I find this article much more interesting as a cultural snapshot than a cautionary tale for founders. $20 million in investment before creating a minimal product, $200 million to find out users won't pay for what you made, and everything propped up by a shell game around online ads. The assumption that the founder of this should have walked away with a fortune is just the cherry on top.
I think that's part of the author's point: that valuations are, in a very important sense, largely fictitious, and that other actors in the ecosystem can make your valuation as large or as small as possible to suit their purposes. If you want to build a business, your actions need to actually do that, and you should be aware of and mitigate the implications of any wild valuation swings. Similarly, if you want to get rich (which may or may not be aligned with building a business), your actions should do that, and that also may or may not follow from getting a big valuation.
As lot of people are saying that, but the empirical evidence suggests that the valuations, as high as they are, are remarkably sticky. I can only name two web 2.0 duds, zynga and fab, but the rest of the unicorns have either held their value or keep rising. It's not like Uber or Snapchat will become the next friendster and myspace. The failure rate for the $40-90 million valuation range seems much higher than the >$1 billion.
Plenty of once-highflying companies from the 2004-2007 vintage exited in down-rounds. Loopt. Xobni. Slide. Digg. Valuations were, in general, less than they are today, and the term "unicorn" hadn't been coined, but these were still companies that were valued at several hundred million at their peak and then sold for 10-50 cents on the dollar.
It's easy for valuations to keep rising in a bull market - that's sort of the definition of a bull market. The big question is how many of those companies stick around when the tide goes out. Historically, bear markets result in a consolidation around a few winners that have managed their cash well and stayed ultra-focused on growth, but they also result in the death of everyone who hasn't been capital-efficient. Their places are taken by "sleeper" hits (remember, AirBnB was started in 2006, but they didn't close their A-round until 2009) that raise at a much lower valuation but have done the work to get true product/market fit.
Groupon comes to mind as another one, relevant to the propped-up-by-ad-spend part of this story. They IPO'd at a valuation of $12.7 billion in 2011, and have since lost about 2/3 of that market value. However as a post-IPO loss of market value it doesn't implicate the same sorts of things described in this article.
Poor market bet imo, Groupon is great at what it does no matter valuation. I would be very sad seeing it to run in serious issues due to its dropping valuation.
They might not be staring death in the face, but you'd call it a dud if you'd bought it at the "unicorn" valuation of $11.5Bn. Given Zynga is losing money not trying to grow so much as reinvent themselves to keep up with their users' short attention spans, I'd be much happier being short on them than long too.
Though FWIW, I think Zynga's performance is probably better than Snapchat will do long term, since they at least nailed the art of generating revenue.
Mind you, I've never used it, but Snapchat has 100 Million monthly uniques.
I can't think of a single company who has reached a critical-mass consumer audience and not been able to monetize. Sure, winds change, MySpaces rise and fall, but it wasn't a monetization failure.
Anecdotally, just a month ago I was walking and because i live in San Francisco I happened across a corner (Howard and New Montgomery) where there were ~20 girls about 13 years old being polled about their tastes, and the questions I heard waiting for my light was "Do you guys like smartphones?" ("yes", duh), "Is your phone more important than your TV?" ("yes", duh), and "What is your favorite app?" and the answer was unanimously Snapchat.
Snapchat is the teenagers answer to the question many millennials have fretted about -- "how will ppl born today deal with having all 18 years of their development online". The answer is: they don't put it online. It's peer-to-peer and temporary by social contract, even if the technology is imperfect.
So far, snapchat has played a savvy game. As an engineer, if they were based in SF, I'd consider working for them. They have tapped into something. Because my 28 year old wife has also been hooked on Snapchat for what seems like a lifetime now. Her most frequent contacts? Both of her 60+ year old parents, numerous cousins and aunts, etc. Her dad uses it to send stupid pictures that you might not expect from a 65 year old white haired CEO-type whose work is about as far away from tech as you can get.
> I can't think of a single company who has reached a critical-mass consumer audience and not been able to monetize. Sure, winds change, MySpaces rise and fall, but it wasn't a monetization failure.
Twitter has been around for almost 10 years now, and while they have been able to monetize somewhat, they haven't been able to turn a profit, and they don't seem to make great progress in that direction.
It's not that they can't make money - it's just that so far, they haven't been able to make enough money to support the valuation.
Twitter had revenues of $1.4b in 2014 - for a tech company (i.e. low marginal cost of delivery), I would say that's enough to support a $24b valuation.
$1.4B revenue, with $0.577B loss, so, they spend $2B to bring in $1.4B; Not a good business.
We can't talk about a profit multiplier (Twitter has never had a single profitable quarter), but even if the $1.4B was all profit, a 17 P/E is not easilly supported.
In my opinion, Twitter has been a zombie for a while - there's no way they'll have enough profit to justify a >$10BN valuation, and that's only if they stumble on some revolutionary profit model. If they don't, even $2BN will be lucky.
Although what is likely to happen is that a stock market crisis will harm all companies, those with potential and those without. So Twitter will go down, "as if" for the wrong reasons, and the business model and its execution will not be found guilty (or not guilty).
> $1.4b in 2014 - for a tech company (i.e. low marginal cost of delivery)
You say this, but IIRC even with that revenue, Twitter hasn't been profitable, which is generally necessary for long-term viability. The "low marginal cost of delivery" hasn't materialized, if they can't turn a profit off of $1.4 billion.
MySpace and Orkut both had over 100M users and failed, but it was because of neglect by their corporate owners, not a failure to monetize. AOL made it to about 30M at their peak; they're down to about 2M now.
I agree with the general point of this thread (that once you get to 100M+ users, there will be a way to monetize), but if you're trying to make the stronger point that once a company gets to 100M+ users they're invulnerable, there are ample counterexamples.
Having "100+ million users" is a relatively new concept, period. It shouldn't be surprising that very few, if any, have failed. But that doesn't tell us anything about the future.
Before Enron, how many companies with $100+ billion in revenues went bankrupt?
Definitely. And that ignores the extent to which they may not be creating any value.
I think they're a "games company" only in the same sense that people who make shitty video poker machines are. That is, they're not creators of fun experiences, but parasites on those inclined to addiction.
Business is mainly about creating value for customers; companies that make money out proportion to the value created tend to get optimized away.
Twitter's also losing money, right? LinkedIn, despite all their tactics, makes double digit millions only? Splunk, at several billion valuation loses more and more money, too (enough that killing all R&D still wouldn't make them profitable).
On the flip (karma) side, as a non-driver, Uber has materially changed my life. I rank it up there with google maps, cell phones, and SMS/imessage/whatsapp in terms of its impact. I can click a button, and in most major cities, have transportation, often at a price less than taxies that would sometimes never show up, in less than 5 minutes. The transportation is safe, clean, and polite (something I would also not have ascribed to taxis in most cities.)
Before you close on any round, you should create a waterfall spreadsheet
that shows what you and each other stakeholder would get in a range of exits
– low, medium and high. What you will generally find is that, in high,
everyone is happy. In low, no one is happy, and in medium (which is where
most deals settle) you can either be penniless or "life-changingly"
compensated, depending on how much money you raised and what terms you
agreed to. It is simply foolish to sell part of the company you founded
without understanding this fully.
Given the most likely outcome conditional on that outcome being positive is a modest success, you should negotiate terms to optimize for that and assume that if you build the next dropbox, everyone will be so rich it will all work itself out.
But yeah, if you blow $200mm without building an enormous business how on earth do you justify getting paid?
"With the $10 million, Richard rents space in SoMa on a seven-year lease, hires lots more people, and within a few months he is able to roll out the minimally viable product to test the market."
There was also $1 million of prior angel investment. So total of $11 million raised before having an MVP to test the market. Is this really representative scenario?
And yet nobody sees a problem in creating stupid crap for stupid users and expecting to ~break even~ get rich selling ads.
This reminds me of a recent article [0], where this line stood out:
> “We just introduced an emoji feature and comments are there so you can have conversations, and there’s more stuff in collaborative streaming that we’re going to introduce,” he added.
"We found a new niche and Twitter is trying to bully us out of it, but look, we'll have emoji soon. Comments too, and more social stuff. It's going to be great!" Sorry to cherry-pick Meerkat, they're actually an OK bunch, but that quote just stuck with me.
Add to this silliness how much money/interest is garnered by apps like Instagram, Snapchat, WhatsApp (actually, arguably solving a real problem), and it's hard to argue we're not in a similarly idiotic bubble to the previous one. Of course, this also creates valuable stuff (my favourite recently being Slack), but I'd be willing to bet that this huge BS-to-usefulness ratio isn't sustainable in the long term.
edit: instant downvote - if you don't just disagree with my tone, please explain why you think I'm wrong
edit 2: I'm not saying I have an answer, but at least I tried to pick something that seemed worth doing (I work at Lavaboom, we're trying to make encrypted email easy to use - with extra privacy sprinkled on top)
I think the issue people have with your comment is that you seem to label things you don't use as stupid crap for stupid users. Snapchat, Instagram and WhatsApp solve a very real problem and are very useful for the hundreds of millions of people that use these services multiple times a day.
It seems that you only label stuff as valuable if it solves problems you have (Slack and Lavaboom).
I'm not a daily Instagram user, but some of my friends love it. They're not dumb, they just get more enjoyment out looking at and sharing pictures of cool shit and their friends.
It seems that you only label stuff as valuable if it solves problems you have
The idea that things that are popular are "solving a problem" is a really bad trend in my opinion. "A problem" is something that has generally identifiable boundaries and detrimental implications if not solved - for example not being able to send someone money is a problem, and one big enough that it warranted the creation of paypal and the like.
I doubt highly that the millions of snapchat users at some point said "If only there were a service that deleted my pictures 10 seconds after I took them."
The major differentiation in my mind between a service that "solves a problem" and another "bullshit service" is whether people are willing to pay for it.
That's not to say you can't get rich off of bullshit, the E! network among others is proof of that, but lets not fool ourselves into thinking these things actually make the world better.
"How do I quickly share pictures without having to worry to much about them sticking around" is the problem snapchat claimed to solve (and does a reasonable job of solving, despite obvious limitations).
People might have actually been willing to pay for that, but if you charge money from the beginning for this kind of thing, someone else just offers it for free and tries to monetize it after they got all "your" customers.
> The idea that things that are popular are "solving a problem" is a really bad trend in my opinion.
Ohh, I think the opposite. Admittedly the "problem" solved by some popular solutions is "novelty" but they tend to rise and fall swiftly (poster child: Secret).
> I doubt highly that the millions of snapchat users at some point said "If only there were a service that deleted my pictures 10 seconds after I took them."
> Snapchat is the teenagers answer to the question many millennials have fretted about -- "how will ppl born today deal with having all 18 years of their development online". The answer is: they don't put it online.
I made this mistake underestimating YouTube: it seemed like any other video site and I figured anyone who wanted to host video could just put it on their own web site -- I am interested in stuff by topic, not medium, and isn't everyone like me? But in fact YouTube solved several hard problem: 1 - hosting and bandwidth, even for people who didn't want to make a site (they were undifferentiated from other sites in this way, but the need was and is there); 2 - they dealt with infringements/DCMA restrospectively rather than prospectively which meant they could move faster at lower cost and 3 - they were first/early at embedding, so you could use video on your site without implementing a lot of crud. Those were all real needs.
There is a completely unrelated problem which is: if you don't have a monetization approach early on, it's hard
to graft one on later. And using my Youtube example: it's my understanding they've never made a profit. But in aggregate their costs are lower (by riding on google's infrastructure, expertise and scale) and add other values to their parent company.
It's hard but not impossible to see that most of these Unicorns could provide value to an acquirer in excess of the acquisition cost. It's possible Uber has enough revenue base to make it worthwhile for (say) Daimler-Benz to buy them at a non-terrible multiple. It's harder to say the same for airBNB.
WhatsApp is not that different from a hundred other messaging services, but people pay for it. I have no reason to believe it's worse than the other messaging services, but it doesn't solve some fundamental problem fundamentally better, either; it mainly just had good luck with network effects.
People pay money for flickr, as a service to host your photographs. By your standard that would make it a non-bullshit service, however it is very annoying to sign up for it. Instagram is simpler, yes, its focus is mobile rather than DSLR cameras but I for one cannot see how that makes it a bullshit service.
The problem with your analysis, eg of Instagram, is that history contradicts you across the board.
Photos Inc. has been a serious business, and generally extremely valuable for a century. There's a reason every smart phone has a camera built into it, and in the near future 2/3 of all humanity will own a digital camera.
Facebook generated $12.4 billion in sales and $3 billion in profit last year. Facebook regards photos as a linchpin to their success. Why? Because photos (sharing, saving, viewing) are one of the most important social activities people do.
The value of photos has remained true through countless technology shifts, and will remain true for the next century, because it's based on a simple principle: people want to save visual memories, and share them with others.
It's not the interest in Instagram that's wrong, it's your incorrect appraisal of what other people value.
Instagram deserves the Unicorn title. It is very useful for both personal and professional ends, and has changed photography fundamentally.
The problem is with its business model - that it will monetize people's attention via ads - and that Instagram is "media." In my view, both Instagram and Twitter are communication networks and should be monetized as such. Advertising is adversarial to the user (privacy) and will kill the networks.
I agree; it seems like Scooby Doo sometimes, where the gang all hop into the Mystery Machine to go track down a guy in a mask hoping to scare off the owners and buy it cheap. In the case of tech, they're going to build an amazing world-changing experience and a huge user-base before smacking everyone with ads just before selling to Goohoocrosoftr and live the rest of their filthy rich lives out on their own private cruise ships.
Zoinks! That just about says it all. I love how you implied that "Goohoocrosofter" was taken so they had to drop the final "e" to register Goohoocrosoftr.com.
> it's hard to argue we're not in a similarly idiotic bubble to the previous one
No, it's not hard at all. It's nothing like the late 90s.
> I'd be willing to bet that this huge BS-to-usefulness ratio isn't sustainable in the long term
I dispute the premise here. Humans are social creatures who enjoy each other. And as we mature economically, we have more leisure time than ever before. And say what you want, but to me you seem blinded by your own personal tastes and temperament. You don't get 100,000,000 people using an app every month without tapping into something bigger than "BS".
Building software that connects people, that people enjoy using, and that speaks to millions is IMO rewarding and worthwhile and no less noble than what you're doing with encrypted email.
Of course terms matter, but the example she gives seems somewhat contrived. Particularly this part:
>> In the deal, Hooli would invest $200 million for equity while in return the two companies would enter into a business development agreement on the side in which Pied Piper guarantees to spend that money in a massive consumer campaign on Hooli’s ad platform. They float the magic “B” valuation. Richard goes to sleep dreaming of rainbows and unicorns.
If you take all that money in with a massive string like that attached (basically no freedom at all to spend it except on one thing), I would think you have only yourself to blame for the result.
That's the whole point of the article tho isn't? Terms matter.
Terms similar to those do exist btw. Investors who aren't going to be able to wrangle board control often attempt to control their money using absurd up-front strategic requirements.
You are correct. Taking that money is a massive mistake, but founders often do it to protect from bottom-line dilution. After all you can often negotiate a better valuation by taking worse terms on the deal.
I've seen it up close and personal, the cautionary tale in the post is a good one. Valuation is important, but you really have to understand the terms you're entering into.
A mentor described it to me as "always be steering for an optimal outcome for partial success". In other words if I'm valued at $10M today, then I want to make sure I'm going to do OK if we end up selling for $20M, as opposed to getting the best possible outcome at $100M. Ya I might leave a bunch of money on the table in the end, but in the ~$100M case I'm going to be really happy no matter what.
In retrospect, it's always easy to construct reasons why person X has only themselves to blame. Blame isn't really a useful construct for systemic improvement, because it always lets us say, "Oh, well this won't happen to me." The vast majority of Silicon Valley's failures were made by very smart people while being guided by very smart and experienced investors.
"How could somebody be that dumb" is Silicon Valley's equivalent of "pilot error", a response that explains nothing because it can explain anything.
Sounds like this is roughly based on the Microsoft/Facebook deal. MSFT invested $240M at $15B valuation but won the right to be the ad platform for FB globally for some period of time.
Not the same as forcing the investee into ad spend, but that's what it conjured up in my mind when I read it.
"If you take all that money in with a massive string like that attached.."
Not to mention, this happens when you already have outside board members from your previous round of investment. So it's not just one dumb CEO making the deal, it's aided and abetted by (presumably wiser and cannier) prior investors. Yeah... that part rang the most untrue in that whole scenario.
Take that out, and the rest of the story is basically a parable explaining what liquidation preferences mean. Is there any VC that would do a deal without 1x liquidation pref?
In fairness, the newish VC needing an apparent success to help raise their next fund back back-story sounds like a worryingly plausible reason for them to be able to overlook the fact that Hoopli should never have been allowed liquidation preferences in addition to a contract guaranteeing they got their funds back through platform spend.
I'd love to know how often this kind of 'instead of giving you free inventory, how about we "invest" conditional on you "buying" from us' shell game actually happens in the Valley though.
I am not saying that it's happening or has happened or will happen, but Google, Facebook, Yahoo, etc. would certainly be the sort of investors who are in position to benefit from such an arrangement.
Here is an interesting real world example that I think not many people know the details about. I don't think any of this information is privileged information. Most of this comes from my (probably faulty) memory with conversations I had with some of Corel's upper management (where I worked). Some of it comes from the public record. There are probably errors since it has been a long time and I didn't not double check the information. It is entirely possible that I was misled right from the beginning anyway, so it might just be fiction. But even if it is, it is entertaining fiction.
In 2000 Microst invested £135 million in Corel. At the time Corel was almost out of cash (if my memory serves they had about $2 million in the bank and with about 1500 employees was going to run into a problem with payroll sooner rather than later). Corel issued new stock to cover the deal and I think it represented about 25% of total equity. This stock was non-voting, but came with a veto over new acquisitions. The rationale was that since Microsoft and Corel were playing in the same office productivity software market, Corel didn't want them to be able to dictate what they were doing, but at the same time Microsoft wanted to protect their investment against acquisitions that they thought were poor judgement.
At that time, growing your business through acquisitions was all the rage and the Corel management team (led by it's relatively inexperienced CEO at the time) was quite keen to use some of the new capital to grow their business. Microsoft encouraged them and even brokered meetings, etc, etc. In the end Corel set up several acquisitions, which of course took some time to go through all the approval processes.
In around 2003 Microsoft sold their Corel stock to the venture capital firm Vector for about £13 million (10% of their original investment). It is possibly not a coincidence that this is a venture capital firm that Paul Allen was involved with, but who knows? According to what the then Corel CEO told me at the time, Vector then threatened to use their acquisition veto if the board did not agree to back a complete buyout by Vector. The problem was that the penalty clauses for backing out of the acquisitions would once again put Corel into a very difficult situation financially. Feeling like they had no choice in the matter, the board approved the buy out and recommended that the investors accept the deal.
Vector bought up all the remaining stock for $133 million, using about $80 million of Corel's remaining cash to finance the deal. Very soon afterwards they laid off a very large number of employees (including me ;-) ) and concentrated on profitability. As far as I know, Vector have managed the company exceptionally well since then.
I heard from trusted sources that Corel's CEO at the time gave up a multi-million dollar parachute to accept a job at Microsoft, so I suspected that there was never really any need to feel particularly sorry for him. But you can see that one seemingly innocuous condition from an investor who is saving your butt can lead to the most unimaginable outcomes.
> As far as I know, Vector have managed the company exceptionally well since then.
I can't say that I've heard anyone mention a Corel office product in over a decade. I see they even own Winzip, DVD/CD-authoring utilities, but again, many of these functions are now built in to the OS.
Are there enough Draw or Wordperfect shops out there to sustain sales? Or am I missing something?
Microsoft Word does not paginate footnotes properly. There is a legal requirements for footnotes to be paginated in a certain way in legal documents. As far as I know only Word Perfect does it correctly and hence has locked in the US DoJ. I have to admit that it's been many, many years since I talked to anyone at Corel, so I don't know what else they are doing.
Seems to me that the problem here is less one of investment terms and preferences, and more one of wasting $200M on an unsuccessful advertising campaign. If you agree to throw that much money at advertising without having any guarantee that the advertising will yield (enough) results, you deserve to walk away with nothing.
Unfortunately you can't guarantee results with advertising. However, you can mitigate some risks by taking an iterative approach and testing things before doing a large integrated campaign. You can save a lot of headache by running some targeted facebook ads to see if they resonate with your audience before buying up a bunch of tv or radio points.
Unfortunately you can't guarantee results with advertising.
Right, which is why you should never commit 90%+ of your available cash to an advertising campaign, but should instead spend a smaller amount and wait to see if you get results before you spend more.
The point wasn't whether or not the $200m ad spend was well advised or well managed. It was included in this scenario as a stand-in for any number of ways that a company could burn through a lot of cash without achieving a sustainable, defensible product / market fit, let alone solid traction.
If you're focusing on what the fictional company did with the money, as opposed to the very real terms under which it acquired the money, you may want to re-read the piece.
[the $200m ad spend] was included in this scenario as a stand-in for any number of ways that a company could burn through a lot of cash
Right, and my point applies regardless of the way that the company burnt through $200M: If you burn through that much cash without results, you don't deserve to walk away from the company with anything.
If you're focusing on what the fictional company did with the money, as opposed to the very real terms under which it acquired the money, you may want to re-read the piece.
I read the piece. I disagree with it. I see nothing wrong with the amounts invested or the preferences, and something very wrong with the fact that $200M was wasted.
You don't really disagree with the piece - the author would agree with you that the $200M was wasted. The point the author was making is that the terms of Hooli's "investment" basically forced them to waste the money, since the investment wouldn't have happened had they not spent it on ineffective advertising using Hooli's own platform. It was that investment that gave Pied Piper its $1B valuation, hence "valuation isn't everything".
You're probably thinking "I'd never be so dumb as to take an investment with those terms", and you're right: you wouldn't be. You also don't own a billion-dollar company. I would bet that somewhere in Silicon Valley, there is a unicorn whose valuation is based on a deal with similarly bad terms, and it will blow up in their face in a couple years, and then we'll all marvel at how stupid someone can be who ran a billion dollar company.
I read the article as a cautionary tale for founders who see "billion-dollar company" and get stars in their eyes. You are not the target market for it; you already understand the point it is making (though perhaps not that it is making that point). There are many other dumbasses in Silicon Valley - I can see a couple in this comment thread - who do not.
Ah, well that's a very different concern. And yes, I agree with you entirely. The idea that a company could secure an investment this large before producing a solid product with a clear path to market is...problematic. And so is the idea that the "founder" of this lunatic non-entity is entitled to anything. The lesson about terms aside, this entire scenario seems like an analysis of moral hazard.
But speaking of massive ad buys, I can't remember which VC noted that start-ups feeling the need to go this route tend to flame out far harder and faster than those that are savvier about their whole approach to marketing (i.e., those who treat marketing as an intelligence-gathering operation, and feed the results of their analysis to competent sales teams).
There's another way to skin this cat. Assume you are not "CEO material", hire someone who turns out to be a complete fuckup to do it for you because of your self doubt.
I saw this happen to a company that basically invented the concept of hosted phone/communication services for business, back in the mid 90s. Their competitors are worth billions now. The third rate/bully/crook CEO the founder hired destroyed, literally, billions in opportunity.
(In retrospect the whole company was rotten to the core, so I enjoyed watching their competitor ring the NYSE bell, but if the founder had taken on the task of understanding his own business, this outcome would probably have been avoided).
Hm. As an engineer relatively new to the world of entrepreneurship, I find myself not really understanding much of the jargon. (Actually, I think I might understand some - but my confidence in my understanding is low.)
It would be cool if there was like, an annotated version of this explaining some of the accounting/investing jargon.
For example, this passage:
Richard attracts Peter, a newly-wealthy budding angel investor, who agrees to put in $1 million as a note with a $5 million cap and a 20% discount.
I think this means that Peter is buying part of Richard's company for 1 million bucks. He's valuing it at 5 million, so that's 20% of the company. However, there's a discount of 20%... Which is where I get confused. Does this mean that Peter is paying only 800,000, but getting 20%? Probably not, given the context. It probably means he gets 24% of the company, right? (He's getting 1.2M worth of shares for the cost of 1M.)
The $5MM is a cap, not a price. If the Series A is raised at $5MM or more valuation, then the angel gets his money ($1MM) converted at $4MM ($5MM * 0.8).
If the Series A goes at $4MM, the angel's money is converted at a $3.2MM valuation (4*0.8)
> .. buying part of Richard's company for 1 million bucks. He's valuing it at 5 million, so that's 20% of the company.
No. The purpose of convertible note is avoid that kind of valuation in % of the company. It is very difficult to arrive at a share % valuation of early stage startups and convertible note solves this problem. Its like a loan given to the company which is converted to equity during Series A round when the company is more mature and its easy to arrive at a valuation
> (Peter)... who agrees to put in $1 million as a note with a $5 million cap and a 20% discount.
In the original article BTV does a 40 Million pre money valuation. Lets assume the share price is 10$.
- Peter gets 20% discount : so for him the shares at at 8$ per share
- his valuation cap is $5 million: so for him the share price is ( $8 per share / ( 40M/5M ) ) = $1 per share
- He gets (1M / 1) = 1M shares for company
(In comparison, the series A round investor (BTV) invested $10 Million. So they also get 1 Million shares.)
- Since the current valuation is $10 per share, his shares are worth (1M * 10) 10Million
A 10x return for original investment of 1 Million. Looks extremely well !
> .. Plus, they want a senior liquidity preference of 1x to protect their downside
Though on paper peter has 10x profit. But if the company gets into trouble and sells out for 10 million or below, peter get nothing since BTV takes off the first 10M
It seems like either the cap xor the discount applies (investors' option), so anything over $6.25MM valuation, the cap would apply and anything under that the discount would apply.
It's too late for me to edit the GP post, so I'll try to correct it here:
At a $5MM priced round, the discount would apply and the investor's note would convert $1MM at a $4MM valuation (25%). I believe that conversion is done pre-money, which means the angel is diluted (like all shareholders) from their initial 25% by the addition of the new money. (None of my angel investments have [yet] raised a priced round, so I haven't gone through this process, though I obviously hope to... :) )
If someone else invests $1MM at $5MM pre-money valuation, all prior investors are diluted by 16.6667%. (Someone who held 10% of $5MM pre-money company will hold 8.333% of a $6MM company post-money. Either way, their position is worth $500K.)
So, to know the angel's ownership in the scenario, you need to know how much dilution happened due to the new money, meaning you need to know not just the pre-money valuation, but also the amount of new investment money. In any scenario where the discount applies, the angel's position will be worth $1MM. In any scenario where the cap is better than the discount, the angel's position will be worth more than $1MM.
> $1 million as a note with a $5 million cap and a 20% discount.
This refers to an investment done on a "convertible note." These particular terms mean that the valuation at which their investment will "convert" from what is nominally a loan into equity will be at most $5m, but if a subsequent investor invests in an equity financing at less than 6.25m, their investment will convert to equity at 20% less than the valuation. Read up on convertible notes for more detail.
> senior liquidity preference of 1x to protect their downside since they feel the valuation is rich
Means that in a sale, the investor will get the full amount (1x) of what they invested before others (i.e. founders, employees) see anything.
> Peter, is stoked that he is getting his $1 million investment converted into roughly 20%
Since the valuation was > 6.25m his valuation was capped at $5m, whereas the investors who are investing got a valuation of $40m "pre-money" or $50m "post-money" which are much less favorable terms than what Peter invested at.
> the preference overhang of $211 million
Means that if the company is to be acquired, it would take an acquisition offer of at least $211 million for founders and employees to see even a penny. That is because that amount was invested with the "1x" preference.
> They ask prior investors to recap
I think this means they are asking previous investors to lower the amount of liquidity preference they have such that in the event of a sale under $211m the founders would see some return.
> the ‘overhang math’.
The wiser employees understand the math that says an acquisition has to be enormous for them to see anything. If they don't think that's likely they will see little motivation to continue working at the company.
> senior preference and a 2x guarantee.
2x guarantee means that they would be guaranteed twice the amount the invested in the event of a sale, possibly ahead of other investors, but I'm not sure.
> waterfall spreadsheet
Indicates how much each interested party would get in proceeds in the event of exits of various amounts. E.g. if company sells for X, investors get Y and founders get nothing. If company sells for Z, investors get X1 and founder gets Z. Etc.
5 million / (1-0.20) = 5 million / 0.8 = 6.25 million
A "convertible note" is a cash investment that "converts" into an equity investment when the company starts doing equity investments. The have two separate mechanisms for rewarding investors for getting in early.
The "20% discount" means the investor can convert the note into shares paying 20% less per share than later investors.
The "$5 million cap" means, if the company has a valuation greater than $5 million, the investor can convert the note into a fraction of the company as if the company was valued at $5 million.
The investor then chooses whichever of these options is better.
Take the example of a $1 million as a note with a $5 million cap and a 20% discount, when series A funding comes along.
If Series A values the company at $4 million, the investor can choose between taking shares at a 20% discount (they get shares valued at $1.25 million for their investment of $1 million) and taking shares at a $5 million valuation (they get shares valued at $0.8 million for their investment of $1 million) and they obviously choose the former.
If Series A values the company at $10 million, the 20% discount still lets them get shares valued at $1.25 million for their investment of $1 million - but now taking the shares at a $5 million valuation lets them get shares valued at $2 million for the same investment. Obviously they choose the latter!
A $6.25 million valuation is the crossover point, where the 20% discount and the $5 million cap give the investor the same number of shares. At a valuation below that the discount is the better choice, and at a valuation above it the cap is the better choice.
Board members can theoretically face personal liability if they fail to discharge their fiduciary duty to act in the best interest of the shareholders.
And in some states I think claims can also be made against directors for unpaid wages -- I'm not sure how the jurisdictional issues play out for a Delaware corporation with employees elsewhere though.
That was exactly the point - the personal liability isn't to the investors, it's to the state, which tends to take a very dim view of unpaid wages. In California, I believe treble damages are standard, so missing a $50,000 payroll can cost you $200,000 in addition to court fees and legal costs.
INALB I'm pretty sure this is what the OP was getting at.
If you get $240 million in investments, and then sell the company for $250 million, I fail to see how it was successful (or "building a unicorn") at all.
The $200M investment was at a $1B valuation, thus it was an origami unicorn. However, one could argue that until someone actually forks over $1B, all valuations (even those of publicly listed companies) are on paper only.
Remember by the time you are taking $240M your valuation is either $750M or $1 billion (depending on the $250M being part of the valuation); all of which you have achieved with some $11M. That is a close to a 100x return. But even if you lost $750M/$500M in valuation before the deal and sold for $250M after raising $11M, that is still a 24x return.
Unpaid employment taxes too -- the cxx levels, the investors, the board, and every single employee who paid any other expense instead of paying the US gov their money.
I wrote more about this in the past, but even bookkeepers have been held personally liable. The government considers employment taxes to be paid by the employee on the date the employee receives his or her paycheck, and the employer is merely holding on to that money temporarily. It seems quite unwise to fuck with this.
No I meant that in order to avoid any possibility of personal liability the C team would give up and liquidate the company much faster than the UK where more efforts might be made.
I have direct experience of this - I even chaired a share holder meeting about a refinancing.
The US states take unpaid employees very seriously. Think about it from the employee's point of view - if the company can't make payroll one week, you might be tempted to let it ride until next week. If they again can't make payroll, you've put 80+ (120+!) hours into the firm with no payment. I certainly wouldn't be happy in that situation.
This also partly aligns with it being very easy to fire people in the US. The government therefore views the employer as having a perfectly reasonable option in the case where they are truly short of money: fire the employees you can't afford to pay before they work the hours you don't have money for (or something halfway, like giving people a non-optional offer to go down to half-time). In most cases that can even be done with no notice, though that isn't very nice. But it is at least seen as more honest than stringing people along ostensibly working for a salary they aren't going to get.
In practice one way to handle this is keep one payroll cycle's worth of liquid cash "locked up" in an account that is reserved for payroll and which you don't dip into for other expenses. So even in the worst case the last paychecks can be sent out before shutting down, if you avoid the temptation to dip into that account "just this once". That does require having a little bit of a cash cushion, but a VC-funded company should be in a relatively good position in that regard.
If there's no personal liability, and the CEO is otherwise looking at bankruptcy, only ethics would force them to be honest with staff about being unable to make payroll. Employees would be out 1 pay at least, probably more, depending on how well the CEO can lie.
So make trading while insolvent a crime as it is in the UK - having a CEO who's panicking about becoming personally bankrupt is the last thing you want in a crisis.
Not sure the last deal would have even been up to the CEO. a deal like that would probably be a board vote, I would think and you may only have 40% of the vote. also, what if it was the only deal on the table and the trial campaign preformed well. Btw, Forbes called they heard about the deal and your going to be on the cover. And let's talk about poor Richard I don't he's managing an Arby's after he ran a billion dolllar company. Probably some kind of senior executive somewhere. Curious if VC would take his calls?
99% of all corporations in the US are private. They operate day to day without intent to ever do an IPO or get purchased.
The alternative answer is: people build a business with actual cash flow and profits that can sustain itself and grow under normal conditions without the need for vast sums of venture capital.
Nearly all of the $18 trillion US economy operates outside the economic sphere this article is talking about.
An interesting exercise is to think about what would have happened if that $200 million spent on advertisement on Hooli campaign gave a positive ROI.
Than Richard would be really happy right now.
What Richard should have done, is before accepting that $200 million, spend some of his own money on Hooli's ad platform to see what it was like, what kind of return they're looking at. If its good, take the money. If not, walk away.
But of course, it's very easy to make the right decision after already knowing the outcome...
Great to see a VC being honest about the business. Richard should have never agreeded to the $200m deal with ad spending strings but I'm sure deals like this happen all the time. The pressure on an entrepreneur in such situations must be immense. I imagine others with much more experience giving advice but with their own motivations in mind. I could easily see founders such as Richard making decisions in the moment which are obviously bad looking back.
So what is the reasonable repeatable way to determine or gauge valuation?
From what we have seen it is "Investor A wants X% of B and is willing to pay Z for it" therefore value is the multiple of Z that equals 100%. AkA Whatever someone will pay for it, AkA market prices. Except it's rarely a market in the traditional sense as it's really ever only a handful of buyers and they value it based on god knows what metrics.
Seems flimsy and based on whatever the most recent investor thinks - due diligence best practices aside.
We need a standard way to determine valuation so that founders and investors alike can point to something that is based in reality and can't be gamed as easily.
Demanding a standard way to determine valuation is in some ways like demanding a standard way of coming up with ideas. The reason prices are determined this subjectively is because information is incomplete. That means you need to use a lot more one off judgements that can't be fit into a standard.
If information was better then there would already be useful standards. There are pretty decent standards for companies that demonstrate a lot of consistency, like shipping companies. There are ways for valuing stock. On the other end of the spectrum, valuing a company that is still a work in progress is a different kind of problem. The upside is bigger and the downside more likely.
The reason prices are determined this subjectively is because information is incomplete.
That is every market ever. No entity makes decisions based on perfect information - but plenty have a process that is auditable and lays out the assumptions.
If information was better then there would already be useful standards.
I think whatever standard or process we did come up with would be more refined/accurate with more information - but I that doesn't preclude having something that can be audited.
I'm not saying that the process would spit out the "right" valuation, because that is impossible to tell prior to a liquidation event. What I am saying is that the process for determining valuations needs to be 100% more transparent. Like it or not there is a process - maybe it's all in one principle's head, but it's there.
All the right things have been said in other comments already, however I'd like to point out that the outcome for Peter, the angel investor is a little unclear from the article. It says:
> Peter, while sad about the outcome, has developed a huge syndication following on AngelList and has recently benefitted from an early acquisition that netted him $3 million on a $250k investment. Can’t win them all, but he’s at peace.
Assuming the investment was in convertible notes, surely the debt would have converted into shares at the same terms that the VC investment happened, including the liquidation preference. So if the VC gets to take chips off the table so would Peter, I assume?
It seems obvious to me that giant valuation means insanely high bar before you see upside. I am a bit skeptical of the idea that it should be as high as possible, since if it's fundamentally ridiculous and there's no way you will ever live up to it I fail to see how this is in anyone's interest.
Hypothetically, assume a company whose valuation increases roughly geometrically at first, but then levels off at an asymptote, and assume that during the geometric phase the valuation fluctuates by 50% around its trend. Assume that no one knows where the asymptote is. Periodically, there are funding events, during which the company sells stock at a 1x liquidation preference; assume it sells enough stock so that at each funding event, the sum of the liquidation preferences is greater than 50% of its valuation. Consider a funding event that occurs when the valuation happens to be 25% above trend; therefore the liquidation preferences will be greater than 0.625 of the on-trend valuation, and then the next time that the valuation falls to 50% below trend, the sum of those preferences will be greater than the company's current valuation. At this point, many of those with liquidation preferences (some of whom may have a short time horizon; or may be risk-averse; or may believe that the current valuation will not rise very much in the future) may strongly prefer selling or liquidating the company immediately, which is at odds with common-stock-holders, who would get nothing in such a liquidation and who would prefer to keep going.
Note that in this model, this result occurred not because of mismanagement, but due to the natural and expected fluctuation in market prices, combined with unavoidable uncertainty about which price changes are fluctuations and which are simply 'the new normal', combined with the sum of liquidation preferences being comparable in magnitude to the fluctuations in prices, combined with the bad luck of a funding event happening to occur when the valuation was above trend.
Is this model reasonable? If so, how should management of such a company approach fundraising? It seems to me that fluctuations are inevitable and that the only thing management could control is how much money they raise at once; if fluctuations are 50% around trend, then management needs to keep the amount of money raised small enough so as to keep the sum of liqudiation preferences well under 1/3 of the current valuation (because in that case even if the valuation falls from 50% over trend to 50% under trend, the valuation will still be strictly greater than the sum of liquidation preferences). More realistically, the size of fluctuations would not be known in advance to be 50% but must be estimated. In the article, the valuation fluctuated from $1bil to $250mil, so the fluctuation parameter would be at least (1-x)/(1+x) = 250/1000 = 4 -> x = 3/5 = 60%, and the sum of liquidation prefs "should have" been kept well less than 250/1000 = 1/4 of the current valuation.
Talking your book much? This story is so contrived that it hinges on a comically inept founder taking $200M to solely spend on an advertising campaign on the platform of the person investing it. If this is the best example a VC can offer to cram down valuations then I'm pretty sure founders are going to keep reaching toward those unicorn valuations.
ever heard of living social? How much of amazon's investment was recycled into purchases (obviously with lower margins than ads) on amazon when they offered a $20 amazon gift card for $10?
