Just read a thoughtful article by Connie Loizos entitled Marc Andreessen: We’ll Invest Up to $100M in One Deal. Sounds awesome on the surface: I mean, if you’re a growing business looking for investment money, more money is always better, right?
Turns out that’s not true and since it’s possible you’ll be surprised by this sentiment, I thought it would be interesting to talk a bit about valuations and venture capital investments.
The most important math with investments is percentage of ownership. That is, how much of your company you are willing to sell to investors, be they your parents who are fronting you $10K so you can demo your brilliant idea at a trade show, or a venture capitalist.
To understand, let’s posit that we have a startup called BizX and that the two of us have created it, from idea to implementation to paying customers. Ostensibly, we’ve split it 50/50, but since we’re trying to raise $250,000, we realize that we’re not going to end up with that percentage of ownership after the investment, known in the biz as “post money”.
What we’d like is for the investor to buy 1% for $250,000, but here’s where the math turns out to be important: if 1% is worth $250,000, that means that the company has a market value of 100*$250,000 or $25 million dollars. That’s a whole lotta money, far more than the two of us can justify to even the daftest investor.
Instead, the investor says “You have 25 customers paying $10/year, a nice code base, a pending trademark registration and an early beta of an iPhone and Android app. That’s not worth $250,000 in total, chaps, sorry to say.”
And so the dance begins, a dance quite common with any valuation event, be it an acquisition or investment. The seller wants top dollar, and the buyer wants to lowball and pay the very minimal amount possible, or even a bit lower than that.
If we can justify a half-million dollar valuation for BizX, then the question of how much would $250,000 buy is easy math: post-money is $750,000 and $250,000 then represents 33% of the company stock. But most startup founders are loath to sell that much equity, afraid that they’d lose control of their destiny, so 15-20% is more common.
Which leads us to Marc Andreessen, his VC firm Andreessen Horowitz, and that fabled $100 million investment. Can you see the problem? Let’s say that a company is willing to give up 20% of its equity for this investment, figuring that the injection of so much available capital will help them become The Next Big Thing.
That means that the company has to have a defendable valuation of $400 million dollars. That’s quite a company, and far beyond any sort of startup. In fact, well known companies that you interact with on a daily basis don’t have that sort of valuation in the market.
For example, in June 2010, Foursquare raised a $20 million investment, bringing its total valuation post-money to $95 million. That means that the company was worth $75 million prior to the investment and that $20 mil represented the purchase of 21% of the stock.
As I said in the beginning, it sounds terrific to contemplate a $100 million investment in your startup, but when you really put two and two together, precious few companies are large enough to justify the sort of valuation that could absorb this level of investment. That’s why if you’re building a company, smaller investments earlier in the game are far more likely to be a good deal.