For regular businesses, there’s an old adage that you can compete on price or you can compete on features. We apply this exact same rule to startup investments.
We see founders as our customers. All else being equal, they want the best price, which in this case means the highest valuation. However, our expected returns are inversely proportional to valuation. So we offer them a distinctive product instead:
–Speed. Most investors take a long time to make a decision, at least relative to how fast pre-seed startups move. Some pre-seed startups are close enough to product-market fit that they could double or triple revenues within six months if they had $150 – $250K. But raising any money at all from most angels and small firms can often take six months. So if we can cut them checks in just a few weeks, it absolutely makes sense for them to take our money at a lower valuation.
–Transparency. Most investors don’t have a systematic series of steps or firm timeframe to close. The uncertainty in progress and timing is particularly costly to the fastest growing startups. They have to devote more attention to shepherding investors and can’t plan near term growth initiatives effectively. Our ability to explain exactly what will happen during our diligence process and when it will happen is the most valuable to those startups on the highest growth path.
–Niceness. We make a real effort to be nice to founders. We’re responsive. We’re respectful. We’re up front. Of course, other investors are nice too. But not all of them. And when combined with speed and transparency, niceness enhances the overall package.
The key to capitalizing on these features is making valuation the first substantive topic we discuss. Our initial goal is to get enough information about their traction to provide an estimate of the valuation range where we’ll end up if we say yes. Often, we can generate this estimate from their web form submission, first email, or 5 minutes into a conversation. It rarely takes more than two or three question and answer cycles.
By putting valuation first, we create the opportunity to make the case for why our product is worth it. We can also quickly triage potential deals that will likely stall on price–creating more time to spend on those that won’t.
In practice, our valuation-first approach results in attractively priced deals via three common paths.
–Up front discount. We explain our approach, the founders agree that it’s a good tradeoff, and we close the amount they were looking for, just at a lower price.
–Adjusted fundraising strategy. Sometimes, founders are looking for both a larger round and a higher valuation than our guidelines. In a subset of these cases, once hearing about the way we work, the founders realize they can reconfigure their strategy to raise a quick, small, lower-priced round from us immediately and then a slower, larger, higher-priced round in the near future. The progress enabled by our capital both increases the probability that their next round will close and its expected valuation. The blended valuation can often end up higher than their initial asking valuation.
–Come back discount. Founders sometimes have other, small investors who are not price sensitive and are in fact offering a higher valuation immediately. In this case, we wish them well, but leave the door open. While somewhat rare, these founders do occasionally come back to us a month or so later, usually with even more traction. In these cases, our investment gets them to their next key milestone, which gets them a substantially higher valuation from next stage investors. So our speed, transparency, and niceness still make us an attractive option even at the lower valuation.
We’re constantly working to refine our system to deliver more speed and transparency (it’s hard to be any nicer than we already are). So our offering becomes more and more distinctive. This continuous improvement explains why our typical valuations have remained relatively flat while the rest of the industry has experienced substantial valuation inflation.
For more information please contact Jeff Pomeranz at (415) 637-7064 or jeff@rightsidecapital.com.
