Perils of a Rich Valuation

The entrepreneur gushed “We just closed a $2.5 million Series A on an $8 million pre-money valuation.”

My response: “Great news – now that you’re a couple months past close, what’s the probability estimate of hitting the 1st year revenue target you set for the VC’s?”

The smile quickly vanished as the entrepreneur acknowledged it was far from being a lock to hit the target. Both the risks and attendant pressures were already starting to hit home.

Valuation optimism can be masked with insufficient data

Unfortunately, this is a much too common scenario as founder drive to minimize personal equity dilution by grabbing the fattest valuation possible seems to override their judgment on what happens post deal.

Typically the culprit is too little thought given to the underlying assumptions behind a detailed bottoms up financial model. Proper models take into account factors like average deal size, sales process steps and time to close, productive lead sources beyond executive team personal relationships and diminished close rates of non founder sales reps. [See my post: Leading Sales as a Startup CEO].

The worst offenders set their valuation target first and then back into a set of projections that align revenues with the valuation goal as they scurry about for data points supporting their wished for revenue trajectory.

While VC’s will certainly review assumptions behind revenue as part of their due diligence, entrepreneurs will get some leeway if the product offering is distinctly different with what’s already in the marketplace (thereby lacking trend comparison with similarly situated companies) and you’ve already racked up a few sales to your credit.

Overly optimistic projections come with consequences

The path to judgment day starts with board meetings in which the new institutional investor board members are now brought up to speed with the insider’s view of your progress against the expected revenue targets that were in the deal.

If you’re absolutely confident you’re right on path to meet or exceed the targets then you’re golden.

But if you’re starting to break out in a cold sweat soon after the deal closes, then you’ve got the hard choice of perpetuating expectations you may not have confidence in or going about the delicate process of resetting expectations.

Perpetuating the improbable is a gamble that ever optimistic entrepreneurs take, believing somehow, someway they will find a solution over time.

However, as projections don’t get fulfilled, that factor alone becomes the biggest reason entrepreneurs get pushed out of the CEO role in favor of someone who has a proven track record of “meeting the numbers.”

And that equity stake the founder was concerned about? When projections get missed and Series A funding dries up while there is still a substantial burn rate – you then have the classic down round scenario where in order to keep the company alive with a new financing, founder shares can get crammed down to a pitiful percentage of ownership compared to their post series A stake.

De-risk with detailed assumptions behind revenue components

You can mitigate risk by building a detailed model for how revenue projections are derived.

List assumptions behind each component of a revenue formula so there is complete transparency and no “black box” – even tilting assumptions towards most realistic, if not outright conservative achievement at critical components of the revenue formula.

The best entrepreneurs don’t settle on just a high level view of 2-3 revenue component steps to come up with a formula. Instead they tear apart every step in the customer acquisition process to find patterns which can be reasonably tracked (with a minimum of admin burden) that help point to predicting success at that particular step in the sales process, and in the aggregate – timing of future revenue flows.

Since early stage companies typically won’t have a large enough team for a professional CFO on staff to build such a model, they can fill the expertise gap with an “Interim CFO” who has the background and strategic perspective to dive in and gather input from multiple team members to guide a true bottoms up model with detailed, defined assumptions.

The best interim CFOs divide their time among a cadre of early stage companies and often have the pattern recognition of having been through this exercise across many similarly situated companies. This helps not just in developing the model but with an ongoing retainer relationship will help their client tweak the model as more data comes in and analytics for management and board are refined.

While it’s best to avoid optimistic projections pre-deal, the earlier that investor expectations get reset to the proper level the more likely you are to retain your credibility as a leader.

So don’t wait for your next round to beef up the visibility and accuracy of your forecast. When you’re depending on other people’s money – than your success, and that of your company, may end up riding on how well you can predict the future with a financial model that you actually deliver on.

[Related post: Embrace Public Company Readiness in Scaling a Private Company]


Overcome Seed Investor Bias

Overcome seed investor exit bias with vision and passion

As an active seed investor with my UpVentures, it’s not unusual for me to be weighing odds of investing in one company with some plausible acquirer targets on the horizon, versus another startup with a more speculative moon shot based on a large, but totally unproven, market opportunity.

This dynamic plays to entrepreneurs too. Wouldn’t a more likely pay day come in a space where others have shown some traction, ahead of being out there on the “bleeding” edge because you’re pioneering something that almost no one else sees yet?

There is no absolute here. Though as a seed stage investor, it is probably a good idea to have a portfolio with a mix of these two opportunity paths.

Investors can under appreciate market timing

Being ahead of the curve in a new and unfamiliar industry raises seed investor uncertainty about where the exit paths will be. This prompts a subtle bias for us to instead focus attention on opportunities that seem to have nearer term possibilities for liquidity.

But as IdeaLab founder Bill Gross recaps in this video reviewing data from 110+ companies he had a hand in, his search for causality in the factors of idea, team, business model, funding and timing (five classic early stage investor criteria) shows evidence that market timing had more to do with startup success than any of the other key criteria we seed investors rely upon.

Even one better is the wisdom of Paul Graham and his insights that come from decades of seed stage investing and running Y Combinator.

Overcome Seed Investor Bias

 

While multiple Paul Graham essays touch on this theme of market timing, one of my favorites is Black Swan Farming – he nails this seed investor bias against new models and markets by sharing logic behind his thinking why he felt Facebook was a lame seed investment opportunity when he first heard of it.

Biggest opportunities powered by multiple macro forces

While startups generally have some kind of societal, market or technological trend underlying their plausibility for being an investable growth business, if you parse through any list of $1B+ exits, you’ll see the big winners enjoyed a confluence of multiple macro trends that drove growth for an extended period.

Overcome Investor Bias | Learn from TriNet Founder Martin BabinecMy appreciation for this factor of multiple trend convergence began as it was probably the biggest reason prompting launch of my own startup journey in founding TriNet in 1988.

While very much a rookie entrepreneur then, I was more than a little passionate about how certain trends were both irreversible and directly related to powering our business model behind outsourced HR services including:

  • Increasing government regulations burdening employers
  • Shift in employment landscape from large companies to small
  • Smaller companies needing benefits to compete for talent (previously the domain only of big companies)
  • Technology adoption driving both speed of business (narrowing core competency that would in turn drive outsourcing) plus add new capabilities to enable efficiency in service delivery across a large number of smaller company customers.

As obvious as these trends might seem today, the late 1980’s was a different world and even venture investors couldn’t warm up to our opportunity since they didn’t then appreciate how our perceived pure service business could be sufficiently technology enabled to scale and leverage these converging trends as fully as TriNet proved to do.

Winning entrepreneurs articulate vision with passion

Vision and passion are important for any startup CEO. But if you’re forging new paths in unchartered models, you’ll be hard pressed to raise seed funding without a founder CEO getting across both these qualities.

Take the time to unpack specifics behind your supporting macro trends. Cite independent sources with data that supports your thesis. Tying multiple trends to defined elements of your business model and execution strategy boosts credibility in your vision.

But even those actions are not enough to sway seed investor interest if there isn’t a clear sense of deep personal passion on why this means so much to you.

Passion comes through when investors become convinced about the entrepreneur’s emotional commitment to the “why me” behind the problem the venture is solving. Our senses pick up the cues for this emotional commitment probably more so by how you articulate, than the logic supporting your argument.

A deep, passionate commitment is essential to overcoming the many obstacles ahead, including attracting the right team members who you’ll be asking to take their own risks in joining a team with an unproven model and/or industry.

Entrepreneurs who get seed investor attention are the ones whose vision and passion are so ingrained in their persona that they clearly differentiate from the crowd of their startup peers.

So don’t fear being “over the top” in getting across your passion and commitment. How you message that emotional commitment, coupled with a clear vision that ties specific trends to your model is what we’re looking for.

Winning investor hearts, along with our minds, is the combination that unlocks wallets to speculate with even greater risk than the semi plausible exit strategy we’re weighing you against as our investment alternative.


Prepping the Pitcher

Tips for pitch event organizers and startup founders from an investor’s perspective

Prepping the Pitcher - Tips for Your Next Pitch EventLast week I attended a local pitch event for the Upstate tech community that included four entrepreneurs pitching their startups. Like many other such events, the audience was a mixed group of entrepreneurs, community supporters and a small handful of investors. 

The pitches unfolded in typical fashion. When I saw the most common pitch errors across each of the four presenters, I did wonder about how the event organizers went about setting expectations and guiding the entrepreneurs doing the pitching. 

Entrepreneurs know these opportunities are important. They definitely spent time preparing, yet missed the chance to deliver a compelling case. Most importantly, none of the presenters specified what help they were seeking. 

What follows in this post are a few suggestions aimed at both event organizers and pitching entrepreneurs who seek to avoid the boring pitch syndrome.

Tip #1: Problem and solution are not enough

Entrepreneurs (particularly those with a technical background) fall too easily into the trap of using precious minutes in a pitch to dumb down the science. They hope to compel the audience by spelling out the technical challenges that were overcome, and the uniqueness of the startups’ product design.

If half or more of the pitch is spent defining the scope of the startup’s technology, it comes across like an academic exercise. The presenter is seen as working too hard to impress with his or her technical mastery – shortchanging the opportunity to secure support beyond defining problem and solution.

Tip #2: Pitch to investors, even in mixed groups

Even in situations where there is a mixed audience with diverse backgrounds and interests, I’m a fan of crafting pitches as if the entire audience were investors. 

Everyone wins by taking this approach in the pitch because: 

  • A standard set of guidelines can be provided to all presenters that directs them to a specific outcome
  • The event can run on a consistent track, making it easier for the audience to compare pitches with a lens that helps everyone think about how investors look at who to fund
  • The entrepreneur gets an opportunity to further hone the investor pitch, addressing things like business model, channels of distribution, margins and other critical business issues

Tip #3: Close with telling people what you want

I believe it’s essential to end a pitch with a specific appeal for help. Often times someone in the audience can assist the entrepreneur. They just need to ask!

Requests for help shouldn’t be limited to financing. Telling people what else your startup needs right now gets everyone thinking about how and who they know that can assist.

Whether it’s introductions to a specific type of customer or channel partner, or finding new team members, mentors and service providers, pitching is an opportunity to make a personal appeal. Someone in the audience may know the right resource for your company, but only if you tell them what you need.

Tip #4: Event organizers call the shots

With so many startups clamoring for the opportunity to get more exposure, event organizers have the leverage to set high standards for who they choose to present.

Instead of filling slots with whoever raises their hand first, consider inviting entrepreneurs to apply for the opportunity.

Even better, give them a short set of pitch guidelines on what you would like to see included in the pitch, and ask them to send a sample deck for you to evaluate.

It’s ok to tell applicants that their submission is just a sample. Ideally you and members of your supporting team can guide development of the final pitch so that it meets your target standard.

UNY50 - Experienced Entrepreneurs & Investors Provide Pitch HelpIf you need pitch mentoring support, resources like Upstate Venture Connect’s UNY50 Network or investors in any of our local seed funds can help. These same groups can also help recommend qualified startups to pitch.

Setting a high standard for your pitch events, and helping startup founders deliver compelling pitches will not only satisfy your audience, but reflect well on you as a sponsoring organization.