Startup Markups and Markdowns: What the heck is going on!?
The reassessment of the valuation of startup holdings at a number of mutual funds, notably by Fidelity, has caused a fair amount of comment of late. Notably of the "Unicorn sky is falling" variety when it comes to mark-downs. And the sky isn't falling ... when it comes to mark-ups. Fred Wilson of Union Square Ventures recently addressed the broader topic of the blurring of public and private capital markets of which this issue a component part.
In my experience there are two common sources of confusion many early stage investors and founders have about these mutual fund valuation changes. They are reflected in these two questions:
1. Why are they doing this in the first place?
And related to this:
2. Why do they move the values up and down "so often"?
As a former sell side research analyst here is my attempt to add a little clarity:
1. The Why Do It At All
This one is easy. Mutual funds change the valuations they report for their illiquid startup holdings because ... they have to. And the requirement to reset valuations applies just as much to marking up an appreciated asset as marking down a depreciating one.
The key point is that investors can buy and sell shares in a mutual fund on a daily basis - and they do so at NAV (Net Asset Value), the price reported by the fund. Hence, as "open ended" investment vehicles, mutual funds need to mark their valuations to market on a daily basis to reset that NAV.
With public securities, assessing the contribution to NAV is "easy" in most cases. For illiquid securities (like holdings in a startup) the valuation reflected in overall NAV needs to be "fair value as determined in good faith by the Board of Directors". (The Board of Directors of the mutual fund in question that is.) Hence, by taking in mutual fund money, a private company goes (a little bit) public by proxy ... because the valuation of its equity is open to potentially daily reassessment by a mutual fund. However, unlike the public markets, any revaluation (again up as well as down) is only visible when a fund choses (or more likely is required) to make it public.
Fidelity funds report monthly holdings although the SEC requirementis for mutual funds to report holdings to them (and hence the public) only on a quarterly basis. Even then, funds have up to 60 days after the end of a quarter to do it. And just to make it clear that this reporting needs to be honest and fair ... the SEC requires a fund's principal executive and finance officer to "certify" the holdings report is accurate.
Less obvious (once you know the SEC requirements anyway) is the answer to the second question:
2. The Why So Volatile
In most cases early stage investors, angels and VCs, and the founders they are backing only see startup valuations change infrequently. This "mark to market" happens when a new round is priced (up or down). At that point there is an explicit one time step function change in valuation that prevails until the next financing provides the next step function change. Obviously valuation also changes when a company is acquired and there is a definitive last and final price assessment.
With very very few angel backed investments making it to the public markets via IPO, and a small proportion of venture backed companies for that matter, the experience of frequent (month to month never mind second by second) valuation changes is in turn uncommon. But that doesn't mean they aren't happening! The point being valuation is a function of many variables and they all (inconveniently!) are themselves changing in real time which is why, of course, public stocks fluctuate real time. So external factors like interest rates, risk premia, the macro economic outlook, market place/competitor developments, media coverage etc as well as internal factors like new product launches, personnel changes, major new investments and earnings reports. Whether visible or not all this stuff happens to start ups too.
"We" just don't revalue them second by second because: a) it would fry our brains and b) circling back to point 1 above ... we don't have to. But, as I laid out above, once you add a mutual fund to the cap table the game changes and in comes that quarterly (or monthly) requirement to revalue. Blame the SEC for that if you will ... and the real world for the volatility!
The "is there or isn't there a bubble in venture" discussion has mostly focused on whether the momentum behind venture financing is showing signs of weakness, whether valuations are (way?) over extended and when, how and why this might unravel. Some say yes, some say no. But most bubbles are only evident after the fact so time will tell on this one. (If it is one ...)
Some unicorns are definitely getting sick, and not just for lack of revenues. Caroline Fairchild wrote on Linkedin that "Theranos, the Silicon Valley startup known for its blood-testing technology, is now in the spotlight in the wake of a deeply damning report out by the Wall Street Journal ..." Neatly she called it a "wounded unicorn".
As we digest the troubling news about Theranos here is something else to worry about: extended periods of loose money and exuberant investment are typically associated with some high profile incidents not just of mis-valuation but misrepresentation, or worse. (I am not commenting specifically on Theranos in that regard, but the allegations there have set alarm bells ringing.)
10 years ago I was the second witness for the US Government in the trail of Worldcom CEO Bernie Ebbers. Worldcom was a darling company that rode the 90s/early 2000s "TMT" bubble to huge success but ultimately to ignominy. Mr Ebbers was convicted and sentenced to 25 years in goal for an accounting fraud in which costs were understated and thus profits overstated ... and which led to the bankruptcy of the company. Worldcom went bust in July 2002 with $107bn of assets making it the biggest in history up to that point. (It ranks #3 now, behind Lehman and Washington Mutual, taken down by the 2007/08 financial crisis after an epic housing bubble burst.)
So, for anyone concerned about the more extreme things that become visible when the loose money tide goes out, what did I learn from the last tech/telecom bubble? What are the warning signs that, with the benefit of hindsight, folks should have payed more attention to ahead of the biggest failures of the last tech bubble?
While nothing more than my own anecdotal observations, here are some red flags today's tech investors might care to look out for:
1. A very controlling CEO (and likely CFO too in a public company context) who has close oversight of all operations to the extent that only a very few people at the heart of the company have a full picture of what is going on. (That was the story at Worldcom.)
2. A CEO with massive ego (and paranoia) - although of course this goes with the territory in many cases so not very distinguishing. But taking aversion to criticism to extremes points to someone who can go to extremes in other ways - in their own self defined reality.
3. Sycophantic media coverage - which dulls sensitivity to any adverse issues and results in self censorship. That is ... until someone does the work and calls the company out ... and gets heard.
5. Vanity Board i.e. a Board of directors populated with "very important people" ... but who lack and domain expertise in the area of activity of the company and hence can't provide effective oversight, and likely don't have the time to commit either.
I was chatting with a founder recently and mentioned my trip to SF end September. OK my sample size is very small, but from VC to startups there was no avoiding the pervasive sense the startup funding environment was tightening, or going to tighten soon. I noted to my friend that this definitely seems like a time to raise early stage money quickly if you have good metrics and momentum, rather than wait for a better valuation or when you feel you really "need" the money further down the road ... because if and when the window shuts, or at least gets tougher to get through, valuations will surely come down and terms will become more investor friendly. (The "it's there, so take it" rationale was the one the Slack founder Stewart Butterfield gave back in April as to why they have raised much more money than they appear to need. Smart guy.)
Four points of angst as I think about this some more:
1. Investor side angst: Since my SF trip at an anecdotal level I keep hearing the same "its' getting tougher out there" vibe from people I speak to back in NYC and there have been some forceful public comments on the matter. e.g. Mark Suster calling out the obsession with unicorns and Caterina Fake melodramatically heralding the Age of the Cockroach. Obviously related to this mood music is the fact that the stock market has stalled (S&P is basically where it was a year ago despite a few good days recently) in no small part pending the Federal Reserve finally raising interest rates for the first time in nearly a decade. Plus we have global economic issues to content with, especially the China deceleration and related commodity price and hence broader Emerging Markets collapse. All that means a less buoyant IPO, read VC exit, outlook. Current data point: Pure Storage IPOed and closed 6% below issue price on its first day - so slightly below the last private market raise valuation. Importantly this is the first VC backed unicorn to IPO since Box in January, according to Dan Primark at Fortune. Also on the exit issue, many unicorns (150 now and counting according to Crunchbase) are simply too big to be acquired and there has definitely been a dearth of hope into reality cash exits for VCs. So VCs get more anxious. Are they holding back? Well Pitchbook just reported that VC Deal volume fell in Q2 (albeit with strong $bn invested, but that is biased up by larger late stage rounds and "VC tourists" like the big mutual funds). The Q2 numbers make for three quarters of consecutive VC deal volume declines ... for the first time since 2009.
2. Corporate side angst:Brad Feld did an interesting post recently pointing out that a couple of M&A deals his fund has been involved with fell apart recently at short notice. This is the flip side of investors starting to get more cautious - corporate acquirers do to. Brad says:"In both cases, the explanation was vague." My hunch is that is because the reasons are indeed vague ... because they are typically emotional: "Do we really want to do this now?", "Is this a risk we want to take?" And crucially ... "Seems likes prices are high, so maybe we can buy this company later ... at a lower valuation." So all to do with confidence in the general environment and conviction in a specific deal. Those two things ebb together.
3. Startup business model angst:Also there have been some pretty specular high profile startup implosions (Zirtual, Quirky) or partial implosions (Evernote) recently that serve to dampen the mood too.Not all rocket ships get to the moon. All these cases have elements of individual corporate shortcomings, they always do. But in my view Evernote is especially interesting because it signals a point where investors start to worry more about business model/revenues relative to user metrics (which can be "monetized later, we just haven't worked out how yet".) When the little boy calls out that the Emperor has no business model clothes on ... and people listen ... then you are in big trouble if you are a company that needs sustained and substantial external capital to survive.
4. Media angst:Regardless of more sophisticated considerations, you know a story is well baked when it hits totally mainstream media for general consumption. Nick Bilton's Vanity Fair piece "Is Silicon Valley in a Bubble ... and what could burst it?" answers its own question, the first one anyway. That was before the end of the summer. (When I was in SF another journalist I met dismissed it as ... "old news that could have been written months ago.") And NPR just covered the skyscraper bubble prediction hypothesis on the Marketwatch morning show with Exhibit A being ... the Salesforce Tower. (The thesis being that market peaks are correlated with building of "mine is bigger than yours" office towers thanks to cheap money and a lot of hubris.)
My bottom line advice to founders based on all of the above is to ignore the noise for the most part. Great companies are founded and grow in good times and bad. Compelling solutions to big pain points that encompass big markets will get funded if the team is awesome and the traction is there. So stay focused on what you are building. But for CEOs, one of whose three key roles is to make sure their company never runs out of money, then financing strategy does matter. Hence this CEO advice:
a) If you are raising money now do so as quickly as you can.Accept standard deal terms without a fight and definitely don't be greedy on valuation. And at the early stage consider a priced round as opposed to a note. Professional early stage investors really do not like notes (other than for a first small pre-seed round maybe) and only do them because they "have to". When they don't have to ... they won't. (Don't use very investor unfriendly docs like SAFEs for example.)
b) Hope is not a strategy. Have a Plan B for an immediate future where the external financing environment is irrelevant to you because you can manage to a very long runway or, better, get to cash flow break even so your runway becomes infinite! I met a founder recently who had done exactly that. Shifted the model somewhat to increase revenues near term and get to cash flow break even sooner. Now the founder has people saying "you are running a lifestyle business" because the company is no longer insanely maximizing growth (and taking in capital to achieve that). But the founder has taken back control of her future ... and is OK with that!
What is the "right size" for my raise and why do I get so many conflicting opinions from investors on it? What am I missing and what am I doing/saying wrong?
Having had many conversations with early stage startup entrepreneurs along these lines of late here are some thoughts from me on the subject. I suspect that I will be accused of giving a long non answer ... but I am strongly of the view that founders need to adopt the policy of:"Taking advice, not following advice." As an entrepreneur, realizing that you will get as many views on your raise as there are investors, means that you need to reach your own view and pursue it based on at least five key considerations:
How much you "need"
The trade off between value creation and control
Location: where you are based and where you will be pitching the most
Whether are you focused on securing angel or VC investment
Sorry, it's complicated
I will start off by saying that this dilemma reminds me about the old saw about economists: Ask five economists their views on something ... and you will get at least six different answers!
In early stage land investors (individual angels, angel groups, seed funds, early stage VCs) have so many different opinions on raise size that there is little if any consistency. Hence my first point to entrepreneurs - no, don't worry, you are not going crazy! The center of gravity of all these voices is indeed hard to discern and is influenced by self interest too. For example and totally understandably a VC will look at any proposition through their own lens - including their usual ticket size. So they might favor a "bigger" raise than an entrepreneur had in mind since that would equate to the minimum ticket size they prefer to invest.
This contrasts with the public markets where the capital markets desks of investment banks pricing deals have at least some chance of consistent price and size discovery. This because of the volume of transactions, more substantial financial data and much more consensus around valuation methodologies and metrics. (Although from from time to time they do get pricing badly "wrong" with resultant often gleeful cheap shots from the media and other commentators.)
Recognizing there is no one "right answer" is at least helpful to maintaining an entrepreneur's sanity. The five factors listed above seem to me to be the key ones that might help you, as the entrepreneur seeking to frame your thinking and head towards as good an answer as you can get. I will tackle these five points in more detail shortly. Also note that I am not making a call here between convertible notes (which duck or at least defer the issue of valuation) and a priced round - that is yet another discussion. But see my post "Startup Convertible Notes - Enough Already" for my take on those vexing instruments!
To further complicate the entrepreneur's thought process ... you need to be prepared to be flexible. Entrepreneurs need to due diligence investors like they due diligence you. All money is fungible but good advice and relationships are not. So if you get talking with an investor or group of investors where you see a good fit and relationship developing but where there is some angst on the other side of the table around the size of the raise it makes sense to be prepared to be accommodative to the extent you are comfortable. So have ready an answer to the question: "If we funded you with $1.5mn not $2mn ... could you make that work?" In fact this can go both ways because the question might well be: "We really like what you are doing ... if you raised $5mn not $3mn how would you put that to work and how much more quickly could you grow!?"
And what about gender?
Some women entrepreneurs struggle with this challenge more than men, in my experience. But to the extent that gender comes in to play it seems most acute at the first time entrepreneur/first raise level. In part that might be a confidence, some might say integrity, issue borne of a lesser willingness of women to self promote, indeed exaggerate. As one (female) founder politely put it to me: "there are a subset of male entrepreneurs who just make it up and are comfortable with that" pointing out the bravado shown by the RapGenius founders. This is a Silicon Valley classic: How Rap Genius Raised $1.8mn in Seed Funding Without Knowing What We Were Doing
However I have heard from (women) VCs on both the East and West Coasts that they see no difference at all in terms of their dialog. They note that the choices that need to be made, as I outlined above, apply equally based on their experience. ie they report no obvious gender based differences in the way entrepreneurs handle them. With that in mind my suspicion is that, by the VC/Series A level, every start up has been through the pain of pitching and iterating their message more times than they care to remember. And having got early angel/seed funding they have built up a network of investors, advisors and entrepreneur contacts that means that they are all better placed to "play the game" ... as best it can be played.
Here is more detail on my five key factors:
As the cliche rightly has it, valuation (especially for start ups) is an art not a science. It is a negotiated answer based on incomplete information, very high levels of uncertainty and, it has to be said, a large quotient of hutzpah. Valuation is a book length discussion but this post by Bill Payne for the Angel Capital Association gives a blog length summary as seen from the investor side. Bill cites the VC Method, the Berkus Method, the Scorecard method and the Risk Factor Summation method. I would add that many investors use more seat of the pants approaches. For example looking at comparables (eg by sector, stage, location) they think are relevant, even just high level average seed stage valuations. Angelist is a good resource here with the ability to compare valuations against a variety of filters.
For any investor the amount you raise will have some connection with her/his take on your company's valuation. For example, if you are at an genuinely early seed stage (maybe not even an MVP, very small team, no customer traction) then a pre-money valuation at or around the $2mn level might be all you can hope for ... and raising more than say $1mn on top will be next to impossible. $1mn new money would mean the founders are giving up a third or more of the company from the get go ... which will put investors off of itself. Why? Well, it makes for imminent disincentive effects as further rounds further dilute you down to zip pretty fast. In that context raising up to $500K say on $2mn seems more reasonable all around plus means you "only" give up 20% of the company.
As your idea morphs into an actual business the options multiply. Say you have an MVP in the market, have built out a team with domain expertise, the right technical talent and others (plus have a good Advisory Board maybe even afiduciary Board) and have some initial traction ... heck, perhaps even customers paying real money! In that context if say a $5mn pre-money is achievable then the raise size debate/dilemma really kicks in. Per the prior scenario yes a $500K convertible note works, but now a $2mn priced seed round might be viable. So other factors come in to play ...
2. How much money do you need!?
Seems obvious but since financial models at the early stage are largely works of fiction it can be hard to pin this down. And as your valuation grows there will be a tendency for investors to suggest you raise more because a small raise leaves outside holders with a smaller position and hence lesser influence. Plus rightly or wrongly there is a perception that bigger valuations simply equate to bigger raise sizes.
So you really need to work out what you truly "need" to either get to cash flow break even (and hence be self funding thereafter) or more likely what will get you to the next major milestone that will allow you to take the story up a notch and raise more money at a yet higher valuation. And "need" means having a well articulated "use of proceeds" that is the best assessment you can make on current information, plus has a cushion built (25%?) to protect you from inevitable startup snafus.
One thing that investors will look at hard, and entrepreneurs should too, is the current and future burn rate. If your raise does not cover 12 or better 18 months of negative cash flow then you have an issue ... because, given how long it takes to raise money, with lesser runway a) there is less cushion for adverse events and b) you will need to start raising money again pretty much when the current raise closes - not good for your sanity or your business!
3. The trade off between value creation and control
The classic Noam Wasserman dichotomy also applies - growth (and thus value creation) vs control. aka Do you want to be rich or King (or Queen)? Sodo you want to grow really fast and are happy ending up with a smaller share of a much bigger pie? Or does control matter - do you want to run the show and build "your company, your way" for as long as possible? Both are totally valid but intensely personal choices. Wasserman's point is that entrepreneurs need to understand their own motivations from an early stage.
If you want to be King/Queen then take as little outside money as possible ... but if you want to grow fast with a view to a) maximize the pie but b) in so doing give up control and c) most likely in just a few years lose your CEO role then in most all cases you need to raise larger amounts.
Some entrepreneurs don't realize that control has only a loose connection with proportionate ownership. As Guy Kawasaki points out in his great presentation on the top ten mistakes of entrepreneurs, owning 51% or more of your company does not mean having control. As you take more money from strangers the constraints on you add up.
In my view trigger point is when the dynamics of your capital raising have created a five person Board (with say the CEO, another funder, two investors representatives and an independent). The moment that happens then, as Founder/CEO, you have appointed your judge, jury and potential executioner. (Because you are "out" on a 3-2 vote if the majority of the Board decides you are performing poorly or are not the right person for the next stage of the company's evolution.)
4. Where are you located? Where are you pitching for money?
The Silicon Valley "Go Big or Go Home" mantra speaks to a culture where all sides are looking for the big wins: in the current jargon its all about finding Unicorns. And big wins come from aggressive scaling ... and raising substantial amounts to do that. So pitching to VCs and even Angels out West with a dinky small raise sends the signal that you are not serious about the big win, or maybe your opportunity isn't itself big enough to deliver one. Meeting over!
On the East Coast I think there is a generally more analytical/incremental (East Coasters would call it "realistic") approach where a well calibrated smaller raise taking you to the next proof point is more accepted as the way to go.
Important to note that VCs can be pretty location specific ... they prefer to invest in companies they can drive to. (Or get to on the subway in New York City!) Angels are the same - the quarterly Halo reports from the Angel Research Institute indicate that some 80% of Angel Group investments are made in a group's home state. (But note that this is a partial picture since total Angel investments made outside the context of groups are much bigger in $ terms given total angel commitments of approx. $25bn/year vs. an annualized figure of about $1bn for groups alone as captured in the Halo report.)
One consequence of local investing ... is that your odds of funding go up if you are located where the money is ... angel money, again per the Halo report, is fairly widely available across the US but VC money is much more concentrated. Approaching 2/3rds of VC dollars are put to work in Silicon Valley, the New York Metro area and New England aka Boston. (You can see the full break down in the the latest PWC Moneytree Regional Aggregate data).
5. VCs vs Angels?
A subject worthy of lengthy discussion of itself ... but the motivations of Angels vs VCs are really very different. And entrepreneurs need to understand this. Steve Blank put it well when he said: "The day you raise money from a venture investor, you've also just agreed to their business model" Basically Angels invest their own money and like to see it come back before too long, In contrast VCs get paid invest other people's money and are prepared to wait more years for (much bigger) scale.
Angels would be very happy if your plans were to use their money to take the company to a $30mn exit in four years. For them the smaller raise can be seen as less risky, maybe enough to get you to that early exit plus gives them the hope that they can retain some influence (esp. via a Board seat). (Basil Peters book "Early Exits" is the angel investors bible on this topic.)
VCs in contrast (above the smaller seed level players) have to have a much bigger exit for their business model to work. So they will be inclined to favor bigger raises from entrepreneurs pitching a much bigger opportunity that yes, can make everyone rich. But it means you as the entrepreneur have to wait longer for your personal liquidity and indeed put that liquidity at risk of some adverse economic, market or competitive development as the business takes longer to scale larger. Plus the stats are clear - you will be much less likely to stay King/Queen for long. (And meanwhile us Angel investors will be diluted away fast and soon lose any hope of influencing the exit process through a Board seat.)