Don’t Let Faux Unicorns Screw Up Your Financing

image001A version of this article previously appeared on Forbes.

It is no secret that the number of private companies with valuations in excess of one billion dollars has skyrocketed since the start of 2014. As show in CBInsight’s chart, the number of such “unicorns” created during the first half of 2014 was roughly equivalent to the number created during the prior three years.

The duct tape securing the faux unicorns’ horns won’t hold up to the market’s scrutiny forever. The inevitable outcome will be the collapse of the weakest companies, while those with sound underlying business models will be recapitalized with reasonable valuations.

If such write-downs only impacted the faux unicorns and their avaricious investors, there would be little need for alarm. Unfortunately, the coming market correction will reverberate to all stages of venture investing.

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Find A Partner Not A Banker

The constant media coverage of the aberrant unicorn valuations has caused otherwise level-headed entrepreneurs to expect investors to participate at prices which are detached from their startups’ fundamentals. At Rincon Venture Partners, we continue to be disciplined, seed-stage investors. However, we have seen pre-money valuations more than double in the past year.

Ultimately, a startup’s value is based on what the market will pay. However, despite the hyped stampede of faux unicorns, savvy entrepreneurs balance the important issue of valuation with the following non-financial aspects of a healthy investor / entrepreneur relationship.

Company Friendly – Investors should demonstrate an entrepreneur-centric approach with their actions, not solely their words. For instance, a company-friendly investor typically only participates in a follow-on funding round beyond their pro rata participation with the Founders’ explicit approval. This is significant because pro rata investors are relatively indifferent as to a future funding round’s valuation. Thus, a pro rata investor’s advice is not self-serving, as their dilution will be the same as Founders and other stockholders, irrespective of the valuation.

Investors that insist on investing more than their pro rata allocation in follow-on rounds have an incentive to compress the company’s valuation to maximize the percentage ownership acquired by their investment. Such depression of funding valuations increases the entrepreneurs’ relative dilution. Investors which either do not participate or do so at a rate below their pro rata are inclined to want as high a valuation as possible.

Shared View Of Success – Experienced entrepreneurs who have previously participated in large funding rounds with high valuations appreciate the direct correlation between the post-money valuation of their latest funding round and the range of financial acceptable outcomes to their investors.

Although mega rounds with high valuations can be an effective way for large VC firms to efficiently deploy their capital, this approach can actually decrease a startup’s chances of success. For instance, assume your investors will not be satisfied with anything less than a 5x return. Thus, if they invest $10 million and own 35% of your company, your venture’s exit must be at least $140 million (($10 million x 5) / 35%). According to Pitchbook, during the first half of 2015, “M&A exits valued at less than $100 million made up the majority of exits or about 65% of the total number of deals, which was up from about 60% in 2014.”

I recently met a young CEO who had previously founded a company that raised a sizable round at a $30 million pre-money valuation from two large, Bay Area VC funds. Shortly thereafter, the company received an acquisition offer which would have put over $15 million into the Founder’s pocket.

When the CEO excitedly called his venture capitalists, he was shocked when they literally laughed in his ear. When their laughter subsided, they condescendingly explained that they did not invest in his company to get a “2 or 3x multiple on our money.”

Years later, the company was sold for substantially less than the total capital invested. Rather than walking away a decamillionaire, the Founding CEO lost most of his life’s savings, as well as a significant amount of his friends and family’s money.

Manage Dilution – Valuation is only one factor impacting dilution. The other is so obvious, it is often not given the scrutiny it deserves: the amount of money raised. Smaller funding rounds with reasonable valuations often results in less dilution for the Founders and their employees. The most effective way to minimize dilution is to raise a modest amount of money and deploy it to create a capital-efficient path to revenue.

You Team Is Not Fungible – Investors should invest your team, not the market sector you are pursuing. Sector investors are more apt to replace founding members of the management team with executives from their professional network.

Ironically, this approach actually increases the company’s execution risk, as significant uncertainty is inherent whenever an ad hoc team is formed. When a senior executive is “transplanted” into an existing team, the risk that the transplant will be “rejected” should not be underestimated.

Multiple Winners – Certain markets inherently lend themselves to one or two companies owning their space (think Uber, eBay, YouTube and Twitter). However, non-market place opportunities support multiple successful companies.

Prudent investors do not demand that entrepreneurs pursue bet-the-company strategies. However, VC’s with large funds require huge outcomes to earn a sufficient return. This dynamic drives these investors to overly-value grand slam outcomes.

An investor looking for a career-making deal might encourage you to take imprudent chances in the hopes you are the “winner” in a highly competitive market. If you fail, their downside is minimal. They will remove your company’s logo from their website and try to forget they ever made the investment. For you, the impact of a negative outcome is far more tangible and dramatic.

Social Contracts Are The Foundation Of Successful Partnerships

When entrepreneurs are viewed by their investors as partners and not their subordinates, a healthy, long-term and mutually beneficial relationship often develops. When entrepreneurs feel they serve at the whim of their overlord investors, trouble (especially for the entrepreneurs), usually ensues. If you choose to chase unicorn-inspired valuations, be sure the source of the funds will be collaborative, rather than combative.

Follow John’s startup-oriented Twitter feed here: @johngreathouse.

Image: CBInsights.com

John Greathouse is a Partner at Rincon Venture Partners, a venture capital firm investing in early stage, web-based businesses. Previously, John co-founded RevUpNet, a performance-based online marketing agency sold to Coull. During the prior twenty years, he held senior executive positions with several successful startups, spearheading transactions that generated more than $350 million of shareholder value, including an IPO and a multi-hundred-million-dollar acquisition.

John is a CPA and holds an M.B.A. from the Wharton School. He is a member of the University of California at Santa Barbara's Faculty where he teaches several entrepreneurial courses.

Note: All of my advice in this blog is that of a layman. I am not a lawyer and I never played one on TV. You should always assess the veracity of any third-party advice that might have far-reaching implications (be it legal, accounting, personnel, tax or otherwise) with your trusted professional of choice.

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