GenuineVC David Beisel's Perspective on Digital Change

July 30, 2012

As more transparency to seed-round funding transaction details have emerged, especially with the advent of Angelist and accelerator programs (which both educate and even sometimes set terms & structure for graduating companies), I’ve noticed an increasing number of entrepreneurs signal pricing expectations much earlier in the seed fundraising process.  By communicating pricing expectations with potential lead investors, I mean sharing either an “ask” or even stated floor for the pre-money valuation of the company (with a priced preferred round) or explicitly stating a valuation cap (for convertible note round).  Sharing these expectations early in potential lead investor discussions fundamentally qualifies the conversations, but it also runs the risk of prematurely losing a potential financing partner or reducing options to maximize a financing process outcome.

Like any economic transaction, the pricing of a startup’s seed round ultimately depends on the equation of perceived supply (the quality of the team, product, & market) and demand (how many competitive alternatives there are to any one given funder, including non-consumption).  In theory, there are three levels of pricing for an entrepreneur to potentially signal to a prospective investor:

  1. Lower than “market.”  This approach is almost never a good idea.  Although some investors will certainly recognize value in a startup which is raising at a modest valuation level, sharing this aspect as a feature to the investment (which I have seen) will likely result in the perception that the company is weak and undeserving of additional capital.
  2. “Market.”  By overtly sharing that an entrepreneur is “looking for the best partner and will accept whatever the market dictates” -or- by stating a figure or range which falls within market, it sets the tone for the fundraising discussion about a collaborative process moving forward looking for a mutual fit.
  3. Above market.  By definition, all entrepreneurs should think that their endeavor is truly exceptional.  But, also by definition, that just can’t be the case.  Directly stating a high valuation expectation up-front can, on the positive side for an entrepreneur, anchor the negotiations to a higher level (assuming that investor takes the leap of faith to invest).  Setting a structure and price in advance can also expedite the negotiation process, especially when it’s with multiple parties.  Yet stating a high valuation number early can risk unnecessarily disqualifying a potential investor because it can create the perception that a zone of possible agreement doesn’t existWith finite time to spend on exploring new investments, a potential investor isn’t going to spend time on an opportunity where he doesn’t think a plausible scenario for him to participate exists.

The key to the calculus above is that an entrepreneur knows what the market range for his startup based on its current state, his ability to generate meaningful funding options, and the external funding landscape.   I’ve observed frequently that situation #3 occurs not because an entrepreneur is savvy in negotiating towards a more favorable outcome, but because there was ignorance as to what the prevailing valuation rate is.

The challenge of early price signaling is further exasperated, as different seed funders are going to have varying degrees of sensitivity to pricing.  Angels can be the most wildly unpredictable about how they’ll react to differing valuation levels.  Probably the most price-sensitive seed investors I know are sophisticated individual angel investors.  This handful of people is extremely and unabashedly cheap, as they’re fully self-aware of their role within the funding ecosystem and are accordingly systematically seeking to invest in startups at the lowest cost-basis possible.  On the other end, I’ve seen the highest-priced seed rounds come from a syndicate of individual angel investors who were essentially price-insensitive (investing in a convertible note without a valuation cap).  At the end of the day, this latter cohort is backing a particular entrepreneurial team and vision no matter what the financing circumstances.

Larger venture firms are probably next in line in terms of seed pricing (along decreasing variability), depending on what their stated (or implicit) seed strategy approach is.  As a general rule, the more seed investments a firm of this profile makes per year, the less price sensitive they are.  With an “option approach” to seed funding, larger firms worry less about ownership initially and more about just being investors in the startup to maximize pole position for later rounds of funding.  Whereas, if the firm only makes a small select few seeds which it treats like a “normal investment,” the same filter for valuation typically applies for the seed rounds as it does for the firm’s later round investments.

Lastly, seed-focus venture firms are going to be least variable in valuation sensitivity.  Fundamentally these firms are financially-driven with the seed round being either the or one of the few rounds of financing where they’re deploying their capital, so there is a bias to focus on pricing in the seed.

Regardless of profile and seed strategy, all investors just have differing philosophies about how to treat valuation.  On side of the spectrum are those who believe that overall asymmetric returns will be derived from being an investor in the one exceptional company regardless of entry price, and on the other side are those who are especially cognizant of the exit market skewing towards moderate-sized outcomes and want to position their investments to be able to capitalize on that reality.  Both profiles are valid because they’re both true; it’s a matter of how investors translate these factors into their own decision-making.

On one hand, sharing valuation expectations early can qualify an investor to ensure he is worth spending time with given their valuation philosophy.  Also, if executed effectively, it can also set a positive direct tone towards all proceeding discussions.   However, sharing valuation expectations too early can communicate that the search for investors is largely about price, not about finding a good partner for the business moving forward.  It’s like opening a job interview by sharing salary requirements.  So the communication may needlessly shy away some investors from the table who would otherwise be good partners.  Over the course of a fundraising process, pricing expectations may shift (either downwards or even upwards given demand), and it’s challenging to re-open a conversation about the business when the dialog broke down early on over pricing expectations which have since changed.

Of course, as a funding conversation progresses from an initial to subsequent meetings, the topic of round structure and pricing become much more natural.  A good investor relationship is born out of fundamental mutual interest in the startup itself, not the deal structure.  So the foundation for that partnership begins with a discussion about the shared opportunity, not the details of the arrangement.

  • http://www.startable.com Healy Jones

    David, solid logic. 

    Usually I’ve found that the most sophisticated entrepreneurs never start the valuation discussion; it’s the investor who asks something along the line of “what are your valuation expectations.”

    How would you recommend an entrepreneur respond if they a) don’t really know what the market rate is, but are open to the #2 discussion you highlight above or b) if they are getting interest from other investors at a particular valuation level (i.e. there are other investors who have, somehow, indicated they are open to a particular price point or convertible structure?)

    • David Beisel

      Healy, I would suggest being both confident and transparent in response to the situation which you describe. I think the best route is to share that you’re seeking the best partner first and then the pricing/terms as a byproduct, but also share where others are signaling – this approach will guide the discussion in the right direction.

  • Joshua Ellinger

    David,

    We are starting to look at a seed round (probably in about a year) and we keep coming up with a slight oddity relative to your article.   We have an established product and clients but want to do something bigger/different that requires external capital.

    Internally, we are willing to price below market to (a) one investor who has helped us out on another project or (b) an investor who brings more than money.  But, in both cases, only if they are looking at a tiny stake.  The point is to get the investor involved early.

    Otherwise, if we sell a bigger chunk, we want to raise enough money (with a little buffer) that we can get build the key parts of the business before raising more capital.  That would be at market or above.

    There is a place for testing an idea.  There is a place for pushing hard to make something work.  We specifically don’t want to wind up in zombie land without enough capital to deliver on our promises — any more than our investors would.

    So, to our thinking, pricing is strongly a function of % ownership.  We almost want to say something like we’ll take $100K for 5% from the right investor, spend the same amount ourselves, and get started OR we’ll take $2,000,000 for 20%, commit our entire business to it, and deliver a full product.  And we are not really interest in much in between.

    In practice, we suspect that this viewpoint really just means that we are not fundable in our current state.  Are we just showing how new we are to the game if we talk about valuation in these terms?

    Josh

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