Boom or Bubble…(just raise enough money to stay out of trouble)
In this market, boom or bubble, valuations are up and everyone has an opinion about what this means for your start-up. Andreessen says boom, Moritz says bubble. No matter what you think will play out next, you will need more capital than you think to get through it.
This past weekend, Mark Suster wrote a piece for TechCrunch on valuation and encouraged entrepreneurs to seek valuations at the “top of normal.” Near the end of the piece, Mark mentions the danger of, “getting ahead of your inherent valuation.” In my mind, this is the thing founders should focus on the most and work the hardest to avoid. I agree that optimizing for valuation is a bad strategy, but assuming all sources of capital are equal, I can’t see why you would raise money at a valuation below “market” either…as long as you raise enough.
To determine how much capital you should raise to protect from future funding environment risk, I think it is helpful to think about how much credit the market is giving you for the future value of your business. In public markets this would be the growth premium, but for start-ups, you can think of it in terms of months of credit.
Here is what I mean:
For simplicity, call the inherent value of the business $5m and let’s assume you will add $1m in enterprise value a month if you hit your milestones. 18 months from now, assuming success, the inherent value of your business is $23m.
[caption id=”attachment_880" align=”aligncenter” width=”398" caption=”Simple model, linear growth”]
If it is a boom market that will give you credit today for 14–18 months of future success, you will see valuations in the $19-$23M range. Sweet.
Now assume you raise the normal 12 months of operating capital, meaning you will be fund-raising again in 9 months. Assuming success in our simple model, the inherent value of your business will be $14M. (Note: I am ignoring the value of the capital invested for simplicity).
If the market is still giving you credit for 14–18 months of future success, you will see valuations in the $28m-$32m range. Sweet.
But, by raising the normal amount of capital in a boom market, you add a new risk to your business: funding-environment risk.
If it is a bubble and the world is going to fall apart sometime soon, you want to be able to operate through the down-turn on the capital you raise today at today’s valuations. If you can’t, it can be very painful for all involved.
Back to the simple model:
Assume that 9 months in the future, the market is no longer in a boom, and is only giving you credit for 6–9 months of future success, you will see valuations in the $20m-$23m range. A flat round after hitting all your milestones. Not so sweet. If it is worse, the bubble just burst and you can only get 0–3 months of credit if you can raise capital at all, valuations could be as low as $14m-$17m. You will have delivered against your plan, hit your milestones only to be faced with a down round.
Alternatively, when the market is booming, you could choose to take some more dilution and raise 18–24 months of operating capital.
[caption id=”attachment_881" align=”alignright” width=”362" caption=”going from red to green really really hurts at 9 months”]
Dilution is painful at any price, but raising more capital mitigates some of the funding-environment risk by allowing you to wait for a sudden down market to bounce back. More importantly, raising more capital when you are in a boom gives you the runway to earn your way back into your current valuation in a prolonged down cycle and limits operating risk by supporting multiple passes over the target if they are required.
By raising more capital in a boom, you are seeking a new round of funding in month 15–21 and in my simple model, you have built $20m-$26m in enterprise value. Even if the market has shifted from giving you 18 months of credit for future success to no credit at all, you have earned a slight up round.
If the current market is a boom and the world is set to explode into hyper growth sometime soon, the incremental capital, and dilution, is still worth it. In a boom, it is more likely that you will be faced with an opportunity to dramatically increase the trajectory of your business. It will probably take capital to go from adding $1m per month in enterprise value to adding $2m or $5m a month and you need to focus on your business in order to catch the wave. If you raised 18–24 months of capital, when the opportunity comes to accelerate the business, you will be able to step on the gas without the distraction of fund-raising.
Timing the market is impossible, but boom to bust with some period of normal in the middle is certain. If you are going to pursue the top of the top, good luck and Godspeed, but make sure to raise enough to earn your way back into the valuation you get today no matter what the market does tomorrow.
If you prefer spreadsheets to graphs:
12 months of Capital
24 Months of Capital
Added value per month of milestones
Months of Credit Today
Months of Capital
Months until next fund-raise
Projected inherent value
Months of Credit at future fund raise