Redeye VC

Josh Kopelman

Managing Director of First Round Capital.

espite being coastally challenged (currently living in Philadelphia), Josh has been an active entrepreneur and investor in the Internet industry since its commercialization. In 1992, while he was a student at the Wharton School of the University of Pennsylvania, Josh co-founded Infonautics Corporation – an Internet information company. In 1996, Infonautics went public on the NASDAQ stock exchange.

Read more or visit First Round Capital

Monthly Archives for 2010

View the older monthly archives »

The Unintentional Moonshot - or how a high valuation can "lock your exits"

No_exit_256x_3 Jeremy Liew of Lightspeed Ventures recently blogged about Asymmetric risk and the dangers of too high a valuation.   This is something I've been thinking about for the last several months, as I observed several new trends:


  • Valuations have increased pretty significantly over the last year. 
    Like Jeremy, I have witnessed an increase in valuations over the last year, with most of the increase occurring in Series B or Series C rounds.  This was validated by the most recent Fenwick & West Venture Capital Barometer which showed a 75% average price increase for companies receiving venture capital in 1Q07 compared to such companies’ previous financing round. This was the largest increase since the survey began. 
  • The number of exits has decreased over the last year.
    At the same time that valuations have increased, the number of total exits have decreased.  According to the most recent NVCA Exit Poll, there has been an 18% drop in the number of venture-backed exits for the first half of 2007 when compared to the first half of 2006.  Specifically, there were 188 exits in 1H 2007 (144 M&A exits and 44 IPOs) versus 228 exits in 1H 2006 (199 M&A exits and 29 IPOs). 
  • An increasing portion of M&A exits are occuring below $150 Million.
    According to the Jeffries Broadview Global M&A database, 72% of Venture-Backed M&A for the past 4 years has been below $150 Million.  Take a look at the chart below.

Exits3

What do these three trends mean?  I believe that under certain circumstances, they argue that that high valuations in a Series B/C round are not always the best thing for entrepreneurs.   Now before you go off saying that as a VC I have a reason to advocate for lower valuations, wait a second.  My firm, First Round Capital, is a seed-stage investor.  As the first money in, our interests tend to be aligned with entrepreneurs -- if the company gets a high valuation for a Series B or C round, both the entrepreneur and my firm experience less dilution.  And if the company takes a lower valuation, we both get diluted.  So we have a pretty good reason to try to maximize valuation.  However, in many cases I think that might be shortsighted.

When a company gets a term sheet with a high valuation, they need to pay attention to the unwritten term on the term sheet.  Specifically, they should make sure they are comfortable with the exit multiple that would generate the returns needed to satisfy their VC.  While every situation is unique, here's a simple rule of thumb:

Series A – 10x
Series B – 4-7X
Series C – 2-4X

So, once you sign a Series B the term sheet valuing your company at a $50M premoney, you’ve basically signed up for at least a $200M exit target.  With the data showing that there are fewer exits -- and those that do exit happen at lower prices -- I think it's worth considering whether you want to eliminate the head-end of the M&A curve (ie, with 72% of all exits occuring below $150M, why force yourself into the “moonshot” trajectory?).   

Now, I’m all for playing to win – and going for the billion dollar outcome.  However, I think there is a concrete financial value to keeping your options open.  As an investor in StumbleUpon and del.icio.us, I can pretty confidently say that had either company elected to raise a Series B round -- it would have been very difficult (if not impossible) for the founders to choose to sell their companies when they did.  And while Jason Calacanis believes that "there is little risk to raising too much money", I respectfully disagree.  Had Jason raised a large venture round at Weblogs, Inc. I doubt he would have been in a position to accept AOL's acquisition offer.

One thing to note, I'm not saying that there aren't times where a company's progress/opportunity is so compelling, that it makes sense to decide to take the asymmetric risk and lock yourself into a big-exit trajectory.  We've definitely participated in several of those deals.  But I am saying that, in my experience, most entrepreneurs aren't making a conscious decision to go for the moonshot.  By optimizing solely for valuation/dilution, they aren't considering the outcomes they are removing from the table, or the added risk they are taking given the changing exit landscape.

As Brad Feld concluded when he commented on Jeremy's post, they key is to "pay attention to the risks of having valuations being both too high and too low, and understand the asymmetries in those risks."

One final note -- I continue to believe what I have said over and over --that "entrepreneurs should focus on building real, long-term value" and "you can't build a company to sell it."  I am not advocating that you build a company with the primary focus to sell it.  What I am saying, is that too many founders are not aware that they are shutting off the majority of exits -- and therefore increasing risks -- when they accept a high valuation.  When people say there is "no risk" to raising a lot of money or getting a high valuation, I think they are not looking at the current exit realities

Comments

Emre Sokullu

Timing is great.

Ted Rheingold

Extremely sensible words during increasingly irrational times.

Anon

How often is an exit multiple placed in a term sheet?

Jason

Great response. I think their is another vector that is not coming up in this discussion: current net worth.

For Marc he's gonna swing for the fences because moving the needle on his balance sheet is, well, hard.

For me three years ago a $25-30M sale was a huge thing.... it represented my family (think parents, brothers, etc) not having to worry ever again. For a lower middle-class kid from Brooklyn that was a step one.

Today? Well, today I feel like going big and the numbers you put up there for B rounds seems like a fine goal.

Don from Smugmug I think has a similar world view today since I believe he's had some nice exits.

You too can relate to what I'm saying having done something *epic* with Half.com.

For a first time entrepreneur I say go for the $20-75M exit and "put some numbers up on the board." If you've done that already try adding a zero... or two.

Rock on,

Jason

Steve Kane

hi josh

thanks for a great blog, i'm a frequent reader and a fan

but i'd like to ask you what i asked jeremey on his blog:

isn't it the case that -- as a practical matter -- the subject of “valuations” is of importance to VC investors (as a negotiating tool to cut deals with startups) but not at all to founders?

in the end all VCs (and their LPs) care about is actual returns, "cash on cash."

and that's all that should matter to foundesr and entreprenurs too -- specifically, how much do they own at the exit?

this is best illustrated by VCs themselves: when doing their own fundraising, VCs never discuss “valuations” and never ask for capital in chunks associated with “milestones” or execution. they tell their investors the maximum capital needed (the size of the fund) and the exit economics regardless of what the ride feels and looks like along the way (the “carried interest”, usually 20% of any positive returns.)

the step-function, neverending fundraising, “valuation” mdoel may be a tough model to move away from, but its only a model.

as I ask this, I know every VC will look at me like I’m an alien from outer space but why, for example, can’t the VCs simply guarantee that the common stock will get 20% “carried interest” in the exit — the same deal the VCs take from their LPs? How that 20% gets divvied up amongst the common shareholders (founders, employees, et al) can be left to the common shareholders, with all sorts of restrictions and penalties for early departure — same as the way the GPs of funds divvy up the “carried interest” amongst themselves and others.

Scott Rafer

@anon, it's never offered, but you can get it a third to half the time.

will

wow steve. . . there is a lot of problems with what you proposed. . . BUT I do think its brilliant thinking. .. deserves someone like Josh to get the discussion going in the community.

Steven Loi

I very much appreciate the insight, Josh. The more puzzling question to me is why the VCs that are part of the B and C rounds would advise for such giant valuations. Even more puzzling, but would they want to unload so much money to the startups? Shouldn't the VCs (I don't mean to generalize here) be looking at not only what's best in the vision of the company they're funding, but also for the best strategies going forward? The above examples you presented only makes entrepreneurs hesitate at raising such money.

Brett Grendahl

Hi Josh!

This was a great read and I feel much more knowledgeable after it.

Ari Newman

Josh, awesome post here. I am a survivor of a company that ended up going down the go-big path. The more money we raised, the lower our chances of an exit. We ended up bringing in over 50M in venture capital, blew off a $125m acquisition offer due to the reasons you cite, and ended up with a fire-sale at 10M. Lesson learned, the very hard way.

mike

Josh - the only place I'll disagree with your post is that there are any "founders not aware that they are shutting off the majority of exits." Do you really think the guys raising $25 at $50 have any illusions about what that does to their exit opportunities?

Rather, I see these guys as pursuing a business strategy akin to running a hedge fund. Yeah, you pitch the home run returns potential, but your personal risk is limited because you're getting strong cash compensation immediately.

Contrast that to foregoing salary while you're bootstrapping and squeezing every nickel. And exits, while more likely at lower valuation, are anything but guaranteed.

BTW - I'm totally with you that the latter is the optimal approach most of the time (we've bootstrapped our own firm.) But maybe on a risk-adjusted-return basis, these guys aren't so ignorant.

Just for fun: if risk adjusted expected return looks like this:
CashCompAvg * Years + Val * EquityPostDilu * ProbabilityExit
=C*Y+V*E*P
the big levers are E & P, but you can easily make the case that expected return for the founder is higher for the guy taking the fat round & oversize valuation.

Not that any entrepreneur does this explicit calc, because all our businesses are above average.


Tim Molendijk

I don't have much experience with the matters discussed in this post, but something's itching.

What can be the problem of raising all the money you can get (at the valuation you desire)? I get your point about shutting of the path to an early exit and putting yourself on an big-or-nothing-track. But, who says that raising money means spending it? If you just don't spend it (because you don't need it (yet)), doesn't that keep all the exit possibilities as open as before the money came in?

So, I mean: why not raise all you can get (because you might not be able to get it tomorrow, and having money in the bank has never hurt a business) and then continue growing your company in a 'carefull' fashion (instead of gambling it all on one baseball swing)?

Or do VCs generally require you to spend all their cash within a fixed timeframe...?

David Armstrong

I've watched this debate go round and round on so many blogs. I think the best advice to entrepreneurs is spend more time with your customers and running a business. Traction with real customers and real revenue puts you in the driver seat with valuations and exits. Too much hype about raising money and exits handicaps business.

Ria Day

We are wondering what the current debt crunch means for the venture market. No doubt we will see a tightening of valuations and "exuberance" if it continues.
http://www.bizorigin.com/2007/the-venture-market-is-there-trouble-brewing-at-the-exit/

شات

I've watched this debate go round and round on so many blogs. I think the best advice to entrepreneurs is spend more time with your customers and running

شات

I've watched this debate go round and round on so many blogs. I think the best advice to entrepreneurs is spend more time with your customers and running

توبيكات

Rather, I see these guys as pursuing a business strategy akin to running a hedge fund. Yeah, you pitch the home run returns potential, but your personal risk is limited because you're getting strong cash compensation immediately.

مركز تحميل

wow steve. . . there is a lot of problems with what you proposed. . . BUT I do think its brilliant thinking. .. deserves someone like Josh to get the discussion going in the community.

rüya tabirleri

I've watched this debate go round and round on so many blogs. I think the best advice to entrepreneurs is spend more time with your customers and running

ktunnel

Hi Josh!

This was a great read and I feel much more knowledgeable after it.

广告联盟

I've watched this debate go round and round on so many blogs. I think the best advice to entrepreneu

en güzel oyunlar

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

çizgi film izle

I've watched this debate go round and round on so many blogs...

izlesene

I've watched this debate go round and round on so many blogs.

mp3 dinle

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

prefabrik ev fiyatları

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

izlesene

I've watched this debate go round and round on so many blogs.

çizgi film izle

I've watched this debate go round and round on so many blogs...

SGK

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

film indir

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

en güzel oyunlar

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

mp3 dinle

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

sinema izle

I like all the other changes and I would like to appreciate the improvements. I will think about this site's offers. Well it is nice to post here.

シティゴールドカード

I've watched this debate go roun

シティゴールドカード

I've watched this debate go round and round on so many blogs...

tek link film indir

I would like to appreciate the improvements. I will think about this.

extenze

hmmm this is too deep for me :(

saglik bilgileri

Fall wieder mal besuchen! Wenn du Lust hast, kannst du ja auch mal auf meiner Homepage vorbei schauen. Ich würde mich sehr freuen. Nun wünsche ich eine tolle Zeit!
Sağlık Bilgileri
Tatil Rehberi
Seri İlan
Haber
fragman
Emlak

louis vuitton damier

I've watched this debate go round and round on so many blogs...

Post a comment

Comments are moderated, and will not appear on this weblog until the author has approved them.

This weblog only allows comments from registered users. To comment, please Sign In.