the dominate species because of our superior ability to collaborate. No other species has ever organized thousands of individuals to do anything. Humans do. And in the process we built the Great Wall, traveled to the moon and created Wikipedia.

Likewise, collaborating startup teams can do a lot. I’ve seen it. Teams of men and women who focus solely on the common purpose of building their startup. The founders of an on-demand laundry and dry cleaning startup called Washa sacrificed the activities young people normally do. Instead they moved in together and started washing clothes. All day, all night, every day of the week. Just washing, folding and delivering. They were like a machine.

The team is the machine. Money is fuel. Without fuel, companies grow slowly. Most big companies have taken generations to built. Fuel applied to a well functioning machine make it run faster. Fast is what we want. Humans are impatient.

Money for startups is called funding. Most startups I meet chase funding. Not everyone should. Fuel only makes the machine run faster. Fuel to a broken or incomplete machine is a waste. Even dangerous. But if the machine works, funding will have positive effects. Conclusion: only raise funding if you got a machine that works.

Most funding comes from institutional investors. Getting funding from institutional investors depends on more than just the pitch. If founders understand what those things are, they can increase their odds. If founders know which things matters the most, they can (almost) control the outcome.

What matters and how much below:

Equation of funding

Getting funding is a direct function of getting the decisions makers (usually the partners) to be positive.

The attitude of the partners is a function of two things: 1) the status of the person proposing the investment and 2) the attractiveness of the investment itself.

1) The status of the person proposing the investment is a function of: A) the person’s level of seniority (associate, analyst, principal or partner) in the firm and B) the person’s level of expertise within the space of the investment.

2) The attractiveness of the investment itself is a function of: C) the attractiveness of the startup and D) the attractiveness of terms.

A) The person’s level of seniority is a function of: I) the person’s track record and II) the time the person has been with the firm

B) The person’s level of expertise within the space of the investment is a function of: III) the amount of own startup experience in the space IV) the amount of investing experience in the space

C) The attractiveness of startup is a function of: V) the strength of team and VI) the size of the opportunity

D) The attractiveness of terms is a function of: VII) how well the investor is protected in a downside scenario and VIII) how much the investor profits in an upside scenario

The equation can be deconstructed further, but this level should do for now.

Now that we identified the variables, let’s assign the weights.

First level. What is most important? The status of the person proposing the investment or the attractiveness of the investment itself? The obvious answer is the attractiveness of the investment itself. Even the youngest associate would get internal support for the next AirBnB or Uber, right?

The problem is this: We only know that AirBnB and Uber were good bets in retrospect. Both startups got turned down by a lot of investors. Let’s take the opposite example. Would a senior partner ever get support to do a really bad deal? Well again, good and bad are assigned in retrospect. In reality senior partners advocate for really bad deals all the time. Most venture backed startups fail miserably and somewhere along the way senior partners were involved.

My current calibration tells me that the two sides weight about the same. Experience tells me that founders don’t know this. Conclusion: founders should pay a lot more attention to the left side (green) of the equation than they usually do.

Second level left side. (1) Because the status of the person proposing the investment weights 50%, it’s relevant to look at the elements making up the status level. Who should the founders seek out?

Is it most important to convince the person has a senior position (A), or that the firm’s expert in the space (B)? In my experience, experts work as gate keepers. They can say no. That makes the expert extremely important but unless he also has high status in the firm, founders cannot solely focus on him. Conclusion: founders should focus on the person with the highest status while making sure the expert is supportive.

Second level right side. History decides if an investment was good. However, certain things seem attractive to investors at the point of investing. Those things can roughly be divided into the attractiveness of startup (C) and D) the attractiveness of the terms. Which is most important?

In this case, the weight is clear. The attractiveness of the startups is by far the most important. Founders know this. In fact, founders think their startup can justify almost any terms they propose. In most cases, sky high valuations. They are wrong.

At Accelerace Invest we have turned down investment solely because of the terms. I know that other investors do too. Even though terms are secondary, the terms still matter. Most founders are ignorant of the economics and business model of an institutional investor. When founders forecast their ownership in the cap table, they tend to assume that investors will be happy if they get a return. Again, they are wrong.

The return for the whole fund most beat the “market”. And in most cases founders don’t even think about the return of their investors. But they should. Not to be nice. But to ensure they get funded.

If founders don’t know what an attractive financial structure of a deal looks like to an investor, how can founders negotiate wisely and get to the best deal possible? They can’t. Conclusion: founders should understand the economics and business model of their investor.

Conclusions made:

  • Only raise funding if you got a machine that works
  • Founders should pay a lot more attention to the left side (green) of the equation than they usually do
  • founders should focus on the person with the highest status while making sure the expert is supportive
  • Founders should understand the economics and business model of their investor

Investment thesis

Projects I believe in

Many investors formulate certain verticals or technologies that interest them. I like to think about it differently.

To me, technology and industries are mere bi-products of human need to dominate our surroundings. In our effort of establishing humans as the most powerful species in the universe, we have undertaken immense projects. Projects that transcend generations and are the headlines of human effort throughout history, and in many years to come. These projects are the core of human effort, and to me these projects are the true aim of the technologies and industries that arise.

As an investor, I am really excited about anything that will help us progress in these areas:

Urban Mobility

Originally cities was a solution to reducing friction in transactions. The Egyptian invention of cities enabled us to live in close proximity to each other. This meant that we could easily interact and get our business done. Traveling for three days to get stuff sold on the market was a thing of the past. Productivity skyrocketed. However, this only worked to a certain point.

Continuous urbanization enlarges cities to the extent that friction starts rising again. I spend a lot of time in China because my wife is Chinese. Here I experience the implication of the rising megacities. Friction is enormous. Just getting simple things done, like going to the post office or buying or buying a new sink for the kitchen, takes forever. Traffic is a nightmare and the stores concentrate in specific parts of the city. The vast number of people creates incentives for cheating. Both buyer and seller mitigate this risk by spending more time ensuring the transaction is valid. Sometimes I spent an entire day just buying a single item.

Luckily technology is our savior. Technology can increase the mobility of people and goods in urban environments. Drones can circumvent traffic. Collaborative consumption can create liquidity in the availability cars, housing and storage space. Review and trust systems make quality providers easy to find. Payment technology saves us valuable minutes in every transaction. We want the benefit of cities without the pain. Any technology that makes it significantly easier to be an urban citizen makes me excited.

Global Mobility

Countries formed coincidentally. Only, a few countries in Africa have been created by design, and they don’t seem to work. The division of the world into independent countries made sense, because mobility was limited.

Geographical distance mattered and countries that grew into empires struggled with this problem. Collecting taxes from Britain and getting the coins to Rome was a problem. Every attempt to sustain empires failed. Thus, countries grew independently and developed distinct laws, language and institutions. Today we suffer from this.

The entrepreneurs that came before us have solved many of the long distance mobility problems. They invented ships, trains, cars, airplanes, phones and the internet. Transferring money from Britain to Rome takes about a minute now. Business can be conducted on a global scale. However, countries still exist. And the asymmetry of laws, language and institutions is a problem.

Again, technology will help us. Technology can circumvent institutions such as banks, courts and government. Technology will make it free to buy stocks in other countries and make it easy to enforce rights and agreements across borders. Technology will remove the friction of language differences and reduce the time and hassle to get from Copenhagen to New York. Any technology that makes it significantly easier to act as a global citizen makes me excited.

Health

Life expectancy has more than doubled in the last 100 years. In large part because of medical advances. The sad story is that the extra years mostly extend old age. 6 out of 10 people now end their life in prolonged states of frailty and growing incapacity. In practical terms, it means that you don’t recognize your children and you are being spoon fed while wearing a diaper. If you want to know more about these sad facts, see Peter Saul’s TED talk from 2011. We are getting older. Just older. Needless to say, this is the exact opposite of what we want.

The thing is that time is not created equal. One year when you are 25 is worth more than one year when you are 90. At 25 you can spend those 12 months backpacking, making children and win Olympic medals. At 90, the options for pumping natural dopamine into your brain have been drastically reduced.

Health is the answer and technology is the remedy. Health adds to the other end of life. It extends our youth and vitality. Technology can provide accurate health information, ensure the right nutrients intake and hack our biology. Any technology that significantly increases our health makes me excited.

Omnipresence

All mammals depend on information. We use it to make decisions. Biological evolution has formed bodies with sensors that obtain information in our surroundings. Humans obtain information from five categories of sensors. We call them the five senses (sound, taste, touch, sight and smell).

However, humans have a disadvantage. First problem: We only got five senses. Many animals have more. Second problem: Our senses are not particularly good. In fact they are downright inferior. We make up for that with superior processing of the information. Still, it bothers us. Imagine if we had senses on par with dolphins, fish and bees.

In fact, we have dreamt about superior senses for a long time. Ancient Gods were humans with superior senses. From the clouds or the top of a mountain they could see and hear everything. They were omnipresent. And because of this advantage they ruled earth. Seeing and hearing everything is the ultimate advantage. The quality of decisions is a function of the speed and quality of information. Any stock broker knows this.

Technology has disrupted evolution. Instead of waiting for nature to give us the sight of an eagle, we can fly drones equipped with high resolution cameras. We can participate in lectures at universities on other continents, and we can follow a package on the way to our door. We are becoming omnipresent and our thirst for this kind of power is limitless.

Startups I believe in

The most successful company in any given ecosystem is the one that is optimally positioned within that ecosystem. A startup is the hope of a future company in a future ecosystem. However, the future is fundamentally unpredictable.

Luckily, the market is a big component of the ecosystem. The market is made up by humans, and human needs are stable and predictable. Humans want to solve problems or/and have fun.

The product takes care of the human need. The founders take care of the company’s position within the future ecosystem.

Consequently, the product must demonstrate that it is superior at serving a widespread human need and the founders must be superior at positioning the company in the future.

The product is the simple part. It just needs to have potential to solve a human need in a superior way. The tell is that early customers really love the product.

The founder team is the complicated part. They need to steer the company into an unknown future. To navigate in an unknown environment requires a team with the right set of complementary skills. The right set of skills depends on the business model.

If the startup has a product that early customers love and has a team of founders with the critical complementary skills, then the startup has a fair chance. It is a bar. An entry criteria that puts them in the bucket of entrepreneurs who have a chance of success. The equivalent would be teenagers above 190cm who want to become professional basketball players. Above this height, they all have a chance and extra height is no longer required to become a top player.

Consequently, this is the minimum requirement for me to consider investing.

However, as investor I do not succeed if the company just survives in the future ecosystem. I succeed if the company becomes the very best placed within that ecosystem. Having a fair chance is not enough. The startup needs to be the likely winner. It needs to become Michael Jordan.

Because most of the things that impact the position of the startup in the ecosystem take place in the future, the founders are the most important element.

The act of positioning the startup in an unpredictable future is the daily act of deciding where to spend the resources (time and money). Founders must be good at attracting resources and spending them wisely.

Attracting resources is a function of the ability to persuade great people to join the startup and to get investors to provide money. People and money make up the resources.

The ability to attract resources is the ability to tell stories and persuade. Like any great leader in history mastered. Conclusion: The founders must be superior leaders.

Spending the resources wisely is a function of focusing the resources where they have the biggest impact. Focus makes up the impact of the resources.

The ability to focus resources where they have the biggest impact, is the ability to learn and reflect. When my daughter tries something new and learn from the process we call her smart. Conclusion: The founders must be smart.

However, the mentioned are abilities are not enough. Founders must put ability into action. They must furiously tell stories, persuade people and make decisions to apply their resources. And they must get these things done in the most effective way possible. Often the most effective way lies outside the beaten path. Often it requires actions that are way outside what other people would consider “normal behavior”. Conclusion: The founders must get things done and be unbound by the limitations of “normal behavior” . People with the latter tendency are often called crazy. So be it. I look for the crazy doers.

The logic of my thesis commands a two step approach. First I check for Entry Criteria. Does the startup have a complete and complementary founder team and a product that early customers love? If yes, then I check for Excellence Criteria. How much do the founders get done, unbound by the limitations of “normal behavior”?. How good leaders are they? and how smart are they?. I will bet on teams with the highest Excellence Criteria score.

Ecosystems I believe in

Many investors formulate certain verticals or technologies that interest them. I like to think about it differently. To me, technology and industries are mere bi-products of human need to dominate our surroundings. In our effort of establishing humans as the most powerful species in the universe, we have undertaken immense projects. Projects that transcend generations and are the headlines of human effort throughout history, and in many years to come. These projects are the core of human effort, and to me these projects are the true aim of the technologies and industries that arise. As an investor, I am really excited about anything that will help us progress in these human projects:

Urban Mobility
Originally cities was a solution to reducing friction in transactions. The Egyptian invention of cities enabled us to live in close proximity to each other. This meant that we could easily interact and get our business done. Traveling for three days to get stuff sold on the market was a thing of the past. Productivity skyrocketed. However, this only worked to a certain point.

Continuous urbanization enlarges cities to the extent that friction starts rising again. I spend a lot of time in China because my wife is Chinese. Here I experience the implication of the rising megacities. Friction is enormous. Just getting simple things done, like going to the post office or buying or buying a new sink for the kitchen, takes forever. Traffic is a nightmare and the stores concentrate in specific parts of the city. The vast number of people creates incentives for cheating. Both buyer and seller mitigate this risk by spending more time ensuring the transaction is valid. Sometimes I spent an entire day just buying a single item.

Luckily technology is our savior. Technology can increase the mobility of people and goods in urban environments. Drones can circumvent traffic. Collaborative consumption can create liquidity in the availability cars, housing and storage space. Review and trust systems make quality providers easy to find. Payment technology saves us valuable minutes in every transaction. We want the benefit of cities without the pain. Any technology that makes it significantly easier to be an urban citizen makes me excited.

Global Mobility
Countries formed coincidentally. Only, a few countries in Africa have been created by design, and they don’t seem to work. The division of the world into independent countries made sense, because the mobility was limited. Geographical distance mattered and countries that grew into empires struggled with this problem. Collecting taxes from Britain and getting the coins to Rome was a problem. Every attempt to sustain empires failed. Thus, countries grew independently and developed distinct laws, language and institutions. Today we suffer from this.

The entrepreneurs that came before us have solved many of the long distance mobility problems. They invented ships, trains, cars, airplanes, phones and the internet. Transferring money from Britain to Rome takes about a minute now. Business can be conducted on a global scale. However, countries still exist. And the asymmetry of laws, language and institutions is a problem.

Again, technology will help us. Technology can circumvent institutions such as banks, courts and government. Technology will make it free to buy stocks in other countries and make it easy to enforce rights and agreements across borders. Technology will remove the friction of language differences and reduce the time and hassle to get from Copenhagen to New York. Any technology that makes it significantly easier to act as a global citizen makes me excited.

Health
Life expectancy has more than doubled in the last 100 years. In large part because of medical advances. The sad story is that the extra years mostly extend old age. 6 out of 10 people now end their life in prolonged states of frailty and growing incapacity. In practical terms, it means that you don’t recognize your children and you are being spoon fed while wearing a diaper. If you want to know more about these sad facts, see Peter Saul’s TED talk from 2011. We are getting older. Just older. Needless to say, this is the exact opposite of what we want.

The thing is that time is not created equal. One year when you are 25 is worth more than one year when you are 90. At 25 you can spend those 12 months backpacking, making children and win Olympic medals. At 90, the options for pumping natural dopamine into your brain have been drastically reduced.

Health is the answer and technology is the remedy. Health adds to the other end of life. It extends our youth and vitality. Technology can provide accurate health information, ensure the right nutrients intake and hack our biology. Any technology that significantly increases our health makes me excited.

Omnipresence
All mammals depend on information. We use it to make decisions. Biological evolution has formed bodies with sensors that obtain information in our surroundings. Humans have grouped the information provided by our sensors into five categories. We called them the five senses (sound, taste, touch, sight and smell).

However, humans have a disadvantage. First problem: We only got five senses. Many animals have more. Second problem: Our senses are not particularly good. In fact they are downright inferior. We make up for that with superior processing of the information. Still, it bothers us. Imagine if we had senses on par with dolphins, fish and bees. In fact, we have dreamt about this for a long time. Our ancient Gods were humans with superior senses. From the clouds or the top of a mountain they could see and hear everything. They were omnipresent. And because of this advantage they ruled earth. Seeing and hearing everything is the ultimate advantage. The quality of decisions is a function of the speed and quality of information. Any stock broker knows this.

Technology has disrupted evolution. Instead of waiting for nature to give us the sight of an eagle, we can fly drones equipped with high resolution cameras. We can participate in lectures at universities on other continents, and we can follow a package on the way to our door. We are becoming omnipresent and our thirst for this kind of power is limitless. Any technology that significantly increases our omnipresence makes me excited.