8. Valuation, Part 1 (Jeffrey Carter)

Nick: Today we have Jeffrey Carter. He is co-founder of Hyde Park Angels and is raising a Midwest venture fund called West Loop Ventures. He also has a blog over at pointsandfigures.com. Jeff, thanks so much and welcome to the show.

Jeff: Thank, Nick, for having me on.

N: So let’s start out with a little background here. Can you walk us through how you got into the venture space?

J: Yeah. I was a trader on the floor of the Mercantile Exchange; I was one of the guys there that changed it from a not-for-profit to a for-profit back in the 90s; we had some huge political battles. We weren’t spending a lot on tech; we turned it from an open outcry exchange to the electronic exchange that you see today. There were about 10 of us, roughly, maybe 15, that really pulled the levers for that to happen. And when you were in the pits, you always saw a lot of deal flow, right? So I’d always see stuff come through, and none of it was good. The check was always 50 or 100 grand, or 150. You never knew the terms, really—where were you getting stock, what were you doing? There was no way to analyze it. So after CME, the Internet bubble burst, and then I was doing my MBA at Chicago and Vishal Verma said to me, “Hey, we should have an angel group and focus on Chicago,” and I said, “What the hell’s an angel group?” And he explained what they did in California and how they got started, and I said, “That is a frickin’ great idea,” and so we did it. We started it up and I really enjoy it for a lot of different reasons. One is that you can talk about making a difference in your community. I’ve invested personally in about 18 or 19 different start-ups, which creates jobs when they’re successful. When they fail, they fail, but it adds the dynamics and diversity to the Chicago ecosystem. Hyde Park has done 30 deals; I’m sure we’ll do more. But personally I get a lot out of it because I like work with people—trading, pit trading, was a people business; it wasn’t all about the money. I think people don’t realize how much of a people business it was. There are a lot of similarities between what it takes to be a god pit trader and what it takes to be a good angel—a venture capitalist. So, I really like that; I like working with small start-ups; I like solving problems for them, creating connections for them, and creating opportunities for them. It’s fun. It’s fun even when they fail—it’s painful when they fail, because every start-up that you invest in, you think could be a billion-dollar start-up. You think that it’s got a great idea, and it’s got great people working for it, so you hate to see it die. But they do die, and what I learned from the pits was that you had to have risk tolerance and measure risk-reward and know about that inherently, and it’s a gut call at the end of the day when you write that check to a start-up. A lot of people want to systemize it. They want to figure out all these data, data, data, and it make it difficult for them to pull the trigger. And also, they have a fear of failure. Midwesterners generally have a fear of failure; they look at it as this black mark. And we’ve said this over and over and over again, but really, I think it’s true—you talk to people and they say, “Oh, no, I don’t want to do that!” They’re willing to—what I call lever up a buggy whip factory by going to an existing business and doing a private equity deal, and load it up with a lot of debt and trying to smooth out operations that way. It’s a totally different mentality than VC. Henry Ford never would’ve gotten anything done—well, actually, how many people told him no? They went and they levered up the buggy whip factory.

N: So the first deal was done in what year?

J: 2007 was our first deal. It was a deal called Shuffle Tech—one of our founders became a CEO; it looked like a good deal; it was the card craze—it didn’t work out. My first deal was Tallgrass Beef, which is Bill Kurtis’s company. It’s the only deal I ever did on the floor of the Mercantile Exchange; he raised the initial seed capital in the [inaudible] hog pits, in porkbelly pigs there. Harvey Paffenroth got me in that deal, and so that was my personal first deal, in 2005.

N: Unbelievable, the way that people get into venture. It’s always a nice story. Okay, so today the topic is valuation. We’re going to jump right in. So, Jeff, why is valuation and price-per-share a critical deal term for investors to be well informed about?

J: Well, it’s not only for investors; I think it’s for entrepreneurs, too. Everybody needs to know it. And I think sometimes, from both an investor perspective and an entrepreneur perspective, rather than thank about straight numbers and straight value, they need to think about strategy. And corporate finance is a strategy; it’s no different than marketing; it’s no different than operation; it’s no different than anything else, especially for a start-up. So if you’re a start-up, the data would tell you, 66,000 angel-funded companies in 2012—about $20 billion put to work. The median pre-money was 2.5 million; the median raise was 600,000, so the median post was 3.1, right? So that’s kind of a rough guideline—really rough.

N: Seed stage. Got it.

J: Seed stage. So what you need to understand is as you go through the corporate finance process of building your company, you need to build momentum every single round. So every round needs to be a little bit higher than the last. From the entrepreneur’s perspective, every single round, they give up between 15 and 20% of equity in their firms. So at the very beginning, when it’s two guys in a garage, they own 100%. At the end, when they close, they own about 15%. If you build a billion-dollar company, if you’re arguing at the beginning over $3 or $4 million, you’re throwing nickels around like manhole covers, because unless you get the money, you can’t build the company. From the investor’s perspective, if they value a company too highly and it doesn’t hit, the next round is a flat round or a down round, which makes it difficult for the investor to raise capital. So even if you have a company that could be a billion-dollar company, but it’s struggling—Airbnb is one that I could think of off the bat—it’s tougher to raise that next round of capital. So there was a company here in Chicago back when we started Hyde Park Angels that presented to us called LiquidTalk, and they were the hottest company around. They were way overvalued and didn’t hit their target, and the next time they needed to raise capital was a down round, and it scared investors away. So I like to have a heart-to-heart with the people I invest in and sit down and talk about corporate finance as a strategy—“Yeah, you think you’re worth X, but let’s sit won and see what you’re actually worth, and I want you to be worth what you’re worth at the end, not just the beginning.” I think that’s a distinction you have to make, and amart entrepreneurs understand it. If you interviewed people like Sean Carpenter from [inaudible] about people sitting on their wallets, he would give you a great perspective; I think that he understands finance from the entrepreneur’s perspective as well as anybody; I think Mark Halpen from [inaudible] does, so there are entrepreneurs here who can get it, and I think they need to talk to other entrepreneurs about what it means, and at the same time I think venture capitalists and angels need to be very transparent about what they’re willing to invest in and what price they’re willing to invest, and how. There are all these different ways—convertible notes, straight equity, convertible equity—there’s all kids of permutations. At the end of the day, you’re going to get the money in, you’re going to have a value, and you’re going to have to execute; that doesn’t change.

N: So you touched on a few key terms in there, and I want to drill into those. Let’s assume I’m an investor—I’ve been investing in the public stock markets as well as a number of other things—brand new to angel investing. You talked about up rounds and down rounds. Can you fill us in on what those are?

J: So in the stock market, you have a totally transparent market. You can see the price; you can see everything. And angel investing is not so; it’s not transparent at all. There are financial statements, but they’re projections; they’re worth about what the Excel spreadsheet is worth. So an up round is—let’s say you do it at a $3 million valuation, post-money. They raise, say half a million dollars. So your next round is, let’s say, 16 months from now. If that round is a $10 million round, and they raise $2 million at 10, give away 20%, so $12 million post, the value of your shares at the $3 million post has increased, but it hasn’t increased by 4x. There’s a little bit of dilution. So you have to do the math as you go forward, and it’s cut-and-dry, but it can get messy because there’s all these different things that happen. There’s, for example, if I’m a seed investor right now, people like to do convertible debt notes with a discount, which means I’m investing in a debt instrument that converts to equity on a Series A valuation at some specified discount with some specified interest rate on it, and then you figure in the interest rate and the discount to your stock price. And that’s the benefit you get for taking the risk as an early investor. You don’t really get that with the stock market. Now if you’re a new investor interested in angel investing—let’s say I’m a high net worth individual willing to commit 1 or 2% of my portfolio—you have to either go out and learn this stuff, and there’s plenty of books and resources to learn it—Fred Wilson’s blog; AVC had MBA Mondays that talks about it; Brad Feld has a whole blog series on it, and all kinds of information out there, so it’s easy to get at, but you have to be active; you can’t be passive. If you don’t want to be active and you’d rather be passive, you’re better off joining a syndicate or putting your money in a fund and giving up the fees, because those people are experts at it.

N: So you already talked about pre and post money. Just to illustrate a simple example, if a company is raising at a $5 million valuation and they’re raising $1 million, pre-money would be $5 million, and the post-money would be $6 million.

J: So the company’s worth $6 million, and that’s where you carry it on your books. So between fundraising rounds, limited partners at venture capital funds kind of want to know how everybody’s doing. And the only was to do that is financing rounds. Even if you’ve got a big blowout, like Facebook or Uber, and it was at $6 million and it’s going to be at $100 million, you can only value it at $6 million. But you can tell your LPs, “Hey, here’s how everyone is doing.” As far as the mark on your books, it’s a $6 million mark.

N: Jeff, what does the phrase “fully diluted” mean? How does it relate to valuation and the employee option pool?

J: So, fully diluted means all the shares of stock, and it includes the option pool. It includes all the discounts; it includes everything. It’s no different than fully diluted earnings per share; same principle.

N: And regarding warrants, warrants are sometimes built into deals. Let’s start off with, what are warrants, and why are the sometimes referred to as stock options?

J: Because they are an option. There’s a specified strike price on the warrant, and when it gets exercised, it gets exercised at that price. And that is dilutive to the cap table, but it’s a way to incentivize certain behavior.

N: Can you walk us through an example of how a warrant would play out?

J: I invested in a company—I’m not going to name it— and we invested in the first round at a valuation. We were given options that expired 12 months from the date of the first investment to invest in the original valuation, but half as much. So if you put $10 in at Point A, at Point B you could invest $5. So that was an example that was dilutive to the cap table, but the entrepreneur wanted it because it saved them a lot of time in getting money. So I got extra juice. It encouraged me to put more money in earlier if I really wanted to take a chance on the company because I knew that I could put more money in later if it was successful. I think warrants are great for employee contracts, and you use them in different situations. So, to get strategics in, you give them some warrants. It’s a way to incentivize employees to work harder. Warrants are really no different than options.

N: Would a founder use warrants to, let’s say, maintain a higher valuation during the negotiation of terms, or are they using them to have the opportunity to get more money at a later time?

J: That’s a good question, and I don’t know the answer to it. I’ve never been confronted with that. I see the use—I believe in option pools for employees, because I think employees that are equity-driven work harder for the company than just based on a salary. I think that founders need to use options and warrants to attract the best employees, number one, because finding talent is really hard, and to incentivize them to propel the company forward. Usually they’re priced out of the money. There’s all this stuff in the news where they’re kind of giving corporate executives a free ride, but in the venture world, they’re always forward-looking. If I get options at $5 million, they don’t invest until a certain valuation and a certain time period. If the company doesn’t hit that valuation, they’re worthless, so I get a little risk, too.

N: What are some of the main factors that ay impact valuation?

J: Well, the biggest thing is probably market size, which is why every entrepreneur says in their pitch that they have a billion-dollar opportunity. How they’re disrupting the environment is another one. So if it’s iterative—and I’m not picking on Quicken, but Quicken was iterative. It wasn’t groundbreaking. It took paper books and put them onto a floppy disk so you could have them on a computer. The company grew really fast and had a huge valuation; it was the 80s, you know? It was a different time. Today, you need companies that are really groundbreaking in some way to get that huge valuation. You need companies that create a new market or companies that get rid of middlemen, and one of the things I think is so great about the Internet is it gets rid of middlemen and brokers that don’t add a lot of value, and it puts customers closer to companies. If you look at companies like Uber, originally it was just allowing people to get in a black car, and allowing a huge mass of people to get it. But if you read about where it could go, it’s disruptive to society and the way we live. Could it be worth $200 billion? Sure. The guys on CNBC this morning said that’s nuts; they think it’s not worth $16 billion. But those guys are accountants; they’re not venture capitalists. The company I’m invested in, NextSpace, is just co-working. But if you think about NextSpace and where it could go, it’s highly disruptive to the way we work; it’s highly disruptive to education. It’s highly disruptive to lots of different things in society, and if they’re successful at executing, they could be multi-billion dollar company. Another factor is whether you’ve done it before and how successful it’s been. So there’s a great company here in Chicago; they’re just starting out; they’ve been going for about 18 months, and it’s called JuvodHR.com. And what they are right now is performance reviews for small and medium-sized businesses. You can get it up and running in 10 minutes, and it’s a really cool company. Well, since the team have both run companies before, you give them higher marks, because they’ve been through the wars. If Jack Dorsey came to me and said, “Hey, I’ve got an idea for a company,” he’s going to get a higher valuation than somebody that’s never done it before. I think if you are an older entrepreneur with a network in the area that you’re developing, you get a higher mark than somebody who just comes in off the street with the same idea. But that being said, I don’t think the mark is going to be significantly higher—it just feels like the risk is a little less, and since the risk is a little less, you’re going to give them a higher valuation. If you look at start-ups in the Midwest, the average pre-money is between $3 and $5 million, and it’s up slightly, but it’s not significantly higher. We don’t have as much competition here, and we have other things that don’t happen here. We don’t have acqui-hire here like they do on the coasts, so that changes valuation here. And there’s also not as much money here, so valuations are smaller. The advent of online fundraising and crowdfunding have helped the entrepreneur a little in that they’re getting a little bump up in valuation that they probably wouldn’t get before, so when I first started Hyde Parke Angels we probably saw $2 to $4 million, and now we’re $3 to $5 million.

N: So when we think about a lot of the factors that are impacting valuation, some of them come off as qualitative, like what stage you’re at or how much competition for capital there is or the venture capitalist’s appetite, or the angel group’s appetite for funding and whether they have a ceiling. What are some of the quantitative factors, and can you give us an example of how an investor may calculate or determine a valuation?

J: I’ll try, because at the end of the day, there’s a feel. You’re going to look at other comparables, because odds are, you’re not the only deal in town. At an early seed stage, you bet on the company, but you also bet on the people. So let’s say there are 2 companies I’m not invested in in the same space. At the end of the day, I’m going to look at the idea and I’m going to look at the team, and I’m just going to pick one, because they’re in the same space and I can’t know their valuation or anything—I’m not invested. So you have to look at risk-reward especially. That’s a hard one, though. It’s a lot of looking at data and history and then trying to project it forward into the unknown. There was a blog post about angel investing, and the guy talked about how he invested in ad:tech, and he calculated with this company that there was a 10% chance that the government would change regulations and put them out of business. Now, he came up with 10%, but someone else might have calculated something different. That’s the thing about venture, is that 2 different firms can look at the same thing and come up with totally different analysis and totally different valuations. It’s very random that way. It’s not like private equity, where you can do a 10-year cash flow and discount it back by some rate and play with it to come up with some inherent value. It’s a lot of conjecture and projection, and at the end you have to trust your gut.

N: So whether it be with your venture fund or your angel group—Hyde Park—you get an entrepreneur in with a great idea and a fantastic team and a track record. Let’s say the valuation’s higher than what you would expect. How do you approach the negotiation process?

J: I would say just be honest with them; I think transparency is important. I was a trader, and my word was my bond; even if it was a loser I’d own up to it. There are certain things in the negotiation process that you don’t hide. I remember talking to one entrepreneur, and he came in and said, “My company’s $6 million,” and we started talking and built a relationship. As he started talking to other people, the valuation came down to a range I was comfortable with. I think as a VC or an angel, the valuation discussion is indicative of how the relationship will be going forward. It lets you see how everybody reacts under stress, because they’re going to be under stress. And it tells you how they’re going to react when you give them adverse information, and that’s going to happen. When you’re sitting on a board, everything’s not always hunky dory, so you learn a lot about the entrepreneur in that valuation process, like how coachable they are. I’ve had people come to me and say, “This is worth $23 million,” or some crazy valuation, and I just think, “You know what? I’m just not interested.” I’ve had some where you’re talking and it’s a great idea and everything’s going great, but you just can’t come to terms. You have to be prepared to walk away. You shouldn’t make a bad deal; it should be a win-win negotiation for you and the entrepreneur. Jason Heltzer, who was from OCA said a really interesting thing about convertible debt: If it’s a convertible debt with a 20% discount and a $5 million cap, let’s say, aren’t I as the investor pulling for you to fuck up so I can get a lower valuation? I mean, sort of. It’s a really interesting point, and he’s right. It’s better to do a straight Series A and value the company than it is to do a convertible debt.

N: Interesting. If they do really well, then you’re leaving money on the table, and if they do poorly then you’re getting a better valuation at their next raise. You know, sometimes the folks that approach you with a $20 million at the C stage—you just have to think, how thorough of a founder are you if you can’t even read a few blog posts and realize that your valuation is an order of magnitude?

J: Yeah, there’s a greater fool theory in real estate, and it works in venture too. I had one guy talk to me once, and I said, “It sounds really interesting; what’s the value?” And he said, “$23 million.” I said,” Really, what did you do your last round at?” ad he said, “$50 million,” and I said, “Well, how do those investors feel?” It’s a great discussion, because valuation ends up encompassing a lot of things. You can talk about markets, strategy, and all kinds of things.

N: So if you do love the idea, you love the team, and there’s a huge market, will you pay a premium?

J: Yeah, I think you will. Especially if there’s competition. Valuation also depends on the stage. So if it’s seed stage and it’s just an idea, you’re not going to get a big valuation; it’s probably smart not even to raise money. If you have some customers, you’re going to talk to the investor and try to discern where this can really go. You’re not going to be able to predict it, but you can at least give yourself a good feel within one vertical. When Twitter started, it was a 140-character microblog. Basically, they unbundled Facebook. Who knew that Twitter could throw a dictator out of office and be a communication device for terrorists and do what it does, right? You never know where these things are going to go. Brad Feld had a post the other day on who can pick a billion-dollar company because that’s all the rage right now in start-up circles, who can pick them, and you really can’t. There’s no way to say, “This is going to be a billion-dollar company. It comes down to the people and the stones they uncover and the markets they unearth.

N: So we’ve kind of talked around this, but what would be the adverse impact for a founder of raising at too high a valuation?

J: So the problem is—and I hate to use this analogy, but when you hit the beach, it’s like D-Day. All hell breaks loose and nothing goes as planned. That burns through your capital. That’s why people tell you to raise 18 months of capital, because it’ll probably be burned through in 12 to 14 months. You can’t build up your business if you’re out raising capital. If you raise it too high, you’re going to have to hit a different set of milestones and the next round will have to be higher. If I go lower, my investors are more likely to be patient and re-invest and help me through really nailing down my product-market fit. A company that I’m invested in, for example, we invested in in 2007-08. It’s a touchscreen company, and nobody knew what their product was. They had such revolutionary technology from the outset that they would go talk to customers, and customers would say, “I don’t even know what to do with this.” It wasn’t until the iPhone and tablets came out with touchscreens that people understood what they were all about. Now they’re getting huge traction—if you walk into McDonald’s, the touchscreens on the smoothie machines are their product. But we were able to invest a few rounds in them before they had VCs. Had they come out at too high a valuation, I’m not sure they would’ve raised the next round of capital, and they would’ve died. That’s the risk you run.

N: Yeah, there’s a company in town that has great traction and growth, but they raised their last round at $8 million, and he can’t raise at double that now. So he can’t raise the money, and he doesn’t want to do a down round.

J: Right, and maybe people won’t even give him a flat round. And if I’m an investor at $8 million and now it’s at $6 million, I know the history and I’m not likely to whip out my checkbook. And there are guys who specialize in finding companies like that and grabbing a shitload of equity—maybe now it’s at $4 million, and an investor says, “Sure, I’ll write a check for $4 million,” but they take a lot of equity. So then the founders don’t own as much as they would have, and the investor makes all the money. The way I see it is that it’s a partnership where they buy a few desert islands in the Bahamas and they can build a few mansions, and I just want to have a comfortable lifestyle out of it. I see it as a partnership, not a tug-of-war or an adversarial relationship.