Dymystifying Valuations & Investors – an opinion from an entrepreneur!

Valuations often have seemed to be a “Black Art”, but they seem to be crucial in determining your strategy for outside investment!

Are they really? How is the early stage entrepreneur going to decide what is reasonable?

Some other questions that routinely come up in the mind of entrepreneurs:

1. How does the process of creating value effect me, my co-founders, my team & investors?
2. How do I maximize value for everyone?
3. How do I get the best valuation in case of an exit?

Entrepreneurs need to understand how money works and see the world from the investors world.

One of the area VCs in the US once described to me this scene sometime back, just after their firm had decided to invest in the start-up:

“There was a lot of interest in this company, and the founders had a fair amount of leverage. They used every ounce of it to extract a higher valuation,” he said. We kept saying that our firm would bring a lot more to the table than money, and that the mentoring, strategic advice, network resources, and political capital we could offer were almost unmatched.”

“The founders however set all that aside and made it about the money. It left a bad taste in our mouth. The deal was still worth doing—barely. But we have less of an equity stake in the company than we would ordinarily want, and given all the other portfolio companies that need my attention, I don’t feel any obligation or desire to give these guys additional assistance.”

The point is that the founders undervalued the non monetary value resources the VC firm had to offer, or they assumed that mentoring and strategic support would inevitably be available from the firm. Given that the negotiation for money and term-sheets is a high stakes exercise with various emotions and personalities
present in the mix, one should not forget that the document at the end lays out how much equity and control a VC will have in return for its cash is all about assigning rights, carving out protections, and haggling over claims to future returns.

So these negotiations are fundamentally about picking the right long-term partner and forging a relationship that can survive the inevitable disappointments, resolve the unforeseen conflicts, and monetize the mutually earned successes to come.

Now as a management consultant, I have tried to put these dynamics into some of the mistakes and solutions of how to avoid them in this blog.

At the end of the day, term sheets can be difficult to understand, and you may need help determining what the various provisions—liquidation preference, anti-dilution protection, pay to play, drag along rights, vesting schedules, no-shop clauses, and so on—imply for your current and future rights and obligations. At the very least, you should contact other companies in the VC firm’s portfolio to find out what was negotiable, why they made the choices they did, and what terms were the most consequential in the months and years after the deal.

So try to check out various VCs and see who you can work with, who has done investments in your space (target market you address) and what it has been for others to work with them.

“Remember you are looking for a partner for the long term and people who you work with will matter in terms of bringing value to your startup especially

the non monetary type!”

So here are some things to consider –

Understand your leverage

One of the thing is the more alternatives you have which means number of other VCs who are interested in your startup, it gives your more leverage. Try to use this to fight for the terms that are important for you. Sometimes one common problem is running out of cash since its hard to forecast the burn rate, and too little willingness to give up equity. As a result, you may fail to take in enough money during early rounds of funding. So look for someone who is willing to fund subsequent rounds or offer bridge loans without significant dilution of founder equity. Its better to negotiate this during the first round of financing when you have numerous alternatives and could command a better price. Many founders have discovered that doing a slightly bigger first round than seems necessary—or perhaps negotiating an acceptable formula for future bridge loans at the outset—can pay off in the
long run: It’s bad when you have few options, but considerably worse when you are running out of options and out of money!

Its okay to look at the long-term goals of the VC partner and take the time to understand what the other side cares about and hope for from their investment which includes accepting money in installments tied to milestones with no dilution in equity.

“So don’t just focus only on your own options.

Understanding the other party’s interests can give you leverage”.

Strive to maximize thrust for win-win situation

Imagine you are the verge of closing a big financing round at the end of the month. When you pitched
last month, the business was gaining momentum and you are on target for all your financial projections. Since then, a major customer deal you were counting on falls apart, and a key employee is on the verge of leaving. Question would be if you would have any legal obligation to reveal this situation, probably not, but imagine you picked up the phone and revealed it. Maybe you think they may re-negotiate the terms of the deal. But most often than not, VCs would reward you for your honesty since they would like to put a premium on your trust! They would value your upfront gesture of delivering bad news as you would deliver good news to them!

Another thing would be around terms, to comparison shop, and to use whatever leverage you have to renegotiate the deal. Its all okay as VCs expect you to ask for better terms, but not after you have given your word on an agreement. The VC world is small and they all keep cross checking on each others deal flows all the time.

“In VC relationships, as in any long-term partnership,

It’s much easier to build  trust than to rebuild it.”

Focus on value and not valuations

If you’re selling your house, for instance, you might not even meet the buyers, and despite issues such as inspections, financing contingencies, and the closing date, the selling price is far and away the top priority. In this case focusing on a single, top-line number sometimes makes sense!

But in case of accepting someone’s money at a startup, the signed contract is the beginning of the relationship, so its a mistake to focus too narrowly on price and not enough on drivers of long-term value. Its like when negotiating a job offer, for example, people tend to obsess over the starting compensation, but factors such as geography, responsibilities, prospects for learning and advancement, and even length of commute can have a greater impact on their enduring happiness and success.

More than one VC has identified this shortsighted emphasis as founders’ biggest mistake.

“Entrepreneurs focus too much on valuation and not enough on control,” one VC told me. “It’s amazing how much control founders are willing to sacrifice in order to obtain a $4 million valuation instead of $3.5 million. These numbers don’t matter much in the long run, but the impact of diminished control can last forever.” The tendency is especially remarkable when you consider the passion most founders have for what they are trying to create, for their company’s mission, and for their vision of its future. Once founders have sacrificed board control or ceded voting rights on too broad a category of decisions, those decisions are, of course, technically out of their hands. Most VCs are very reluctant to use their control rights to contravene the wishes and objectives of management, but if conflict or a breakdown in trust between management and the board occurs, founders may find themselves severely constrained, if not replaced.None of this means you should ignore valuation—it’s an important consideration. But it’s a mistake to confuse it with value, given that most founders also care a lot about factors such as their role, prestige, self-identity, and autonomy.

“To maximize valuation without regard for non-financial considerations

is to sign something of a Faustian bargain.”

Strive for Understanding not Conflict

Even when control is not the concern, you ought to pay close attention to terms other than valuation; there are additional provisions that can have a huge impact on how much money you’ll eventually see. And if you look at them carefully, the terms a VC firm proposes can help you understand its unspoken concerns and assessments of your start-up’s future.

Well as in any relationship you need to look well beyond the contract and far beyond today. The lessons offered above are targeted toward those who are striving to create strong partnerships with VCs—but they are relevant for anyone negotiating in a world where a signed contract is not the end but merely the beginning.

So folks go develop products & solutions and please don’t forget to connect your wares to a customer persona and a pain-point they may have to resolve and rest will follow!

I will do more posts on understanding terms like liquidation preference vs. participation for example in term-sheets from the perspective of an entrepreneur.

7 Habits of Effective Early-stage Entrepreneurs that are counter-productive to scale

There’s plethora available on success stories of mega corporations, on their genetic code and on how they operate. There’s also a lot of glamorous coverage on start-ups & start-up leaders as well. We hear of the best practices and management learning from successful large Enterprises, and we also have a plenty of advice for the Start-up leaders.

The Growth BumpHowever, the fact remains that only a miniscule number of all promising start-ups actually break-through to the big league. And for those who do, the script of their painful & paradoxical journey is often oversimplified or just plain uncovered. And one of the most important aspects of such successful transformations – from a successful start-up to a mega-business – lies in whether entrepreneurs are able to successfully transform the genetic code of the organization.

Entrepreneurs & Start-up leaders that are successful in the Jump-start phase are so because of certain effective habits that they either have or have developed during the initial phase. However, the same habits, if carried forward too long become counter-productive to scale for their business. The main reason being that once the business is off the ground, it’s not about the entrepreneur any more, but about the engine that propels the business. Also, entrepreneurs my find it harder to adapt because of the early successes. It’s tempting to think that the same characteristics that brought them a string of successes can continue to play their part as the business grows. And unfortunately, they cannot just bring in a new leadership to take over and do this for them. They have to start with themselves – precisely for the tremendous zeal with which they brought the organization to where it is – and, then infuse new leadership accordingly if needed.

Let’s look at some of such habits, why they are great for start-up and how they become counter-productive for scaling.

1.    The Jugaad Syndrome

JugaadEntrepreneurs are adept at figuring complex situations out, and to find simplistic “anything that works” solutions to keep going through the grind of early stages. That is one trait that’s critical early on when one has to contend with perennial set of challenges with minimal resources. However, this tendency, over time has to give way to intellectual freedom for others in the organization and also a more systematic set of problem solving techniques for the organization to scale. Consistency and Repeatability are important for scaling organizations.

The ability to simplify the complex situations is a great trait in general. However, as the growth requirements demands scaling up, business faces more complex problems posed by variety of employees & customers across the spectrum. A process and systems driven approach is called for, and while that doesn’t have to yield to a more cumbersome and rigid process driven organization, still a more structured approach to handling the commonly confronted situations is required so that people at various tiers can operate on their own at operational level. Hence, the “Jugaad” tendencies have to give way to more structured operations.

2.    Dynamic, or too dynamic for own good

Adapt on the flySuccessful entrepreneurs are masters at adapting on the fly. Early on, this is important because most times the foundations of the business are not validated with the real markets and real customers. Ability to change the direction as required by the market is important in the early stages, even at strategic level. This “Pivoting” is becoming even more critical in the fast paced technology environment, especially in the consumer markets where one cannot always be sure of the right combination of the product, pricing, positioning and promotional approaches. This dynamic thinking, earlier on, helps validate multiple hypotheses built into the business model. One pivots as fast as one can, and as often as one can, until a successful combination emerges or until one runs out of resources. However, once the business model is validated and organization is set to run in one direction, this tendency to shout the marching orders down the hall becomes unproductive because other leaders find it difficult to fall in line at the drop of the hat. This can get chaotic pretty quickly.

This argument against “too much agility”, however, should not be confused with the agility required to be watchful in a fast paced environment, where an empowered team would be able to pinpoint a change in trends and be able to adapt quickly to changing business conditions. The tendency that needs to be curbed is the one where the decisions are made at the drop of the hat without due consideration to how the organization needs to change in short term as well as longer term in response to a changing situations on the ground. And, more importantly, not to disrupt the process of building the operationally efficient organization in the business that is on path to scale.

3.    The Owner takes the ownership

delegationAn entrepreneur takes pride in taking the winning shot. It’s not just the pride or ego, but a sense of duty and sense of right, mixed in one. When the stakes are high, it’s abnormal to think of delegating the authority (looked upon as responsibility). However, this tendency gets deeply embedded in routine decisions. Unless a systematic transition to delegation and transfer of ownership happens, the organization remains a single-cylinder engine.

A scaling organization requires empowerment and that cannot come from “just assignment of responsibility” but through the “true delegation of authority and freedom to take important decisions”. However, what also happens is that by the time the realization to build an empowered team strikes, the entrepreneurs find themselves surrounded by other leaders who are too habitual to take the orders and are unable to devise the strategy on their own. It’s not a matter of competency in most cases, but the way the business leaders get wired into working in a certain way, and looking up for directions. They also get into a habit of kicking the issues and conflicts upstairs that makes the organization slower to respond to urgencies on the ground. Scaling organizations require the Entrepreneurs to let go of the sense of control and ownership, and empower the team in true sense.

4.    The Kingship

Crowning the selfThe initial thrust in business comes from the reputation & credibility of the entrepreneur. This leads to a cycle of further boost of personal branding, further resulting into more business driven in such a manner and so on. It very quickly reaches a point where the Business and the Entrepreneur become synonymous to each other. While that is great initially, an organization looking to scale into a mega-business needs to balance the company objectives against individual objectives earlier than later. In other words, the leaders need to put the organizational goals ahead of personal goals. Even as there is little doubt that success of the company is a passionate personal goal for start-up leaders, the way it happens most times is by putting their personal whims & fancies, and branding, at back seat, and let the organization harness the power of people at all levels. The earlier it is done the better.

Entrepreneurs that are more focused to the longer term scaling of the business need to ensure that the business or the product is branded explicitly with bigger intensity than the owners of the company. I had earlier highlighted on this paradox of Branding as one of the five paradoxes of successful product business. And this remains one of the things that are difficult to fix quickly since branding takes time and change of stance in branding from personal to business is often tough unless done from the initial stages.

5.    Juggling

Multiple HatsAn early stage of a start-up requires the leaders to juggle a lot of balls at once, making them a habitual juggler. It’s an invaluable trait to be able to juggle priorities, handle multiple things at ones across functions, to be able to venture into the unknowns and come out stronger. Great start-ups are known to thrive on minimal resources and require the leaders to be able to act on multiple initiatives at the same time, almost to the point of craziness.

This, however, gets deeply embedded in the habitual code as “uneasiness” and “impatience” with anything that requires systematic and long-term sustained focus. There develops a tendency to kick-off the new exciting projects on the periphery of the organization, which is difficult to do without affecting the focus on core business. Normally, operational leaders are appointed to sustain and expand the businesses that are doing well, which is fine but a scaling business also require the continuing focus of entrepreneurial mind in the core drivers of business. Successful large organizations have spun-off multiple businesses, but they do it upon the successful scaling of the core business, not at the behest of the core. Biting those bullets before the time comes is hazardous to the health of the business.

6.    Networking and Personal relationships

customer-relationsNetworking and relationships are the core strengths of a start-up business. Focus on relationships gets the best out of the organization in order to delight the first set of customers. Early-on in the life of the organization, relationships and personal networks play a critical role across all the areas of the business – hiring, business acquisition, delivery, financing, marketing & PR, and so on.

On Customers front, there are two sides to this coin. Acquisition of new business, as well as sustenance of existing business are driven through relationships, which helps because of the lack of early credentials and referencible successes. The flip side is that these relationships tend to be personal relationships. The customers expect the leaders to show up at the drop of the hat. It’s not scalable for an entrepreneur to show the face and shake the hands at every opportunity to build new business or when there is fire at an existing one. This needs to go beyond the leader at the helm. The organization needs to go beyond personal relationships into professional customer oriented relationship mindset – which is easier said than done once the organization is already growing.

Similarly, entrepreneurs find it hard to confront the performance issues among employees & partners due to the personal and emotional connects that hold most of these relationships together. These connections can quickly become a liability if the leaders (and hence organization) lose the ability to make objective decisions in these relationships.

7.    Heroism

Call-Your-HeroEntrepreneurs tend to demonstrate heroism, and inadvertently (or sometimes intentionally) promote heroism. Start-ups are replete with stories of celebrated heroism – Single-handedly acquiring a new customer, heroically defusing an exploding customer situation, over nightly launching an offering, and so on. Due to the nature of various functions, this heroism is found more in Sales, Marketing, and delivery of larger projects. Sometimes, plain pure planning & preparation – an aspect that gets often overlooked in a start-up scenario, also necessitate such heroism. This is partially also acceptable to entrepreneurs because a start-up typically takes pride in informality (bordering on casualness unfortunately) and flat (or absent) structures.

Start-up leaders themselves set examples of heroism that over time plays down a systematic, well-planned bricklaying approach that a scalable business is built upon. Many times, the heroism culture also inadvertently sabotages any chances of under-played sustainable success, because of the glamor and awards attached to such celebratory moments. However, it has been proven that the most sustainable and scalable businesses are built by behind-the-scene bricklaying executioners. It is important for entrepreneurs to make that transition in the genetic code of the organization. An emphasis on sustainable & repeatable success requires setting up the rewards & bonuses in line with a structured longer term approach, with due importance to the backend jobs in operations, deliveries and finances, while of course not losing sight of any heroics that really save the day in true sense.

Way Forward?

It is obviously a matter of perspective. The same traits that are huge leverage in one situation can be a liability in another.

The point is not whether these traits are good or bad, per se, but to understand where they are effective and where they get counter-productive. Business situations are often complex and it is difficult to pinpoint what is actually holding back the progress of a company. Most start-ups, when faced with complex situations like this, look for help from outside – in the form of funding, leadership talent, or even partnerships and exit plans. However, it is also true that most successful mega-businesses crossed the chasm between the start-up phase and the maturity phase with the core entrepreneur/start-up team still at the helm. While, upon introspection, some of these bottlenecks can be identified, it is difficult to ascertain how much impact some of these habits have on the overall results. However, it is safe to say that recognition of these and an attempt to consciously look at the transition can only help.

Happy scaling!!

PS: This post was originally published on YourStory as 7 Habits of Effective Early Stage Entrepreneurs that are counter-productive to scale