From Eli van Goudoever – Sanoma Ventures

During last quiet summer period I spent some time drinking coffee with a number of very early stage startups. I enjoy the founders’ energy and adding an investor’s perspective to their plans – even though their stage does not match with the investment parameters of our fund.

A handful of times I was asked my opinion on the startups’ prospective valuations. Not surprisingly, the startups’ ballpark valuations where often way north of mine. Naturally a strong belief in your startup’s future world dominance (which btw you should have!) comes jointly with a high perceived valuation, but starting talks with investors at unreasonably high valuations causes various risks and problems – and likewise does investing.

Let’s start with the startup’s viewpoint. Some investors immediately slam the door when confronted with a valuation they deem unreasonable. Starting too high can also harm both the negotiation dynamics and your own mood: you will feel bad each time you lower your ‘virtual’ valuation. Lastly, closing at a high valuation often increases difficulties in raising the next financing round: if things move a little slower than anticipated, the odds of hitting a down round increase sharply. Now a down round does not necessarily equal failure (as Facebook has shown), but down rounds do bring a type of stress that none of your stakeholders will like.

Switching to the investor’s viewpoint, we know a couple of things about killer exits. Amongst what we know best, is that killer exits are scarce – and the earlier you invest, the scarcer they are (although this not being entirely true, the chances of hitting a decent exit are). What we also know is that the ‘killer exit proceeds’ are likely to be less than pro rata be distributed to the early investor’s entry valuation/funding amount (resulting from dilution in consecutive financing rounds, and –lesser known to many but potentially yielding equal outcomes- liquidation preferences).

Statistically an average 1 out of 10 investments produces a killer return to the fund. As investors we need such proceeds to cover the fund costs (usually 2-3% of the fund size per year), offset losses among the portfolio and make a return for our principals that aligns with the risk of the asset class (generally somewhere between 20-30%).

An angel investor once told me that he leaves out the valuation discussion at all, by investing under discounted convertible note structures. I believe a slender 10% (or even 25%) discount doesn’t make up for the risks associated with investments in early stage tech companies – but at least the respective investor doesn’t need to worry about all of the above.