When even the leadership at Softbank say private valuations are getting too steep, that really tells you something. It’s heady times in the venture capital market right now, both for sustainability and for the innovation industry altogether. Dollars are flowing into startups at a record pace, and valuations are far beyond where they were even just a few years ago.
Valuations and the amounts of venture capital are tied, of course, in what I like to call the “1+2=3 math” of venture capital valuations. Let’s say just for argument’s sake that in every round of venture capital, the new investors grab 1/3rd of the company’s shares, or market cap. Well, then the size of the round dictates the valuation.
This seems illogical to many entrepreneurs new to venture capital, or to many investors similarly not used to this framing on valuation. Wait, it’s based on proportions? Where’s the discounted cash flow analysis? But no, quite often in VentureLand the valuation exercise truly is that simple: What’s the dilution hit the existing investors and management team are willing to take? And then what’s the size of the check? Valuation pops out as an end product instead of being an input. Maybe that’s not how it “should” be, but to be honest, in the early stages of a startup the range of possible outcomes is so wide and so hard to estimate, any DCF analysis will be more guess than fact anyway. Terminal values are even more of a guess. So venture capitalists have learned to ignore such “fundamental” analysis as just so much speculation anyway. And so you end up with 1+2=3 math.
So, if the size of the venture check dictates much of the valuation of the round of financing, as bigger checks are written valuations will increase. It just follows.
The next problem is, of course, that this process then represents a few simplistic heuristics and a lot of speculation and subjectivity. Is a startup truly worth the valuation a VC puts on it? Many, many years ago I was close to one solar startup that had received an (at the time) astronomical valuation of “$10 on $20” (ie: $20m premoney valuation, $10m round) term sheet. But then that got trumped by another venture firm’s $20 on $60 term sheet. One of these professional venture firms valued the company at $30m post-money… and the other valued it at $80m.
And in the end, the company eventually was worth zero. Oops.
Ironically, when valuations start getting frothy at the peak of a market cycle, this thinking also encourages investors to get even more frothy. After all, the immediately visible benchmarks are even more untethered from fundamentals, and firms and individual investors are even more desperate to put money to work while things look so exciting, so it starts to create a positive feedback loop. Startups become like pokemon: Gotta catch ‘em all. Price is no object.
This is understandably disorienting for early stage institutional and individual investors. If the market is saying you need to pay more to win deals, but you don’t want to just sit out the happy part of the cycle, what should you do? This is where angel investors and other early stage non-VCs can benefit by asking themselves a few key questions regarding each company they’re considering.
What do I hope this company can achieve within the next seven years?
If your answer isn’t “get sold or IPO”, then you should actually think hard about whether a classic preferred equity, “venture capital” round is appropriate for that company at that time.
Preferred equity is at the heart of the modern venture capital model. It’s also a promise by a startup. It’s a promise that they will get sold or IPO within seven years or die trying. Why? Because of how it’s specifically structured. Most “preferred equity” investments put the new investors into a new, senior class of shares that may have some dividends on paper, but are really designed onto to cash out at a liquidity event. In other words, when the company gets sold. No one puts preferred equity into a startup hoping to get those single-digit interest rate dividends, in fact in many cases they don’t even accrue. Single-digit dividend rates are not what such investors are interested in, in any case.
No, everything about the governance and financial structures of preferred equity are geared around three simple things: 1. You will grow this company quickly and then sell it so we the investors can finally get our returns; 2. Even as minority-ownership investors, we are going to have enough control to force this path upon you; 3. If the sale of the company doesn’t generate a positive return for the preferred equity investors, it’s you founders and other common shareholders who feel most of the pain, thanks to liquidation preferences (the “preferred” in “preferred equity”).
Many great entrepreneurial stories have benefited from this aggressive preferred equity approach, to be clear. When founders’ expectations match these “grow like crazy and sell” expectations, it can be a powerful accelerant. And as ample evidence shows, if things go really well, the sky’s the limit with such financial resources available.
But venture capital i.e. preferred equity is only a very infrequent form of what startup capital and capital structures actually look like in the real world. Only 0.05% of startups raise venture capital. Does that mean 99+% of startups are a bad idea? No. It just points to what a rifle-shot fit venture capital and preferred equity are — great for an extreme few, but not a fit for most. And among those that do raise venture capital, only 1% or less become “unicorns” worth $1 billion or more, or IPO. The rest are going to have to be sold off eventually for much less of a return.
So when entrepreneurs come to me asking advice on how to raise their first round of venture capital, I always start by instead asking them this first question about what their goals are for their company in seven years. And unless it’s “turn it into a rocket ship and then sell it”, I urge them to consider alternative capital sources. Maybe don’t go the preferred equity route at all.
Is a high valuation right now actually in the company’s best interest?
In the eyes of many entrepreneurs and their early-stage backers, one key goal of any next venture fundraising effort is getting as high a valuation as possible. It’s seen as a sign of momentum, and even with the 1+2=3 math it tends to mean less dilution, or at least a bigger check. For example if you’re raising a $10m Series A, maybe you can get away with only giving away 25% of the company. Or maybe even less.
But few entrepreneurs realize what a double-edged sword it is to raise early money at a high valuation. Yes, maybe it’s the beginning of a march toward unicorn status and a world-changing outcome. On the other hand, the higher your valuation coming out of a financing, the harder it is to grow into justifying that valuation for the next time around. And also, the more preferred equity you raise, the more preferences you have to earn through.
It’s quite possible, and in fact I see it happen often, that establishing a high valuation and high liquidation preferences on a company too early stifles its potential. It makes it hard to raise additional capital without it being a “down round” that hyper-dilutes the founders and puts them under even more of a preference stack. Or if the next step is to sell the company, it significantly limits the universe of potential acquirers willing to pay even that last-round valuation unless there’s been extreme growth since then (and if so, why are you selling such a fast-growth company anyway?).
High valuations are seen as an unmitigated win. But believe me, too much capital at too high of a valuation too early in a company’s life can be deadly. During frothy times when such valuations may indeed be on offer, existing early investors in a company would be wise to steer the founders toward more moderation.
How else can we fund the growth without large amounts of venture capital?
In the cleantech sector a decade and a half ago, pretty much venture capital was the only available way to finance all the needs of a startup. And yet, many of these innovations involved hardware or physical projects. A lot of oversized venture rounds were forced upon companies that needed tens of millions of dollars just to get to a growth stage, because they needed to pay for putting steel in the ground somewhere. This is, in my opinion, one of the key reasons why the Cleantech Bubble of the 2000s burst — too many companies were forced to raise too much venture capital before they even got one dollar of revenue, and the resulting high valuations couldn’t be lived up to.
But these days there are alternative sources of financing, we now have a more robust capital ecosystem. In particular, early project finance can serve as off balance sheet growth financing. Grants and philanthropy can often be available to support any “first of a kind” deployment, and then project finance can be available for the deployments after that. So that the venture capital raises at the startup itself can instead be smaller and targeted at accelerating sales or new R&D or any of the other more traditional uses of such expensive capital.
A good recent example of this is Atlas Organics. This composting startup tapped into project financing two years ago to accelerate their project deployments (full disclosure: via my own firm Spring Lane Capital), which allowed them to quadruple their footprint in a very short amount of time. That growth has now allowed them to “graduate” to a new partnership and significant new financial resources with a very strong project finance firm, which should help them take their expansion nationwide. All on very little actual venture capital.
I’ve seen early stage investors force CEOs to reject project finance offers in favor of over-sized venture rounds. Because even though they would be then spending expensive venture capital on steel in the ground, it would also mean a higher valuation and bigger headlines. But as discussed above, that isn’t necessarily good news for the company long term. It’s candy for breakfast instead of a well-rounded meal, it may feel really good at first but before lunchtime you’re in trouble. Early stage investors should instead be helping their startup founders explore all the alternative sources of financing that are now available alongside venture capital, with an eye toward reducing the dependence upon large amounts of VC dollars.
It’s been an exciting last couple of years in the world of startups and venture capital. Especially in the sustainability sector, which has finally enjoyed its moment in the sun. But with many industry observers overtly calling a peak in private valuations, now is not the time for entrepreneurs and early stage investors to be blindly pushing for high valuation, preferred equity rounds to finance their growth. For some, perhaps that is still the right fit! For most, probably not.
Exploring other pathways may end up being a more successful, stable and lucrative decision in the end.
