Later-stage rounds and “setting the bar too high”

I recently had a number of conversations with CEOs of later-stage startups (generating significant revenue) that went something like this. They want to raise more money, and VCs are offering them money at a high valuation. The CEO is worried that taking money at that valuation will “set the bar too high” and make it difficult to sell the company – if the time comes when he/she thinks it makes sense to sell – at a price that isn’t a significant multiple of that valuation.

These CEOs are worrying too much. VCs know what they are doing and almost always invest with a financial instrument – preferred shares – that protects them even when the valuation is very high. Preferred shares behave like a stock on the upside and a bond on the downside.  The only way investors actually lose money is if the company is sold for less than the amount of money raised (which is generally significantly lower than the valuation).

Here is what the payout function looks like for common stock (for example, what you get when you buy stocks in public markets):

And here is what the payout function looks like for preferred shares:

 

So, to take a concrete example, Dropbox reportedly raised their last financing at a $4B valuation*. If you think of this as a public market valuation of common stock, you might think this means the VCs are betting $4B is the “fair value” of the company, and will lose money if Dropbox’s exit price ends up being less than $4B.  But in reality, assuming the standard preferred structure, the last round investors’ payout is as follows :

Scenario 1: Dropbox exits for greater than $4B ==> investors get a positive return (specifically, exit price divided by $4B)

Scenario 2: Dropbox exits for between $257M (total money raised) and $4B ==> investors get their money back (possibly more if there is a preferred dividend)

Scenario 3: Dropbox exits for less than $257M ==> investors lose money

If reports are true that Dropbox is profitable and generating >$100M in revenue, then scenario 3 – the money losing scenario – is extremely unlikely.

Will investors be thrilled with scenario 2?  No, but they are pros who understand the risks they are taking.

Going back to the entrepreneur’s perspective, in what sense is a high valuation “setting the bar high”?  In the preferred share payout model, there are two “bars”:  money raised and valuation.  I don’t see any reason why entrepreneurs shouldn’t be as aggressive as possible on valuation, especially if they are confident they won’t end up in scenario 3.

An important point to keep in mind is that, in order to maintain flexibility, entrepreneurs shouldn’t give new investors the ability to block an exit or new financings. Investors can get this block in one of two ways – explicit blocking rights (under the “control provisions” section of a VC term sheet) or by controlling the board of directors. These are negotiable terms and startups with momentum should be very careful about giving them away.

 

* Note that I have no connection to Dropbox so am just assuming standard deal structure and basing numbers on public reports. I am making various simplifying assumptions such as not distinguishing between pre-money and post-money valuation.

 

Dropbox and why you should invest in people

It was reported today that Dropbox will generate $100M in revenue this year.  Whether or not those reports are right, it is certainly a great product, beloved by its customers and will almost certainly be wildly successful. I knew the founder, Drew Houston, back before he started Dropbox. He was an MIT CS guy, hanging around Boston in 2005 when I was working on SiteAdvisor and spending most of my time trying to recruit great devs. He was introduced to me by my investor and friend Hemant Taneja, another MIT CS guy, as a super smart kid I should recruit. I tried to recruit him but lost him to another company called Bit9.

(Funny side story about Bit9:  After we sold SiteAdvisor to McAfee in 2006, I encountered Bit9 again when I was visiting SF and crashed a party hosted by one of their investors.  This investor was a lifetime middle manager from Symantec who had never started a company and was now a partner at a big VC firm.  He spent 30 minutes giving a speech about how the Internet was dead and people investing in it were stupid and his firm was focused on Cleantech instead, and then started talking about how rich he was and how many wineries he owned (yes, seriously). He barely mentioned the poor startup that sponsored the event. It was totally embarassing and represented everything wrong with the old, dead VC world. When I was introduced to this jackass VC after his speech as someone who had just sold his company to McAfee, he said to me “Bit9 is going to eat McAfee’s lunch.” Trying to neg a startup guy by saying a startup is going to beat an incumbent just shows how incredibly clueless and middle-managery this guy was.).

Anyways, the next time I met Drew was after I left McAfee and rented a small temporary office space in the garmet district in NYC. We were on the 19th floor of this awful shared place called E-merge (this was before the resurgence of incubators) in a tiny room infested with fruit flies. I was sitting there with my pals from SiteAdvisor Matt Gattis and Tom Pinckney coding some random machine learning ideas which eventually led to the seeds of Hunch. Drew came by to get advice on his new startup and we met for an hour or two. We chatted about strategy, recruiting, fundraising etc – the usual early stage conversations. He then moved off the California – I think to do Y Combinator. Next time I heard from him he had just closed a round of financing from Sequoia. I was never offered to invest in the company but probably I could have if I asked Drew since he had come to me for advice. Sometimes when people come to you for advice like that they are really hoping you will ask to invest and I didn’t. I’d have to say in all honesty if I were offered I probably would have passed.  2005-6 saw about 100 consumer backup/storage/file sharing companies raise funding. I remember after Drew left my office I looked at some article on RWW or Mashable or someplace that listed page after page of consumer backup/storage/file sharing companies. It just seemed like an insane idea to start another one and it seemed like Drew’s only thesis was that his product would work better.

Well, it turned out storage is a hard problem and having an MIT storage guy who builds a great product actually matters. I don’t know how under any investment philosophy that emphasized theses, areas of investment, roadmaps, etc you could have decided to invest in B2C file sharing company #120 in 2007. Obviously Sequioa knew better than me and invested. I think the only way they could have made that decision was by ignoring the space, competitors, etc. and simply investing in a super talented person/team.  Dropbox is one reason I now have a strict rule to only invest in teams. There are other examples of companies I missed and other examples of the converse – companies where I invested in mediocre people chasing a great idea and the company failed – but Dropbox is emblematic to me as to why you should always invest in people over ideas.