Posts Tagged ‘returns analysis’

Series-shifting, terms, and fallout

March 4, 2009

The good news in the startup landscape is that companies are getting funded, and the pace and quality of startup activity remains strong, especially here in Seattle.  This seems to be the case in the valley too

But the deals that are getting financed are generally “obvious” ones; series A deals where the founders have solid track records or later stage deals that have proven they can acquire customers and most importantly, monetize them.  The deals everyone would like to do. 

What about all the others? 

Well, they’re ruled by the bleak exit landscape for venture-backed companies.  Any investor looking at a good company now is doing a returns analysis using much lower exit valuations than they’d used six months ago.  The economics have to adjust downward to make the numbers (and the risk) workable.  Make no mistake, the obvious deals feel this “compression” effect too, perhaps the fundraising process moves more quickly for them.

The first “compression” effect I call “Series-shifting” – when a company that’s out raising its B round gets valued as if it were on its A.  Or a C round company gets valued as if it were raising a B round. 

Colley Godward reports median Series C valuations dropped almost 40% in 4Q08 compared with the prior 1Q08-3Q08 timeframe.  40% isn’t a bad approximation of the step-up in value you might expect from the Series B post-money valuation to the pre-money Series C valuation, based on the company’s progress in developing the business.  In today’s fundraising environment this means the market is assigning little to no economic value to that progress.  Ouch.

As an aside, this introduces some nuance into your fundraising.  The post on your last round is likely high relative to today’s market.  At an appropriate time, you need to signal that you know this and will be flexible on valuation without prematurely putting a “fire sale” sign up.  If you wait too long to signal, you’ll scare off investors who think you’re out of touch with today’s market.  There’s no rulebook for how to handle this, just experience and good judgment; the goal for both parties is to be fair and realistic, not to take advantage of either party.

There’s a second “compression” effect: terms are getting much more aggressive, reflecting today’s more conservative assumptions on returns and capital recovery.  While not painless to the entrepreneurs and early investors, liquidation preferences can be a way to let the valuation retain some “loft” while enabling the new investor to limit the downside if the outcome isn’t what everyone hoped for.  If everything goes as planned, everyone’s happy, if not, it’s the new investor who gets protected. Ouch again.

Don’t take it personally, it’s just math, not a case of predatory investors.  It’s the messy reconciliation of the business model of the startup and the business model of the investor.  If you choose your investors (or your investment) well, this is a juncture that can be navigated honestly and transparently, but perhaps not painlessly.

So now what?  How many businesses are going to be able to pass through filters that have such conservative assumptions or where new investors need such aggressive forms of protection?  The answer is, not a lot. 

As Andrew Chen also highlights, there are just too many Web2.0 businesses out there, and as with the Web1.0 bubble, a lot of these in hindsight are features of someone else’s platform, or have thin value propositions to begin with.  We’ve seen this before, and lots of companies just won’t get funded, or won’t raise their follow-on rounds.  In the medium term, a good thing for the industry, in the short term a lot of carnage will result.

Paul Holland of Foundation Capital says it well in a BusinessWeek interview “The most healthy thing for this industry would be a clearing out of people who don’t have the stomach for it.”  That applies to both sides of the table, companies and investors.

Healthy, yes.  Pretty?  No.