Oxstones Investment Club™- Posted by Jeff Carter
The other day I was talking to some people about early stage investing. They hadn’t done it before but were interested. Early stage investing seems really simple. Find a good idea, put some money behind it, and then make millions.
In hindsight, it is simple. It’s when you are evaluating companies with foresight where it’s really hard.
Be aware, early stage investing is a lot of hard work. There are all kinds of things that successful early stage investors must do prior to investment, and also post investment to help companies succeed. It’s not a passive activity. If you want exposure to early stage investing, but are unwilling to do the work, invest in a fund or asyndicate on Angel List.
Another thing early stage investors should realize is there is no exit for at least 5-10 years. Even if you invest at a $3M post money valuation, if the company gets financing at a $20M valuation you won’t be able to get out under most circumstances. Early stage investing isn’t stock picking.
There is a lot of randomness in figuring out how to value a company. There is no math equation, no Excel spread sheet program, no calculus that spits out a value. It’s a direct negotiation between the investors and the entrepreneur.
Here is the trend on median valuations at a seed and Series A level.
Valuations are starting to go higher. If the probability of the company’s success is the same as it always was (and it is) why do initial valuations change?
One of the reasons is macro. The Federal Reserve has pursued a 0% interest rate policy since late 2008. Quantitative ease and keeping its pedal to the metal on money creation has changed the risk/reward tradeoffs for stocks, bonds and is seeping into startups. When the Fed raises rates, I wonder if that will change the trend in valuation?
Another reason is competition. As more people like my friends start to hear about startup success, they are attracted to startups. Hedge funds and corporations are getting into the startup game. More money going into something increases prices. At the same time, entrepreneurship in the US is down-so there are actually less startup companies to pursue. This also is driving higher initial valuations.
Another explanation could be newbie investors. Newer investors haven’t ever had to price startups before, and will make mistakes. If I had a dollar for every deal I have seen that promises me riches with a $20M pre-money I wouldn’t have to invest at all. That’s why newer investors should seek angel groups to work with. Early stage investors do better in packs.
(added later) Acquihire also has an effect. As long as Google ($GOOG), Apple ($AAPL) and the rest of the big guys buy startups simply to acquire talent, the valuations can climb to close to acquisition price. This type of investing isn’t true angel or seed investing. It’s speculating.
Crowdfunding has had an effect. It’s made capital flow a little easier despite the government oversight. Freer flow of capital helps markets adjust faster. This has had an upward impact on valuation.
With mobile, it’s possible to reach customers quickly and scale businesses quickly if you find the right recipe. Everyone is a node on a network now. It’s possible to have a company that with international scope almost immediately. That changes incentives on initial valuation.
When an entrepreneur pitches an idea there are several factors to consider when valuing it.
- How big is the initial focus market? Is it a multi billion dollar market or not? This also depends on the framing of how one looks at the market. Uber initially went after black cars but clearly the market is much much larger than that.
- Has the entrepreneur done this before? Startup companies are hard. If an entrepreneur has done it before, they will be familiar with most of the trials and tribulations. Even if they failed the last time, as long as you can talk candidly about the failure and what they learned, they get points for attempting it at least once. Shawn Carpenter, the CEO of Ycharts had done a company and failed before. He calls it his $7M MBA. But, he had learned a lot and is building a great company today.
- How disruptive is the idea? Is it transformative or iterative? This is a hard one because ideas pivot as they go. Brilliant is the largest social network in the world of smart people solving math and science problems together. It started out as a way to be transparent on tuition costs. Their initial site still exists,AllTuition. They saw a larger opportunity and pursued it. Not all of the initial investors were happy.
- How many competitors do they have? This is an indication of market size and opportunity. It’s can be an indicator of whether the timing is right or not. Investors have to look ten years into the future and imagine this business being a blow out business. For example, if someone came to me today with a parking app, I am not likely to invest because it’s already been done a lot. At the same time, you have to evaluate each opportunity independently because you never know. Facebook ($FB) wasn’t the first social friending application.
- Are they riffing off one of the macrotrends permeating society? Unbundling, network, etc. If so, how do they fit, and how do they disrupt existing processes or habits? Nextspace fits a lot of these trends, and so does Desktime.
- How much education does the business take-and what is the sales cycle? This points to customer acquisition costs. I invested in TallgrassBeef.com in 2005. It was on the bleeding edge of farming back then. The educational process at that time for consumers was long. 9 years later, some consumers are waking up to the healthfulness of grass fed/grass finished beef-but not enough so the bulk of the population understands and is demanding it.
- Does the team have any direct DNA into the problem they are solving? This is a double edged sword as well. If they have direct DNA, they surely understand the need, but they might be too traditional in their thinking to solve it. Sometimes outsiders solving a problem don’t feel bound by industry constraints. Kaiser built the most ships in human history during WW2, but prior to the war he’d never built a ship before. UICO‘s founders had direct DNA into their business. They had a highly disruptive solution that is only getting better over time. But in 2008, they didn’t know their product could be put in things like wearables. They also have developed newer touch technology that no one else has in the past 6 years. No investor envisioned that in 2008.
- How many rounds, and how much money to exit? This is all fuzzy math and isn’t a big concern. If the business builds value and increases the metrics it’s being evaluated on over time, the money should be there. It’s a good idea to try and think about who is likely to co-invest with you in later rounds.
- A corollary to #6, is this a business that a VC will invest in? If it isn’t, the metrics change because the probably exit value changes. The probability of selling the business at greater than $20-$40M are smaller. It is also harder to raise money for this kind of business. It’s better to have all the money the business needs sitting at the table in the beginning. A VC would pass on this kind of business, but an angel can make money.
That’s some of the calculus. I have seen some valuation creep in the Midwest, but it hasn’t been as significant as the coasts have seen. I remember trading the markets in 1996-2000, the one thing I learned: It’s important to keep your discipline. Have a process, rely on it. You will miss some opportunities, but you will feel better about the ones you get into.
Tags: company valuation, crowdfunding, disruptive idea, early stage investing, early stage investors, entrepreneur pitches, evaluating companies, hedge funds, startup success, VC investing