Investor Alert: Founders are Using Investor Math Against Us!
Two weeks back I was sitting in on a pitch wherein a healthy snacks company was looking at raising its seed round from us. The company was yet to launch its products in the market, but the team had the requisite experience and plan to get the venture off the ground. The company checked all the boxes on why we should take the deal forward until they opened their “Valuation” slide.
The company expected itself to be valued at an eye-popping Rs. 16 crore ($2.5 million). Now before you point out my Marwari heritage for balking at the valuation this is a company that does not manufacture its own snacks and (as of that moment) hadn’t sold a single chip. Therefore, their expectation of how much they should be valued at was jaw dropping. The founder claimed to have two funds backing that valuation, making the unbelievable situation become completely ridiculous.
As is the norm in a situation like this, we got in touch with the fund managers and inquire on the rationale given for valuing a group of entrepreneurs with huge plans a valuation of a midsized hotel. Their reason – the company wanted to raise Rs. 4 crore and since the fund manager wasn’t comfortable diluting them more than 20%, he reverse calculated the valuation which worked out to the awesome figure of 16 crores.
I agree that this reverse calculation methodology is very often used by us angel investors to come up with a valuation for an early stage start-up, since it is very difficult to decide on a value created in Excel, especially for a venture that is in the pre-revenue or early revenue stage. However, at that very moment I realized that founders have caught on to this methodology. They are using this formula against the investors by increasing the ask, so that the valuation increases for them!
Is it smart? I don’t think so.
When a company asks for a high valuation, the expectation of performance increases multi-fold. As I have mentioned in the past, there is a mathematical logic with which early stage investors invest. If the company gets a high valuation in the first round, the next round will be expected at an even higher number. To reach that “high” number, the company must perform at a scale which gives them very little room to conduct experiments, make errors and pivot, if needed. Taking away those privileges from early stage founders is seriously detrimental to the health of the venture. That investment (then) is a complete gamble on the founders to find the product market fit and achieve scalability, with an almost-zero chance for errors.
Now armed with the knowledge that founders have caught on to the lazy math utilised by early stage investors, we have decided on a range that a venture should raise based on where it is in their journey to becoming a business. When their requirement is beyond that range (above or below), we look at the expenses sheet to figure out why. If the expense is justified, we do not raise the valuation but are offering the founders a clawback based on hitting a number that will justify the expenses they need. This in turn, has helped us tamper down the valuations.
However, that healthy snacks company got the “we pass” email because not only was the valuation very high, but also the two well-funded backers of that valuation were committing just 25% of the round, thereby putting the onus on lead investor to make the math work… and I knew that I couldn’t do it.