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science, art or sorcery?
clues to .com valuations

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A lot of people throw around pre-monies without clarifying how many shares they are assuming to be outstanding. I don't want to get too technical, but there are only three moving parts, so I think this audience can handle the math. You multiply per share price by total shares outstanding. That gives you your post-transaction valuation. Now, subtract out the new money that came in and you have your pre-money valuation.

Entrepreneurs say, "We saw in your term sheet that you are trying to alter the option pool." We are doing that because it's in your best interest and we want to make sure you are comparing apples to apples. When we look at a capitalization table, we are going to look to see how many options you have reserved to incent and build a world-class management team. As a general rule of thumb, we like to see about 20% of the option pool unallocated. Is that a hard and fast rule? Of course not, and we generally try not to just automatically go to the 20% number. We want to have a little bit more precision, but the precision is easy to do. I'll tell you exactly the math I do. I look at your management team. I sit down with you and talk through where you see holes in that team and how we can help you build it. We help our portfolio companies make a lot of hiring decisions, so we know how many options it generally takes to recruit at each level in an organization. We know that a vice president of marketing is going to cost you X%, COO, Y%, whatever. The end result of this needs assessment, however, will almost always have the same goal—we are going to try set aside enough options to buy you one year's worth of runway. That's where the magical 20% comes from. More often than not, in a high growth business, one year worth of hiring runway will require close to 20% in option grants.

My final advice is very, very important. Remember the golden rule, or at least my golden rule. You can sum up entrepreneurial fundraising activities in this one statement: There are only two kinds of entrepreneurs, those who run out of money and those who don't. Keep in mind what your goal is. Cash is king. You need to raise money so that you can grow, and you need to make sure you are viewing the entire lifecycle of financing your company.

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What is a typical VC's valuation methodology? VCs don't talk about this much, but, heck, let's give it a whirl. It's surprisingly non-analytical. You heard the first two speakers give a great lay of the land for the public markets. We VCs can't build off of traditional metrics because the companies we invest in are generally too early-stage. Here's a real life example, two of our last three deals had three people in them when we invested. How do you value a company with three people? They didn't even have their Web sites developed yet. They had phenomenal ideas and we loved the management teams. They're absolutely inspired, so we wanted to do the deals.

I'm trying to get you to understand our dilemma. It's very, very tough to value a company at that stage. Looking at public comparables is almost meaningless—not in terms of assessing how compelling the idea is, so don't pull the public comparables section from your business plan altogether—just don't put it in your valuation expectation section. Instead of being quantitative or analytical, the VC valuation process is often guided by rules of thumb. I tend to use five categories differentiated by feel: $2-$5 million dollar pre-money, $5-$10 million pre-money, $10-$20 million, $20-$50 million and $50 million+. Is there any rhyme or reason to those categories? I don't know; it just happens to be what I have developed over time. What I can tell you is, if you were to put the four of us who comprise FBR Technology Venture Partners in separate rooms and just slid business plans under each door, telling us to put them in value buckets without any communication between us, I bet that we would have almost 100% unanimity.

I wish I could give you something more concrete, but it's difficult. I can tell you that there is certainly room to move within a category; however, the ability for a company to jump from one valuation bucket or category to another is very, very rare. Angie Kim pulled it off, and I'll let her tell you her secrets. The best way for a company to increase its valuation is to be able to demonstrate a reduction in risk. As I said, valuation is a function of the magnitude, timing and risk of future earnings. If there are things you can show us to convince us that the risks of your business are easily managed, it's going to enable you to jump from one bucket to another.

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One more point that I think is very important. A lot of people don't understand the kinds of returns we are looking for. Our goal is 10x returns or higher. Honestly, it's not because we are greedy; it's because we do very risky investing and there are going to be a number of companies in our portfolio that don't quite make it. We have been very, very lucky. In our first fund, I think we will have over a 50% IPO rate, and a number of those will return well in excess of 10x our investment. That's fantastic, but we are also getting a bit of a draft from the public markets. We get business plans from people who say they have a guaranteed 2x return. Philosophically, even if I believed that it was 100% guaranteed at 2x, I don't think we could do that deal because that's not what our limited partners want from us. They hired us as an alternative asset class. They want us to swing for the fences, and the sure thing 2x just isn't it. They want home runs that go out of the park, into the parking lot and keep rolling down the street.

The last point is that, ultimately, valuation is determined by supply and demand. It's that way in the public markets, and it's that way in the private markets. That's why we are starting to see some valuation creep. We are starting to see a lot of larger-scale private equity funds, the traditional buyout groups, who generally do valuations using metrics, math and Excel models. They are seeing the returns that the VCs are getting, so they are coming down market. The good news for entrepreneurs is that they tend to pay more. As a result, we are seeing valuation creep upwards. In the end, if you have something that's red hot, I don't care what bucket I think it belongs in. If you absolutely sell us on the idea and we want to make sure we are a part of it, we'll try to work with you to make a valuation work. It's in your interest and, in all honesty, it's in ours also.

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angie kim: the netpreneur

Thank you. As Jeff mentioned, I just went through the whole valuation mess, as I call it. It's a very mysterious process that we netpreneurs have to go through.

I would like to tell you a little bit about what our funding adventure was like so you have a context and tell you a couple of observations and hints that I learned from some of my friends who went through this process before me. I was a little bit skeptical because the stories seemed so quirky. After having gone through the process, I now definitely can say that some of those weird things you hear about, the ones you just sort of discount, they are true.

To give you a quick overview, EqualFooting.com, is an online marketplace for small businesses in the industrial supplies and equipment sector. I started it in May with two of my colleagues from McKinsey & Co. who had also focused on E-commerce. We all quit our jobs in early June and got our first employees around July. About three weeks ago, we closed our first round of $8 million from New Enterprise Associates, as well as FBR Technology Venture Partners, so Scott knows what he was talking about.

Of the things we learned, number one echoes what Scott was saying about discounted cash flows and those types of analytical valuation methods. We completely went through them. Our business plan in early June highlighted the DCF method. My two partners are Wharton finance MBAs, so they went through this very complicated model using a pretty reasonable discount rate of 50% pre-money. We realized very quickly that nobody even looked at our financial models. They just asked us very basic questions about certain revenues and whether we were actually going to have revenues. Other than that, there weren't any specific questions around our DCF models, assumptions, methodology, discount rate—none of that seemed relevant. In fact, yesterday I was going through our financial model just to see what we had thought back in June (which now seems like a very, very long time ago) and realized that what we had was so completely absurd even at 50% pre-money. I showed it to all of the 30 employees we have now, and we all got a huge kick out of it. When they calculated what the discount rate would have been using the same model, revenue assumptions and cash flows, but actually getting the pre-money valuation that we had ultimately settled on, the number was a 200% discount. I thought that was illuminating, since we were pretty happy with our pre-money valuation.

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The second thing is one of the quirky secrets that was passed down to me from friends who had gone through raising funds in Silicon Valley and on the East Coast. We talked to a number of West Coast VCs and angels and we talked to a number of East Coast VCs and angels. There seems to be a marked difference in the valuations that are typically given by the two. For some reason, I'm not sure exactly why, West Coast VC valuations are on average higher, sometimes significantly. I had heard this from a number of people and was skeptical about it, but our own experience bore it out. We did a lot of comparison shopping among term sheets, which I'm sure frustrated some of our VCs, but I can definitely tell you it's a bizarre difference. West Coast VCs, we were told, tend to be very geographically focused. They tended to tell us that if we wanted to do their deal, we had to move to the West Coast.

Even though we weren't interested in moving to the West Coast, I'm glad we went through the process. You see, since West Coast VCs, it seems, give somewhat higher pre-money valuations and sometimes can move a bit quicker, probably because their methodology is a bit more scrutinized. I'm not sure, but, in any case, because of that difference we were able to quickly get some attractive term sheets from West Coast VCs and use them to hurry along the East Coast VCs that we really wanted to do deals with. The process probably somewhat heightened the pre-money valuations we ended up getting. We really didn't do this consciously, but it ended up working out that way.

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The third thing is about how valuations are paid, and, more importantly, when it is paid to the company. One thing we found is that raising money, no matter how fast you want to do it, no matter how fast you get the term sheet, takes a really, really long time. Even with the lawyers all lined up to go and term sheets that clarify everything, it still took us a good couple of months to actually close the deal. So, as Scott said, do not ever, ever, ever be in a position to run out of money. Make sure that you have enough money to stay afloat.

Having said that, one thing that most people don't realize, and we just realized it after we closed, is that a company's value seems to be pegged at the time of your first meeting with that particular VC to start talking about pre-money valuations. For example, we started talking to a lot of VCs in July after we did our seed round. We got term sheets in August and September and closed some time after. From June—when there were just the three of us working out of my basement in Great Falls with no partnerships and pretty much nothing except the concept—until we signed the term sheet, at which point we had maybe 20 employees, a beta that we were working on, some customers who had signed up as pilots and some agreements—still our valuation seemed to be pegged more to the time that when we first seriously started discussing our company's pre-money valuation in June. There was even a lot of activity between signing the term sheet and actually closing that I'm sure were relevant to valuation, although that's obviously off the table. If I had it to do over again, I think we would do a couple of things differently. One is, as long as you are comfortable that you won't run out of money, try delaying the meetings until you get over a significant bump in your company's history, whether it's hiring the first employee outside of the founders, developing a prototype, or signing your first major marketing agreement—whatever it is for your company—try to wait until it happens before having your first meetings.

The second thing we did, based on our lawyer's recommendations, ended up being great. We did not put a valuation on the company at the seed round, which included friends and family as well as some angels. We took about a million dollars in and did it as a round of convertible debt that converted at the VC price. We had very nice friends and family who were willing to do that. If you have access to that kind of money where you can delay putting a valuation on your company until after the first venture round, well, we found it very helpful. Based on conversations with other entrepreneurs who have had similar first round pre-money valuations, I think we suffered significantly less dilution.

Those are the lessons learned and some observations. Thanks.

 

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