Over the last year, I’ve observed a recurring pattern:
- A pre-revenue (or low-revenue) start-up pitches an exciting new product or service. The start-up asks for a seed investment, with a budget showing that the new capital will provide approximately 18 months of runway. Projections show the start-up achieving target metrics for revenue, active users, customers, or the like within a year. After those milestones are reached, the start-up plans to raise additional financing at a significantly higher valuation.
- The team is impressive, the market seems substantial, and due diligence indicates that potential customers are eager to work with the start-up. Investors invest.
- 15 months later, the start-up is back. Everything is going great — but the software development scheduled slipped and the pilot customer loves the product but can’t make a decision on a purchase because of a management transition. The company’s success is inevitable. It just needs more time — and, therefore, more capital. Would the initial investors please provide a “bridge” investment?
My question is always “A bridge to where, exactly?”
As a Sand Hill Angels member, I sometimes have the privilege of being the Director of a portfolio company, and, as such, get to work closely with the CEO. I recently spoke with a CEO who was struggling to communicate effectively with the company’s investors.
We started by talking about the appropriate items to include in a monthly investor update, using Jason Calacanis‘ blog post on the topic as a guideline. Using a suitable template is a good step, but I also wanted the CEO to have a good mental framework for thinking about investors. Communication is not just about what is said but also about why it is said.
Over a decade ago, I had a conversation with Dick Hardt, who was at the time the Founder & CEO of ActiveState. He told me that (to paraphrase) “Investors are just a different kind of customer.” I didn’t understand what he meant at the time, but Dick’s insight is profound, and one that every CEO should understand.
Every year, Sand Hill Angels invests in number of start-ups. We know how much money we’ve invested (several million dollars a year) and what we’ve received in return (securities of various types). But, we have not, until now, tried to determine what those shares are worth.
One approach is to declare the problem vacuous. Our portfolio consists mostly of companies whose shares will be illiquid for a long time to come. So, whether the shares are (in some theoretical sense) worth one dollar or one million dollars, there is no way to exchange the shares for dollars. And companies that look great often fall apart, companies triumph after appearing all-but-dead, and markets shift quickly.
But, I believe it is important to value these companies precisely because they are so illiquid. Valuation, even if far-from-perfect, provides useful feedback to investors about their portfolios.
So, how can we value a portfolio of illiquid start-ups?