The importance of investor signaling in venture pricing

Suppose there is a pre-profitable company that is raising venture financing. Simple, classical economic models would predict that although there might be multiple VCs interested in investing, at the end of the financing process the valuation will rise to the clearing price where the demand for the company’s stock equals the supply (amount being issued).

Actual venture financings work nothing like this simple model would predict.  In practice, the equilibrium states for venture financings are: 1) significantly oversubscribed at too low a valuation, or 2) significantly undersubscribed at too high a valuation.

Why do venture markets function this way?  Pricing in any market is a function of the information available to investors. In the public stock markets, for example, the primary information inputs are “hard metrics” like company financials, industry dynamics, and general economic conditions. What makes venture pricing special is that there are so few hard metrics to rely on, hence one of the primary valuation inputs is what other investors think about the company.

This investor signaling has a huge effect on venture financing dynamics. If Sequoia wants to invest, so will every other investor.  If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.

Part of this is the so-called herd mentality for which VC’s often get ridiculed. But a lot of it is very rational. When you invest in early-stage companies you are forced to rely on very little information. Maybe you’ve used the product and spent a dozen hours with management, but that’s often about it. The signals from other investors who have access to information you don’t is an extremely valuable input.

Smart entrepreneurs manage the investor signaling effect by following rules like:

- Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides space and mentoring.  If a big VC has any involvement with your company at the seed stage, their posture toward the next round has such strong signaling power that they can kill you and/or control the pricing of the round.

- Don’t try to be clever and get an auction going (and don’t shop your term sheet). If you do, once the price gets to the point where only one investor remains, that investor will look left and right and see no one there and might get cold feet and leave you with no deal at all. Save the auction for when you get acquired or IPO.

- Don’t be perceived as being “on the market” too long.  Once you’ve pitched your first investor, the clock starts ticking. Word gets around quickly that you are out raising money. After a month or two, if you don’t have strong interest, you risk being perceived as damaged goods.

- If you get a great investor to lead a follow-on round, expect your existing investors to want to invest pro-rata or more, even if they previously indicated otherwise.  This often creates complicated situations because the new investor usually has minimum ownership thresholds (15-20%) and combining this with pro-rata for existing investors usually means raising far more money than the company needs.

Lastly, be very careful not to try to stimulate investor interest by overstating the interest of other investors. It’s a very small community and seed investors talk to each other all the time. If you are perceived to be overstating interest, you can lose credibility very quickly.

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