37. The Algorithm for Raise Amount & Valuation (Leo Polovets)

The Full Ratchet Podcast on iTunesNick Moran Angel List

Leo Polovets of Susa Ventures joins Nick to cover The Algorithm for Raise Amount & Valuation. We will address questions including:

  • You’ve outlined three major steps in “The Algorithm for Seed Fundraising.” The first, is the amount of the raise and you cite revenues, expenses and timing as key variables. Can you walk-us-through this step and how an investor can quickly evaluate the numbers and know if the startup is raising an appropriate amount?
  • Step two has to do with price and length of time to raise. Can you first talk about how much time startups should be spending on their raise and why?
  • Can you highlight the four profiles that help determine the appropriate valuation range and what those ranges are?
  • The third step has to do w/ performing a sanity check on the numbers. Directionally, what should be the relationship between raise amount and price?
  • If founders are looking at a fundraise amount and price that cause too much dilution, what options are available to proceed with the raise w/o selling too much equity?
  • Many angels have advocated for using tranches and/or rolling closes at different prices or caps, to incentivize angels to act. You’ve advised against this. What’s your message here?
  • There are some common rights that investors ask for during a seed financing. You mention pro-rata, board seats and Most favored Nations. Can you take a minute to describe what MFN is and why it’s so important for early-stage investors?

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Answer to Last Week’s Brainteaser was the Syndicate.  If you’d like more information on the difference between the two and how they compare, check out the Economics of Syndicate vs. Venture Fund spreadsheet.

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Key Takeaways:


1- The three steps to the algorithm

Step 1: How much do you need?
Step 2: What is your target valuation?
Step 3: Perform a sanity check

For step one, Leo advocates to start w/ an 18 month duration. Then the founders must calculate all of the expense-side costs… salaries, office space, infrastructure, utilities, marketing, PR, legal, accounting, etc. And he also suggests to assume that Revenue will be flat over that 18 month horizon, regardless of one’s intent to grow. Once all of the costs are aggregated, he asks a startup to add a 10-20% cushion and this number, over the 18 month duration is the suggested fundraise amount or variable X.

For step two, Leo first thinks about the four stages that a product fits into… and remember that he is often looking at B2B SaaS companies in the Bay Area and the definitions of Seed vs A vs B have become a little fuzzy and are different depending on who you ask. Here are Leo’s four stages:

1. Pre-product or alpha product ($3-$6M valuation)
2. Beta Product, some pilot customers and revenue may be $1k-$20k ($6M or $7M valuation)
3. Mature Product w/ established revenue, but sales are still high-touch maybe in the $25k-$100k range (~$10M valuation)
4. Mature w/ a repeatable sales model w/ $100k+ in monthly revenue (Series A territory or $15M+)

And this step includes Leo’s point about raising a round within 2 months. If significantly faster than that then the startup is underpriced. Significantly longer it’s either overpriced or there may be fundamental issues preventing the startup from getting funded.

Finally, step three for Leo is the sanity check. In steps one and two we calculated the raise amount, X, and the price/valuation, Y. He now likes to assess if they make sense.

So, Y should be about 4-6x variable X. If that’s the case, then it is appropriate to proceed w/ the fundraise. If Y is significantly more than 4x of variable X, then Leo suggests coming up w/ a more aggressive roadmap since more money could be raised w/ acceptable dilution. And if Y is less than 4x, then the founders are probably taking too much dilution. Leo believes that it rarely makes sense to give up more than 20% of the company at the seed stage. His rule-of-thumb here is that dilution should be between 1/6 and 1/4 or 17% – 25% of equity. And this leads us into takeaway #2, which is…


2- Options if you can’t raise enough money at the preferred valuation

First, let’s recap that investors are trying to de-risk their investment by finding out:
-Are the founders good?
-Can they sell the product?
-Can they build the product?
-Does the Market want the product?

So, if the founder is unable to raise the amount they want or raise at the price they prefer, they must do what they can to address those factors and de-risk the investment. This includes:
-Self-funding or taking less salary
-Raise a little less and aim for a bridge round by achieving some near-term milestones
-Implement a less-conservative plan and finally
-The founders can take more dilution


3- Most Favored Nations

Most simply, most favored nations, MFN, protects early investors from getting worse terms than others. Remember that angels often get money in very early, when risk is at the highest. If a VC or other investor comes in later and negotiates for better terms, the angel doesn’t want to be stuck w/ a higher price or worse provisions. MFN guarantees that the early investor, will get upgraded to the best terms, within that round, if better terms come in later-on.
While Leo doesn’t handle the legal docs, his understanding of the way that this plays out is that there is a trigger tied to the MFN, so that if a subsequent cash infusion sets off the trigger (I’m guessing it would be time-related or $ amount of the raise), then it is considered a new round and the early investor does not inherit the new terms. However, if things are going well, then the terms will almost certainly be less favorable in a subsequent round than the previous.

While this may seem like a simple clause, it can have great effect. Especially, when individuals or small groups of angels do not have the bargaining power or deal experience of a venture capitalist. It’s likely that the MFN clause will rarely be necessary, but in the rare case that it is, the riskiest capital should, at the least, be at par with less risky capital.”



Tip of the Week:   The Rolling-Close Gathers Moss

Below is the 'Tip of the Week' transcript from the Podcast Ep37: The Algorithm for Raise Amount & Valuation (Leo Polovets) In the past we've talked about the benefits of the rolling close. How a startup founder can incent angels to act by creating tranches of better terms, if they invest by a certain date. While, there are some benefits to this, today we talked about some significant drawbacks to the rolling-close The cited problems include: (more…)Read More...

*Please excuse any errors in the below transcript

Nick: Today we have Leo Polovets on the program to talk the algorithm for seed fundraising. Leo is in Mountain View, California. He’s a general partner at Susa Ventures, and also does some angel investing on the side. Leo, thanks so much for the time today.

Leo: Thanks a lot for having me, Nick.

Nick: Leo, can you start us off with your background, and how you got involved in venture?

Leo: Sure. I was actually a software engineer for about a decade after I graduated college. I was fortunate enough to be one of the early employees at LinkedIn. I worked at one of the [inaudible 00:00:31] internships, and so I joined with the company was about a dozen people. I was there for a couple of years.
After that, I went to Google and worked there for 3 years on payment fraud detection, and then I worked at a start-up in L.A. called Factual, where I did a lot of data processing work.
About 2 ½ years ago, I left Factual and was trying to figure out what I wanted to do next. I was actually kind of thinking of starting a company, but realized that I didn’t really know much about really early-stage companies in terms of, I’d never been involved in fundraising. I’d never built a product from scratch. I’d never created a team from scratch.
I was trying to find ways to learn about that stuff, and right around the time that I left my job, one of my friends actually came to me and said, “I have this seed fund that I’m starting with a couple of other people, and we’re looking for somebody more in the technical engineering side. You ought to check it out.” That seemed like a really great way for me to learn about kind of the 1- to 10-person stage of a company.
I tried it out, and I really liked it, and so I’ve been doing that for about 2 ½ years now.

Nick: Did you make some angel placements before you launched into the fund itself, or did you start with the venture fund?

Leo: I was just starting to, so I think that was right around the time when [inaudible 00:01:47] came out, like a few months before I started at the fund. Also, I went to a couple of like angel group meetings where I lived, but I was just starting out when I joined the fund.

Nick: Can you give us a little info on how that fundraising process went? Clearly, you found some co-general partners, and then did you commence sort of a traditional raise, or did you have certain ELPs in mind before you decided to proceed with the launch?

Leo: It was … I guess it’s kind of a long story, but basically we knew that fundraising, as a fist-time fund, wouldn’t be easy. We had, 1 of our 4 partners had a lot of angel investing experience, but we wanted to make sure that the rest of us could work together, could make good decisions together.
We actually starting investing as a syndicate, and we did that for about 8, 9 months, and made 6 or 7 investments where we just basically, as an informal syndicate, we’d each write a small piece of each check. I think once we saw that we were making good decisions, we could work together well, we liked it, we started fundraising.
One of my partners had pretty good connections among like family offices and multi-individuals, so the fundraising process wasn’t super short, just because a first-time fund is hard. We managed to close 25 million dollars in about 7 or 8 months or so.

Nick: Was that mostly existing network, then, or were you going out to folks that you hadn’t interacted with in the past?

Leo: It was both. I think maybe the first third or so was existing network, and then after that we started getting connections to people we’d never met before. We kind of got connections from all over the place, sometimes through our friends, sometimes through founders we were working with. I think it’s a lot, probably, like raising money for a start-up, where you just kind of hustle and try to get money where you can get it.

Nick: Remind me of the total time between when you started the raise and when you closed it?

Leo: I think it was like 7 or 8 months or so.

Nick: Leo, today’s topic is the algorithm for seed fund raising. You’ve written about this in the past, and have outlined 3 major steps [00:04:00]. The first is the amount of the raise, and you cite revenues, expenses and timing as key considerations for determining raise amount. Can you walk us through this step, and how an investor can quickly evaluate the numbers and know if the start-up is raising the appropriate amount?

Leo: Sure, so I think a lot of this basically comes down to pattern matching and experience. It’s largely based on, if you’ve seen a lot of deals in your area, and you kind of know what things go forward, then basically calibrating off of that. If you haven’t seen a lot of deals, maybe looking at AngelList and seeing what … Compare what companies are raising in your area.
I kind of see it as several stages. One … The first stage for start-ups is pre-product, so sometimes people try to raise with just an idea and a deck. At least for Silicon Valley, usually those valuations tend to be a bit lower, maybe like 3 to 6 million. I realize that maybe in other locations, they’d be a lot lower than that, but that’s kind of the going rate in Silicon Valley.
The valuations kind of progress as the company progresses, as you go from pre-product to a working prototype to starting to make money and finding product market fit, the valuations kind of go up a couple million with each step. If you’re a pre-product, it might be like 4 million or 5 million. If you have a beta version, maybe like a few thousand dollars in revenue every month, maybe that’s more like 6 or 7. If you’re making like $30,000 a month, maybe that’s closer to like a 10 million dollar valuation. Above that, you start getting into Series A territory when somebody crosses about a million revenues.

Nick: As part of step 1, you’ve talked about the lists of expenses involved in a start-up’s maturation. You’ve cited salaries, office space, infrastructure, marketing, PR, accounting, et cetera. In terms of time frame that the raise should last, how would [00:06:00] you recommend structuring the amount that’s raised, and think about the amount of timing and runway that that raise provides?

Leo: I think that the magic number I usually try to recommend to people is to try to get 18 months or more of runway. The reason for that is, people often … They have these milestones that, “If I had a million dollars, I could do this in 12 months, and then I’d be ready to raise in 12 months.” Unfortunately, it doesn’t work like that, because fundraising for a Series A might take 3, 4, 5, 6 months.
If you hit your milestones, but you hit them right as you run out of money, that’s basically it. You can’t wait 6 months after that to go raise your next round. The reason I tell people to try to raise about 18 months of runway or more is that if you take off 4 to 6 months for fundraising at the end, that still gives you 12, 14 months to hit some good milestones. If you’re raising 9 months of runway, that means you only have 5 months to hit some milestones before you need to raise your next round, and 5 months might not be enough time, especially if it turns out you have to pivot a little bit or change your business model a little bit. I think 18 months is a great goal to shoot for.

Nick: If I were the start-up founder, basically I’m looking to take my top line numbers, maybe with a conservative hedge, and look at my cost side, and figure out what the cash flow looks like, then, for that 18-month period?

Leo: Yeah, exactly. I think it’s probably good to just assume that if you have revenue it’ll, for whatever reason, maybe it stops growing next month. Let’s say your revenue stays pretty even, and then you have some hiring plan, like you probably have some goals of, “I want to add 2 engineers, and I want to build this feature, and then after that, 3 months later, I’ll need a sales person.”
You start budgeting for those people and try to think about, “If I hire [00:08:00] them in month 4, and then I’m paying them for the next year, year and a half, until my next round, how much money does that take per person?” You add in a little bit for office space and maybe Amazon for infrastructure, and add a little bit of buffer, and that’s kind of your good 18-month number.

Nick: That covers step 1, which is you tee up as variable X in this algorithm. Step 2 is related to … Is variable Y, which is the valuation and the price. Before we jump right into the valuation, you talk about the length of time to raise. Can you first illustrate how much time start-ups should be spending on their fundraise process, and why?

Leo: This is just my personal opinion, but I think targeting about 2 months or so is a good goal to shoot for. Sometimes really hard start-ups, they’ll raise in a week or 2. I think usually that means 1 of 2 things, although not always, but it either means you really underpriced your round, and so investors kind of basically were tripping over themselves to invest in a bargain, or it means that maybe you got some good investors, but in a week or 2 there’s only so well you could know people.
I think it’s really valuable, if you’re going to be working with somebody for the next 3 or 5 or 10 years, to try to get to know them a little bit. Have more than 1 meeting; have 3 or 4 meetings, meet all the partners, make sure it’s a fund or a VC or an angel investor that you want to work with.
I think if you can close money really quickly, in some ways that’s great, but in other ways, maybe you’re missing out on better investors, or you could have had a slightly higher price or something like that.
The flip side, I think, if it’s taking you 5 or 8 or 12 months to raise, that means something else. That means basically the opposite. Either you’re over-pricing it, or maybe your vision isn’t compelling enough, or you don’t have the right founding team. You need like a better [00:10:00] technical co-founder, or better business co-founder.
I think if it’s taking that long to raise, that should be a time to step back and really think about, why aren’t people investing? Try to address those issues, and maybe that means raising a little bit less on this lower valuation. Maybe it means trying to find an additional co-founder. I think 2 months is sort of a good time, where it shows that you found a price that people like, but they don’t fall over themselves trying to invest in. It’s also not so long that it just distracts you from building a company for 6 months.

Nick: When we’re considering very early seed-stage companies, and the need to go after angel capital, for instance, through angel groups, often it can take months to get on their calendar in terms of their cycles. If an angel group meets every couple months, maybe you contacted them at the wrong time, or at a time that falls between those meetings.
They may have you come in to 2 different evaluation sessions. Maybe you come in for a small angel group meeting with 10 members, and then they invite you to the broader group. Considering some of these early stage capital sources, can sometimes take 8 to 12 to 16 weeks, how do you advise that start-ups and founders should think about this time to raise with sources that may not be able to turn in 2 months?

Leo: Yeah, that’s a great question. I think this is where my advice probably applies a little bit more to the really large markets, like Silicon Valley and New York. At least from what I’ve seen here, I think angel groups tend to be a little bit less active. It tends to be either individual angels or VCs, and both of those, at least in seed stages, really move pretty quickly.
Obviously, if the main source of funding that you’re [00:12:00] talking to operates on a 12-week schedule, then I guess you’re on a 12-week schedule. That’s OK. I think that the reason I picked 2 months as a milestone is, I intended it to be more as like, you found a good, fair market clearing price, and so it’s kind of like, if in your market, 4 months is a reasonable time for fundraising, then target 4 months, because if it’s taking you 12 months, it’s still … That still indicates some kind of problem with what you’re doing.
I think also, a lot of times, if there are individual angels in the area, sometimes you can just e-mail them cold if you have a really nice personalized message, and they’ll reply, and the same thing with VCs. I think that could be another channel, too.
I actually … One of the fundraising strategies I really like is to start with angels, because a lot of times, at least in Silicon Valley, individual angels, they’ll be willing to write small checks without too much diligence, if they like a founder, or they like a company, they like a vision. A lot of times that’s a great way to build momentum, but then also those angel investors could manage VCs who, other angels, other VCs, other angel groups, so that could be a good way to get the momentum rolling and get a little bit of money in the bank early on.

Nick: Right, yeah, sometimes you see these founders that are raising for 12 months or 18 months on end, and you kind of have to scratch your head and think, “Is this a fundable company, or is your price way out of market for what you’re proposing, or the traction that you have?” Certainly, the 2-month raise as a target, I think, is a good one. If you can close it in that amount of time, then you’re probably … The market has spoken that you’re probably in the right range.

Leo: Yeah, and I think … I definitely mean it as kind of a rough guideline rather than, it should be 2 months exactly. If it’s 3, or 4 ½, that’s OK. If it’s like 9, that’s probably an issue. [00:14:00]

Nick: The other piece of the algorithm, variable Y, is related to price and valuation. You touched on this before, but can you highlight the 4 profiles that help determine the appropriate valuation range, and what those ranges are?

Leo: Sure, so I think there’s … Again, these are Silicon Valley numbers, and they’re just headlines, and there are exceptions to any of these. There’s pre-product, where you either haven’t started working yet, or you just started. Those valuations might be in the 3 to 6 million dollar range. There’s kind of … You have a product beta, maybe you launched it, you have a tiny bit of revenue. I look a lot at SAS companies, and so a lot of times they might have 1K or 10K or 15K in monthly revenue, and those tend to go for maybe 6 to 9 million dollar valuations; kind of the higher the annual run rate, the higher the valuations tend to go.
As you get closer and closer to repeatable sales process, maybe you’re making 25, 50, 75K per month. Those valuations tend to slide into like the high single digits, kind of low double digits, so maybe 7 million, 9 million, 12 million valuation.
Finally, once you have a repeatable sales model, you’re basically ready to raise your Series A, and then your valuation might be like 13 million, 15 million or more.

Nick: The third step has to do with performing a sanity check on the numbers. Directionally, what should be the relationship between raise amount and price, this X variable and this Y variable?

Leo: I think targeting about 20 percent dilution makes a lot of sense. A little bit lower or a little bit higher is fine, like if you’re at 15 percent or 25 percent. I would say generally Y, the valuation, is … If we’re talking like pre-money valuations, it might be 3 to 5 times X, which is the amount raised. [00:16:00] Again, you’re getting diluted somewhere between a sixth and a quarter. I think that’s a pretty good range.
I think if you’re doing less than 15 percent dilution, it probably means you’re not raising enough; not always, but probably. That seed stage cushion is so important, just because before somebody finds product market fit, you need … You really want the runway to be able to examine a little bit, to figure out what did you guess right, what did you guess wrong about the market? If you can … If you’re getting 12 percent dilution but you can raise another 500K and make it 18 percent, that 500K is probably worth it.
On the flip side, I think once you start getting over 25 percent dilution, it starts to make the company a little bit less functional long term, just because if you give up, say, 35 percent in your seed round, and then maybe you need to bridge, and you sell another 15 percent, now you’ve basically sold half the company and you haven’t even gotten to a Series A. I think that starts hurting you, when you start growing out there to Series A.

Nick: Just general numbers, rule of thumb, you said 4X to 6X. If we call it 5X, and maybe you’re doing an early seed at 500K, you’re looking at a 2 ½ million dollar valuation, and that means you’re directionally in the right range?

Leo: Yeah, exactly.

Nick: Great, so you talked about dilution, and selling more than this 20 percent. If that amount is significantly more than 20 percent, what are some of the options that are available to proceed with a raise, without selling too much equity?

Leo: I think it depends on why you aren’t able to raise the money. Is it that your valuation’s too high, or is it that your valuation’s reasonable, but you can’t seem to convert investors to invest? I think the source of the problem matters, but in general, [00:18:00] I think self-funding, or taking less salary, is one option, although it’s a hard option, especially if you have other obligations, like family.
Another option is to try to raise a little bit less, at a more palatable dilution amount, and then kind of shrink your goals a little bit so that instead of aiming for a Series A, maybe you’re aiming for a bridge round. If you need a million and a half, but the market’s only going to give you a 2 ½ million dollar valuation, maybe you raise 500K, use that to progress for 6 or 9 months, and then start to raise for a bridge round at a higher valuation.
You can also make your plan less conservative, if that’s possible. If you’re trying to raise a million and a half, and you think that would put you in a great place for an A, maybe you can raise a million, or a million and a quarter, and still have a good shot at a good A round. Maybe your plans are tweakable.
I guess the last option is, if you have to, you can always take more dilution. It’s a risk, but having money in the bank’s better than shutting down.

Nick: I guess traction speaks, right? If you …

Leo: Absolutely.

Nick: … If you can’t get what you’re asking for at the appropriate valuation, then raise a bit less, get some more traction, and then go back to the market?

Leo: Yeah. I think to a large extent, valuation is basically traction plus how much of … How many risks you’ve removed from investors’ eyes. It’s like, you’re trying to de-risk … Are the founders good? Can they sell? Can they build this product? Does the market want this product?
Every single one of those boxes that you can check, should be able to bump your valuation up a little bit. If you can check one of those boxes off in a couple of months, maybe it’s good to wait a couple of months, or try to just raise a little bit, and then raise more in a couple of months.

Nick: We’ve talked a couple of times on the show about the nature of these rolling fund raises now, and how a seed [00:20:00] seems to be split up into different tranches, with people raising at different valuations over time, and maybe smaller chunks of capital coming in. Are you seeing this as well, in the Bay Area? Is it related to this very issue?

Leo: Yeah, I think it’s partly based on, sometimes people can’t get the valuation they want. They’ll raise a little bit at a lower valuation, and then as they make progress, they keep bumping it up and up.
I think the other situation I see it in is when a round is basically very hot, and so maybe somebody aims to raise like 2 million, and they start closing it so quickly they realize, “Hey, maybe I can just close a million on 6, and raise the next batch at 8 or 9 or 10.” I’ve seen that as well.

Nick: There are a couple of caveats that you mention. One we’ve talked about in the past. Many angels have advocated for using tranches and these rolling closes to incentivize angels to act. You’ve advised against this. What’s your message here?

Leo: There are a couple of things I don’t like about this, and it’s just a personal opinion. I don’t think it’s a hard and fast rule. I think one is, it adds a lot of complexity. It creates weird incentives, because if 2 people got in, and 1 got in at 4 million and 1 got in at 8, then for example maybe 1 is really happy if you get acquired at 7, and the other one will try to block it. If everyone just got in at 4 or 5, you don’t run into that issue.
I think another thing that people often miss is that the dilution, they say, is usually pretty minor. As an example, somebody might raise a million and a half at a 5 million pre, or they could raise 500K at 4 million, 500K at 7 million, 500K at 10 million. It sounds like the second approach is a lot better, because you’re kind of raising most [00:22:00] of your money at 7 and 10, but you’re actually only saving like half a percent of dilution, if you do the math. One and a half on 5, is like 22 percent. The other approach is 22 ½ percent.
It’s a lot of paperwork. It’s a lot of making some investors feel slighted. It’s a lot of legal complexity and all of that, for drawing the process out and saving half a percent, which I think in most cases is not worth it.
I think finally, if you do a tranche round, the higher your final valuation in that round, the higher your expectations for the next round. If you raised a million and a half on 5, if things don’t go great, maybe you can go raise at 8 or 9 in a year. If you do it in tranches, and your last 500K was at, let’s say a 10 million dollar valuation, you have to get a lot further on the same money to do a bridge after a 10 million dollar valuation.
Instead of getting to 8 or 9 million, maybe you have to get to like 18, and that’s a lot harder. That’s basically Series A territory.

Nick: I guess the big difference between the multiple seed rounds before, that we talked about, and more of this tranched approach, is that the situation before involves significant traction, increases over time that merit a higher valuation, whereas the rolling tranches toward a seed is more related to, can you raise the capital? If you’re raising the capital, as opposed to acquiring traction and progress with the business itself, then you’re trying to get more capital in.

Leo: Absolutely, yeah, I think that’s a great way to think about it. If your valuation is going up because you’re hitting milestones, then like everyone is very happy with that, and people realize that before you had 10 risks, and you were at 5 million, and now you eliminated 2 of those risks, and now you’re raising at 8 million. That makes a lot of sense.
I think what’s harder for investors is if you’re raising at 5 million and then now you’re investing [00:24:00] at 8 million, and your reason is because it’s a week later. I think that can also sometimes be hard for professional VCs, because they at some point have to report to their limited partners, and they have to explain, “This other fund got in last week at 5, and we got in at 8. The only reason we got in at 8 is because we came late, but the company’s not actually further along.” I know a lot of funds have kind of passed, just because they want to avoid that issue.

Nick: There are some common rights that investors ask for during a seed financing. You mentioned pro rata, board seats, and most favored nations. Can you take a minute to describe what MFN is, and why it’s so important for early-stage investors?

Leo: Sure, I think that’s actually probably most important for angels, although it’s great for everyone. MFN basically says that if another investor gets in at better terms in this round, you get upgraded to those terms if you have an MFN clause. That’s really nice for angels, because I think sometimes you can have this fear that, “Maybe I’m going to put in 25K at a 5 million dollar valuation, and then some VC fund comes in, they have lots of bargaining power. They put in a lot of money at like a 3 or 4 million dollar valuation, and I invested at 5, and that kind of sucks.”
The MFN clause basically protects you from that, so that if somebody does get better terms, like if that VC invests at a 4 cap, your investment automatically gets upgraded to that.

Nick: Got it. Will you put a time consideration, as well as an amount consideration, on that MFN clause so that you can say over … If you raise over the next, let’s say 6 months, anything between these 2 values, then you do inherit the best terms? Because clearly, your MFN clause cannot sustain [00:26:00] perpetually, as the start-up proceeds through subsequent series.

Leo: Yeah, so to be honest, one of my partners handles most of the legal docs, so I’m less familiar with the specific docs. I think usually there is a time limit. It’s usually limited to like the current round, and if there’s kind of a next financing event triggered, the MFN does not apply to that.

Nick: When you guys are doing your diligence, let’s say you’ve found a start-up, you like the team, you like the market, you like the idea, when you’re going through the diligence phase, are you taking a step back and applying this strategic algorithm as you’ve weighed it out, to make sure that the fundraise amount is actually appropriate for the 18-month runway, and the valuation makes sense based on directional progress and things of this nature?

Leo: Yeah, absolutely. I think this is a framework, and so it’s kind of like if you don’t know where to start, I think this is a good place to start. These aren’t hard and fast rules, so there are exceptions. A lot of times, you do see exceptions, but then I think this framework is good because it helps us really think about, if this company should be at 8 million and they’re raising at 12, what makes them exceptional enough that we think 12 is justified?
I think we tend to look at it from that perspective of, we have kind of an anchor for, “Here’s what we think this start-up should be raising at.” If they’re within like 5 or 10 percent, it doesn’t matter. If they’re like 40 percent away, or they’re twice where we think they should be, that’s when we start really digging in and trying to understand, is there something exceptional that makes them worth twice as much? Is it kind of, the start-up market’s hot, and they’re able to raise it at twice the fair valuation, and that’s what they’re doing?
In those cases, [00:28:00] if it’s more the market being hot, we’ll usually pass because we want to get it in at a fair price.

Nick: Speaking of the market being hot, there’s been kind of a lot of chatter about, “Are we in a bubble? Are we in a boom? What’s the nature of the market, escalating valuations, lots of private market activity in the late stages?” Do you have any thoughts on the stage of venture on the whole, and if we’re in a bubble or a boom or something else?

Leo: I don’t have strong opinions on this, but I would say that I think there’s definitely some over-pricing in places. I don’t think it’s bubble territory, where we’ll hit 80 percent corrections or something, in the near future. I mostly look at things in seed stage and Series A, especially seed stage. Excuse me … I think the main challenge I’ve seen, especially in Silicon Valley, is there are a lot of employees … Early employees from companies like Facebook, Twitter, in my case LinkedIn, where they got to cash out a little bit from being early, and then now they’re looking for things to do.
They start angel investing because it’s a really fun activity. A lot of times it ends up driving prices up a little bit. I’ve met with a lot of companies, for example, where I think they should be raising at 6. They’re raising at 9. When I ask them, “Why are you raising at 9? This feels like it should be worth 6.” They basically use angel interest as a proxy for explaining why 9 is a fair price.
I think a lot of times, the people that are investing as angels, their motivation’s not just money, so they tend to be a little price-insensitive. You get this slight creep from somebody who, instead of raising at 5, is raising at 7, or instead of raising at 7, they’re raising at 10. I think that’s not bubble territory. It’s not like they should be raising at 2, and they’re raising at 10. [00:30:00] I definitely think that there’s kind of a bit of a premium paid in a lot of companies these days.

Nick: Do you use a combination of comps and valuations calculated based on traction and pedigree and things of these nature, or do you kind of focus on one valuation methodology over another?

Leo: I think a lot of this is kind of internalized. My partners and I, we probably kind of look at about 100 companies per month, at least recently, and probably dig into, I don’t know, like 30 or 40 of those. At any given moment, it’s pretty easy to just think about the last month or two and say, “We saw these 60 companies pretty deeply, and based on how those are priced, this one should be priced at this amount, and they differ greatly from that. Let’s figure out why.”
I think we’re kind of using this algorithm, but it’s kind of … It’s more implicit than explicit, because we’re … The algorithm is based on the comps we’ve seen. Because of the comps or whatever, we can just think about the comps, too.

Nick: Leo, what are you currently most focused on?

Leo: You mean in terms of how I spend my time?

Nick: Typically, I let guests take this wherever they want to go, so it could be … It could have to do with Susa, it could have to do with start-ups you’re looking at, your writing; take it wherever you’d like to go.

Leo: I spend about half of my time looking at new companies, doing research on companies we’re diligencing right now. I spend about a third of my time working with existing portfolio companies. I think for me that’s … I think that’s probably the most fun piece, because I really like digging in with founders when I have a chance, and when I feel like I can actually be helpful.
I spend the rest of my time doing a lot of random things, like thinking about what’s going on in the industry, writing blog posts. We’re starting to think about when we should raise fund 2 with Susa, so the rest of my time kind of goes into those buckets.

Nick: If we could talk … If we could cover any topic in venture, what do you think should be addressed, and who would you like to hear speak about it?

Leo: I think one thing that’s really interesting is that, as an investor, I get a really good cross-section of what founders are doing, like what they’re doing in the [00:50:00] fundraising side, what they’re doing in the company-building side. I have very little transparency on what other investors do.
I don’t know, even with the investors I’m friends with, I don’t always know what kind of diligence questions do they ask, or what do they do after they invest in a company? I would actually kind of be interested in having almost like a panel of founders talk about … For the founders that have had 10 or 20 or 50 investors over time, what kind of behaviors they like and dislike, what kind of help they value and don’t value.
I think that’s the kind of thing that works. It’s worked for them, where I get a great cross-section of founders that I can observe, of great investors, and for them it’s the opposite. They know founders. They probably don’t see those founders we do. They don’t know too much about the fundraising strategy, but they see a lot about what investors do. I think it would be really great to see investors from a founder’s perspective, because I think that would help everyone become better investors on the investing side.

Nick: We certainly hear from a lot of folks, on a weekly basis, about getting more insights into the process and the approach of other investors, so you’re not alone in that, Leo. What is the best way for listeners to connect with you?

Leo: I have a blog. It’s CodingVC.com. There’s a bunch of … My e-mail address is linked there. It’s Leo at SusaVentures dot com, and it’s got links to my LinkedIn and Twitter and all of that. That’s probably the best place to go.

Nick: Leo, I’ve been a huge fan of your writing for quite some time over at CodingVC, and especially your recent value of data series. Everyone in the audience, I would encourage you to go check it out at CodingVC.com, and Leo, thanks so much for the time today. I really appreciate your insights.

Leo: Thanks a lot, Nick. I really enjoyed chatting with you.