Tech startup valuations have gone up significantly in the last year. One research indicated that stock in leading private tech startups was up 54% in the last six months. This trend is across stages and that is a worrying trend especially for early stage ventures. It is one thing for Facebook, Groupon and Twitter to be overvalued and a completely another for a seed stage company to be overvalued. For the biggies, it just valuation correction, but for the seed stage companies this could mean harakiri!
Case in point, a seed stage web services company with zero revenue and product in development was looking for funding at a pre-money valuation of $2.5 Million and is getting traction from some angels. Gone are the days when any seed investment valuation was in the range between $500K to $2 Million. Seed valuations have doubled in the last year. Most of this is driven by supply side economics of availability of angel capital for startups. Companies have embraced this trend and the general approach seems to be to raise as much capital as needed for at least a few years of operations (that includes founder salaries, office expenses etc.). For entrepreneurs, this could be great in the short term to raise significant capital by giving up lower equity. But I think they might be setting themselves up for failure for the long term and here is why.
:: One, higher seed valuations translate to high expectations - For example, if a company raises 500K at pre-money valuation of $2 Million, the investor expectation is that this venture would be worth between $40-$50 Million in the next 5 years. That would mean revenue expectations of at least $8-$10 M per year. That is a huge expectation from a company that has barely gotten its original value proposition and market position clearly defined.
:: Two, if the young company does not hit the ball out of the park the first time or even otherwise needs additional funding, future rounds (from institutional investors or other angels) would come if at all, at a deep discount much to disappointment of initial shareholders and founders. This in turn significantly reduces the incentive to succeed for the founders and hence would be sub-optimal.
An alternate and more effective approach would be for entrepreneurs to raise only as much capital as needed (in multiple rounds) to hit the next milestone, while using realistic valuations. First place to start would be to establish realistic revenue and EBITA goals for the young company. If a startup is able to prove its value prop and generate $2-$3 Million in revenue within the first 3 years, I think it would a great foundation on which something tangible can be built on. Otherwise it is just vaporware! Also, when done in a very low cost way - no or minimal salaries for founders, and either low salary and equity combination or offshore staff, tangible enterprise value can be created in an efficient manner. Such a company would be much more credible and attractive for institutional investors down the line and have a much better probability of becoming a successful venture.
Recent trends in Web2.0 and cloud based infrastructure has made it much more easier for new ideas to germinate. There are a lot of great ideas and good ventures being launched every day. If startups can embrace the notion of 'deferred gratification', we might be able to create something very special. Happy Holidays to all readers!