Valuation of seed stage startups
I don’t care that much about valuation, and thus pay slight attention to this parameter when deciding whether to invest or not in a startup. Apparently, I am not the only one. In a recent post, Sam Altman, of YC fame, provided his recipe for successful investment in startups, which doesn’t mention valuation at all.
Hunting for a diamond
Similarly to what Fred Wilson stated in his post “Venture Fund Economics: When One Deal Returns The Fund“, I don’t try to “swing for the fences“, I just try to create a reasonably well-diversified portfolio that corresponds to my values and interests.
Some will read this and suggest that our business is all about swinging for the fences. But I don’t think so. There are hitters in baseball, the best hitters in fact, that hit balls out of the park when they are just trying to make good contact. That’s how you have to do it in the venture business. You try to make 20 great investments and you work with them closely in hopes that four years in you have six or seven that have home run potential, and after ten years, you maybe hit one or two out of the park. If you try to hit every one out of the park day one, you’ll strike out way too much and the fund won’t work out very well. – Fred Wilson
Swinging for the fences would require being in the 1% of the angel investment community, and being capable of identifying entrepreneurs that are also in the 1% of their industry. It implies being capable of making extensive use of second-order thinking. Without contradicting the above, Altman’s guidance for “thinking big” additionally applies:
You should try to limit yourself to opportunities that could be $10 billion companies if they work.
From hypothetical to real value
Investing in seed rounds is going from hypothetical value to real value.
In seed investments don’t focus too much on hard metrics but rather on more intangible factors such as the grit of the founder, size of the future market, optionality (did anybody say pivot?) and potential systemic leadership of the startup that you are considering funding.
In my view, most financial analysis is backward-looking, and the discounted cash flow analysis performed at the due diligence stage is only based on the founder’s promises/narrative. With these tools, how are we supposed to appraise the potential income or impact of a startup?
This said I am one of those that firmly believe that you should hold founders accountable for their projections vs. real achievements. Once you have agreed to the goals self-imposed by founders, do hold them accountable for the gap between expectations and reality, and let them explain how they will overcome any obstacles that they didn’t initially anticipate. You should challenge the action plan if it is not bold enough or clearly pointing in the path to failure, in all other cases I normally stay put until the next investor update.
Another way to look for value
Asking hard questions in addition to those that I included in doing due diligence as per my investment criteria
- Are you meeting your financial targets?
- What’s your path to profitability?
- How much fundraising is required to get there?
- How much will investors get diluted?
- What’s your burn?
- How much runway is left?
- What are the anti-dilution rights?
- What is the liquidation preference of the money already raised?
Valuations measure the trade off between current prices and a very long-term stream of expected future cash flows. Every useful valuation ratio is just shorthand for that calculation. Every valuation ratio that fails that criterion is inferior, and you can show it in historical data.John P. Hussman, Ph.D.
President, Hussman Investment Trust