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When to reach for the stars

July 28, 2011

When to reach for the stars

As anyone who follow the start-up world knows, valuations for high
potential young companies as of late have been trending upward (how's
that for an understatement) and are fairly divorced from underlying
traditional (ie revenues and earnings) metrics.  This is currently true
with both "later" stage companies such as Foursquare's $600M valuation
and earlier stage companies that are seeing pre-money valuations that
are 1.5-2 times what one would expect to see in "normal" markets.  As an
entrepreneur this naturally sounds like good news, and it largely is,
although I thought it might be helpful to share some of the perspectives
from the investor side as well as some potential watch outs.  

As an investor, when to "pay-up" for a compelling opportunity is one
of the more difficult decisions we make on the new investment side of
our daily lives.  If you do it across the board, you will end up with a
portfolio that has sub-par performance, but if you miss out on great
companies by being too disciplined, the opportunity cost is
exceptionally high.  So when confronted with such situations as an
investor, some of the things that cross our mind are as follows:

  1. Is there downside protection in terms of the underlying asset?  The
    best example of this that I recall is a conversation I had with one of
    my former partners at Greylock in discussing their investment at $500+M
    value in Facebook.  At the time he told me that he was unsure about the
    upside from there, but that he was sure given the company's user growth,
    early revenues, relatively limited capital raised to date and the
    company's strategic importance, there was no way way they were going to
    lose money on the investment.  On Wall Street, they call these
    asymmetric trades: lots of upside and low downside.  While they may not
    all pay off, it can be a savvy approach for an investor to take.
  2. Is the amount of capital being raised sufficient to get through
    important milestones?  Even if they long term upside is high, if the
    capital being raised at a high valuation is not enough to get the
    company through enough value creating milestones that allow the next
    round to be at a higher price, it is unlikely to be worth pursuing as
    the pain of down rounds,the impact on morale and other issues can be
    painful.  Interestingly, this thought process often leads to larger
    rounds, with more dilution for entrepreneurs, and creates a whole host
    of risks that come along with too much capital such as lack of focus and
    unrealistic expectations.
  3. The last, and perhaps most obvious point, is that as an investor
    when you are reaching in terms of valuation, it needs to be for the
    right reasons.  At Flybridge, we rank our investments on a host of
    criteria including the strength of the team, the size of the
    opportunity, how robust the business model is, whether there are real
    network effects and how disruptive the approach is.  to reach on price,
    we need to be convinced on all dimensions as the criteria together
    indicate a strong likelihood of creating a lot of value and that the
    company can quickly grow into the value being established.  The wrong
    reasons to reach are competitive pressures or investments that are
    viewed as strategically important for the venture firm's brand.  Our LPs
    don't pay us to win all the time nor do they want us to use their
    capital to create a perceived halo that comes from being involved in
    high profile companies.

From an entrepreneur's perspective, raising capital at high prices
sounds like a great thing.  There are, however, some words of caution
that are worth running through having had a first row seat in the last
overheated market.  The first is to recognize that a successful fund
raise does not equal a successful business, so don't believe your own
press and take an eye off running the business lest the next round be
more challenging than the one you just closed.  Second, be careful about
pushing your investment partners too far.  I remember one company where
we were A round investors and they raised a Series B at very high
prices and the VC director that came along with that financing was
extremely dysfunctional when the business hit the inevitable bump in the
road.  I don't think he was a bad apple, but rather was under a lot of
pressure with his partners having gone to bat for the high price only to
have the company do well, but not well enough to justify the
valuation.  Finally, as alluded to above, reaching on valuation too
early implicitly raises expectations that you have for yourself and
others (employees and investors) have for the business and this can lead
to the pursuit of overly aggressive strategies too early.  So the final
word is be aggressive, but realistic.

Chip Hazard
is a General Partner with Flybridge
Capital Partners
.  You can find this post, as well as additional
content on his blog called Hazard
Lights
.  You can also follow Chip (@chazard) on Twitter by clicking here.