by David Grimm
The early stage investment sector in London has never been more vibrant. There are more early stage investors, start-ups, entrepreneurs and accelerators than ever before. At the UCL Technology Fund we’re excited by the dynamism of the market. We can invest at the earliest stages (we’re even pioneering pre-startup investing!), and that allows us to work with some of the most interesting and innovative entrepreneurs and technologies.
Being an early stage investors is not without its complications though. One of the trickiest issues is valuation. Later in the journey metrics like MRR or DCF calculations help to bring rigour and an understood market position. But often the businesses we see don’t have a product yet, let alone customers or revenue. How can everyone be sure they are getting a fair deal? More importantly what is the best deal for a company?
I used to think that getting to the right value was just a matter of finding a price the investor was willing to pay and the entrepreneur was willing to accept.
I was reminded of this recently as I looked at a business set up by former traders. As we got to the valuation discussion I could feel them gearing up, preparing to use all of their finely honed negotiating skills to ensure they pushed the price up as high as possible and resist my attempts to force them lower.
But they misunderstood my intentions, just as much as I misunderstood the factors for a finding the right value earlier in my career. My mistake back then was to forget the real driver of value in any venture backed business, the entrepreneur. Albion Capital has successfully backed businesses for the last 20 years, and at the heart of that success is a focus on backing businesses run by their owners, not by managers. Ownership requires a meaningful stake in the business.
Our focus in all early stage deals is to find a balance. Entrepreneurs acting as owners with a price that will give an optimised return to our investors.This balance has to take into account the future funding journey that a business is likely to take.
Push down on price too hard and often round sizes are cut as the company shifts its focus to minimising dilution rather than optimising growth. This may seem like a good deal to the investor at the time, but when the company fails to reach inflection points, and wastes valuable time and resources trying to ‘bridge’ the gap with further financing, growth is hindered or even destroyed.
Even if they achieve exciting growth, will they be reticent to raise capital and drive further growth if their stake is already too small and would be further reduced?
On the other side of the equation we need to provide a return to investors in our fund. Prices should reflect the risk of investing before product market fit and mean that the successes compensate for the inevitable failures.
To ensure a good return for Seed investors the price of a Seed round must allow for value growth. It’s not uncommon, particularly in hyped sectors (AI we’re looking at you!) to see Seed rounds priced at values that give almost no room for pre-product-market fit Seed companies to grow into the accepted product-market fit Series A prices.
That situation not only begs the question; ‘why not wait until the Series A?’, but also sets alarms ringing. Lofty valuation expectations at the start of the journey are only going to get worse if the company achieves some measure of success. Will a detachment from the reality of market values mean the company fails to raise when it should?
Finding the right value means balancing lots of factors which need to give a good return and keep the entrepreneur as an owner; round size, current cap table, total capital needed to exit, number of rounds to exit, market values of equivalent companies both now and in the following stages through to exit.
So next time you are sitting opposite an investor, and they are furrowing their brow as you reveal your target valuation, it’s worth remembering that they are probably trying to balance a complex equation in their head. You never know, as we’ve occasionally done in the UCL Technology Fund, they may ask to pay more!