As the chill deepens in the early-stage environment, our fund is seeing an issue emerging in the way investors and entrepreneurs view first round pricing.
At least a half-dozen times over the past few weeks, when I have asked CEOs where their note cap or first money pre-valuation came from, the response has been: We based the value on all the great milestones we will achieve with the money we raise this round!
I’m sorry, dear entrepreneur, it doesn't work like that.
Early stage companies must be valued only on what they have done, not on what they are going to do.
Those future corporate deals, potential revenue, amazing hires, tech breakthroughs, all remain mythological at the time of the first raise. They may happen. As investors and supporters of the company, we hope they do happen. But, they don't actually exist and so can't be figured into the company's current value.
Now that may seem perfectly obvious on the face of it. So, why do entrepreneurs so frequently push to have future value in present pricing? Two reasons. One is that, during boom times, entrepreneurs can sometimes get away with this. Hopped up investors who lose track of the fundamentals and are fighting to get into a deal might convince themselves that a price inflated by future expectations is OK, because the rising market means that value will be justified by future rounds. More fundamentally, a higher price represents a comfort for some startup CEOs, allowing them to feel like they have accomplished more than they actually have and to retain more ownership than the bald facts would allow them.
It is easy for entrepreneurs to cast the truism that early prices can only be based on actual performance as an expression of investor greed. We grabby capitalists want it all and will push the price as low as we can get it, to own as much of the company as we can. Certainly, investors want to produce return and the initial price is part of that calculus. But the biggest negative impact of too-high an early price isn't on the VC, it is on the entrepreneur.
The VC has a whole portfolio of companies to derive value from. If one is mis-priced, others can step in to generate the needed return. But the entrepreneur has only one horse to ride in the race to success. If the odds on that horse are bad, the entrepreneur takes the full negative impact, with no recourse.
Let's say a startup has current sales of $1M, but believes they will have $3M in sales over the next 12 months. If they price at a 5X on that $3M, they do a round at $15M pre. But now, let's imagine that (as so often happens) sales take longer than expected, customer churn is higher, there was a major glitch in the software that delayed deployment of key new features. The actual delivered revenue over those 12 months was only $1.5M. That only supports a valuation of $7.5M, half the valuation of the previous round.
This puts the CEO and the company in a real bind. New investors will hesitate to come in at a price lower than the previous round; they don't want to offend currently committed investor colleagues and they know that negotiating a round like this takes a lot of time and generates a lot of stress. So they usually just move on. If they do make an offer, it is likely to have hard-nosed down side protections because the company has over-priced in the past.
If, instead this company had priced the earlier round on real revenue, $1M, and done a $5M pre round, that $7.5M, while not an ideal outcome, would still represent an uptick in value and the basis for a positive next raise. This is the better course, for both investors and entrepreneurs.
We are all living in dangerous times right now and need to bring a real world, pragmatic perspective to all aspects of company creation, getting round pricing right most of all.