On Negotiating Valuations…

…and the impact of VC portfolio construction on startups.

Since starting Notation Capital earlier this year, we’ve led (or co-led) 8 pre-seed rounds in new companies. Each investment involved at least some amount of negotiation, often regarding valuation. Negotiating with founders on price is one of the least enjoyable parts of an investor’s job, but it’s an inevitable occupational hazard. What follows are some thoughts on valuation, the market, negotiating with founders, and ultimately making investments and forming long-term partnerships.

Let’s start at the beginning: Why does valuation matter to VCs?

Paul Graham wrote several years ago that angel investors shouldn’t pay much attention to early-stage valuations. If the ultimate outcome for the company is potentially billions in value, does it matter if you initially invest at a $7M pre-money rather than a $4M pre-money? The answer, like many things, is yes and no.

For that particular billion dollar company, no, it doesn’t matter. If you had the opportunity to invest at the seed stage in Uber, Dropbox, Airbnb, you should have done so. In hindsight the initial valuation wouldn’t have mattered much, because the ultimate outcomes for these companies have been so extraordinary. In a typical venture capital fund, there will be 30-40 companies in the portfolio. So if you believe that you have the ability to pick a multi-billion dollar company in each basket of 40 seed-stage companies (or in our case pre-seed), then you’ll do well, irrespective of the initial entry point valuation. You can invest at $10M caps all day long and it won’t matter much.

The catch is…no one can do this (consistently over time). No one. Not even Chris Sacca. Not anyone. I suspect this is the same reason YC now has 100+ companies in each batch.

If, however, you don’t believe you can consistently pick a multi-billion dollar exit in each seed-stage portfolio of 40 companies (because you can’t), then average entry valuation suddenly becomes a lot more important. This requires some quick and dirty math to demonstrate.

Let’s assume the target for your $8M fund with 40 portfolio companies is 3x cash-on-cash returns, and that after subsequent capital raises your ownership in successful portfolio companies will ultimately be diluted by approximately 50% (although in many cases it can be much more).

Scenario #1 - If the average initial valuation is $6M, for $200k you’ll own about 3% initially, which over time will be diluted down to 1.5%. To return $24M to your LPs, the approximate implied enterprise value of the portfolio has to be about $1.6B - A huge number.

Scenario #2 - If the average initial valuation is $3M, for $200k you’ll own about 6% initially, which over time will be diluted down to 3%. To return $24M to your LPs, the approximate implied enterprise value of the portfolio has to be about $800M. A big number, but not surprisingly half as large as scenario #1.

It’s important to note that these are extremely rough demonstrations of portfolio construction implications, enterprise values, and don’t take into account pro-rata rights, among other ways to maintain ownership over time. But it’s a useful look into what the numbers have to be to provide meaningful returns for a small seed fund…and the numbers are undoubtedly large. As demonstrated above, assuming we’re not super confident we can pick a multi-billion dollar company out of 40 at the seed stage, initial average valuations matter (a lot). It can very well be the difference between a top-performing fund and a mediocre one.

Aside from simple portfolio construction, there are two other major reasons Notation cares about valuation and ownership.

The first is a simple story that we told our own LPs and investors (which you can read in our deck). As a small fund that takes a relatively concentrated approach and works closely with our portfolio companies, we might earn higher ownership on balance than the average angel investor could do alone. Our goal is to do what we said we would.

The second reason is that we spend a lot of time with each company we partner with and need our ownership to reflect not just our financial investment, but our time as well. The founders we’ve partnered with will attest to the fact that in the early days, we really dig in and help in key areas: technical recruiting and team building, product architecture and scale, capital raising. We also pride ourselves in being available - literally 24/7 - to the founders we work with. We celebrate wins, but we’re available to chat through tough days too, and we figure out together how to keep on going. We do this because we really do love it. But we also do this because we have proper financial incentives and at a very basic level, that means meaningful ownership in each business we invest in.

Thus far, in the eight months we’ve been operating Notation Capital, our ownership expectations tend to be initially higher than the founders we work with. This doesn’t come as a surprise– there is almost always valuation tension between founders and VCs.

So how do the founders we work with initially tend to settle on valuation expectations? Below is a list of some common items founders tend to reference in our negotiations:

1) Other Founders - Startup founders often know many other founders in the community. In the same way VCs trade valuation notes, founders do too. We often hear that “my founder friend X raised at $Y valuation.”

2) Friends / Family / Advisors - Startup founders almost always have friends, family and advisors helping them through a financing. Raising capital tends to be stressful, so it’s good to have a support system. This category tends to have wildly varied views and advice regarding valuation.

3) AngelList / Crunchbase Data - These are great sources for aggregate level market data and we often hear that “On AngelList, a seed-stage company on average should raise at a $5M valuation” or some version thereof.

4) Techcrunch / Press

All of these sources, except for maybe Techcrunch (lol), can be good starting points and/or guides in a valuation negotiation. At the early stages of a company, it’s impossible to value the business as the present value of its future cash flows, so it helps to point to something.

Founders tend to take early-stage valuation negotiations very seriously, as they should when they sell a part of their company. But often it goes further than that, particularly when founders tend to tie valuation to self-worth and/or the odds of success. Although helpful as a starting point, each of the sources above can also be critically flawed.

Valuation data for early-stage companies in aggregate can be very difficult to apply to a particular company in a uniform manner, particularly given the myriad of differences between founders, markets, and everything in between. Yes, a friend may have raised their seed round at a $10M valuation pre-launch. Friends, family and advisors, although helpful from a support perspective, tend to be extremely valuation insensitive. For example, a founder’s mother, in order to support her daughter, may write a small check at a high valuation for no other reason than she loves her daughter unconditionally. An advisor, incentivized by advisory shares, may also push a founder to expect higher valuations than normal. These folks tend to write small checks at very high valuations, which is not necessarily indicative of the real market clearing price and can cause complications down the road.

Here’s the bottom line: The current valuation is what someone will pay to buy a meaningful piece of the company.

What constitutes a meaningful sale for early-stage companies? I think I’d consider it 10% of the company or more. Anything less, although it may be material to the founder, is not an entirely accurate reflection of current valuation. What we see often, which can be challenging for founders to correct, is a friend / family / advisor writing a small check at a high valuation, encouraging the founder to go out and raise a round at that same valuation, only to find it must be amended, or worse, it negatively impacts a fundraise because institutions balk at the high price.

What makes a valuation negotiation particularly bizarre, is that at the same time the VC is negotiating a founder down on price, she is making clear by wanting to invest in the first place that she believes the company may be worth considerably more in the future. What founders often mistake is that the current value of the company tends to account both for the size and the odds of a potential future outcome. In other words, risk. When we offer a term sheet to a founder, we’re not speaking to the ultimate future value of the company (we obviously think it will be a lot higher than it is now). We’re not speaking to average valuations in the market or the press. We’re not speaking to whether or not we believe the founder is capable of executing. We’re simply speaking to what the valuation and ownership must be so that we feel properly compensated for the investment risk being taken and the amount of time we’ll spend working with the founder and the team.

Sometimes there are other investors that may offer higher valuations than we do. It’s not necessarily because we’re wrong and they’re right (or vice versa)…it’s simply because they price the risk and time effort differently. The early-stage startup market is becoming more and more efficient every day, so founders can be reasonably confident that they will find the appropriate valuation and clearing price. Although inevitably emotional, founders would do well to try and not take the ultimate valuation personally, especially because it will never get any easier or less emotional. Consider public market CEOs who have to face the judgment of the masses every single day.

An interesting note: in recent conversations with other seed stage VCs, it’s remarkable how many investors are terrified to have honest and open negotiations with founders. In a frothy market in which founders often have more leverage than the capital that supports them, many investors are throwing basic portfolio construction theory to the wind and crossing their fingers for that $1 billion plus outcome out of 40. A few will come out huge winners, but most small funds won’t make it through the winter.

Alex and I started Notation because we’ve always loved working with technical founders in the trenches, at the very infancy of an idea. We think we’ve gotten pretty good at it and we think we can be really helpful at this stage in NYC. We’d like to do what we do for a very long time - we’d like to be around come spring.

And so for us, that means discipline in a hot market. That means math that feels like it makes sense. And that often means negotiating valuations with founders - something that makes our jobs less fun than they usually are. As it turns out, something unexpected happens when you have brutally honest conversations with founders at this early stage - you build the basis of a strong working relationship right from the start.

We tell the founders we partner with that we’re rarely the cheapest source of capital in town, but that we work hard for every share of ownership we earn. If we don’t earn it, we know founders won’t be good references for us in the future, and without stellar references, there’ll be no future to speak of. So ultimately the founders we partner with will decide our fate, and maybe that’s just the way it should be.