Hey investors, it shouldn’t be how low can you go but how big can you get

There are many criticisms levied at the Australian early-stage investment landscape, and valuation is one of the key areas requiring careful reflection.

Far too many investors, particularly within angel investment networks, undertake their default investment behaviour of ‘value investing’ when presented with an early-stage investment opportunity.

There is too much value investing in Australia and it is hurting startups, the investors trying to back them and the whole ecosystem.

Value investing is the practice of trying to determine the value of a share of a company and doing everything possible to pay a price less than or equal to that number.

It’s the act of trying to get a good deal by negotiating to get the holding cheaper than the entrepreneur’s asking price.

It might sound logical but it’s probably the worst possible way to approach early-stage investing for both the entrepreneur and the investor. Very few successful businesses will survive this stunting effect so early in their life.

In startups, there’s no real market for the securities and no way to fairly price them. Value investing doesn’t make sense as there is no such thing as a fair market price that you can beat.

Founders and startups should engage investors in a discussion on their equity dynamics that answers these questions:

• How much money does the startup need to successfully achieve its next milestone to step-change the valuation?

• How much equity does the investor need the founders to retain to maximise the company’s chances of success?

The answers to these questions might ultimately mean the investor pays more but will definitely mean a better outcome for everyone involved in the longer term.

If the company does not have enough capital to make it to its next milestone, the percentage the investor owns is largely academic because it will be diluted, most likely through a down round which will be expensive.

If the founders do not have enough equity to remain interested and throw all of their blood, sweat and tears into the venture, the amount of equity the investor holds is also academic, as it will definitely fail.

Founders will typically need to raise more money across more capital rounds than they anticipate. So if they have been squeezed on equity percentages in early rounds, based on a traditional valuation approach, their share will be so heavily diluted after what could be three or four rounds before they launch that again – failure is almost certain.

As these themes illustrate, the dominant investment thesis today is binary investing.  Binary investing assumes that anything you are looking to back is potentially big enough that it’s academic how much you own because if it succeeds you will make a huge return on equity or if it fails your holding is worthless.

One of the more difficult challenges for investors is to commit to only backing companies that have the potential to be significant.

If investors stick to this, the valuation of a target company has nothing to do with its present position because in the future it’s going to be much more significant than it is today.

The percentages held in an early-stage company should be organised to maximise the chances of the venture’s success.

The remainder of an investor’s concerns can be managed with effective investment terms that provide for downside management through liquidation preference and equity ratchets.

The key terms early-stage investors should be looking for are:

Liquidation preference – in what order do the various parties in the venture get capital returned in the event of a sale or wind-up?

Down-round protection – who takes the risk if a future valuation is lower than the current valuation?

Founder departure – what happens if/when one or all of the founders leave?

Equity incentives – how should the equity percentages change based on founder performance or future valuation?

Valuation bridges – how can you defer valuation discussions until there is more clarity? Could convertible notes that provide a time and risk discount be offered on an investment made now without knowing a future round’s valuation?

There is not a one-size fits all approach to designing effective investment instruments for early-stage companies.

We need bolder and more sophisticated thinking that understands the true risk in startups is usually not valuation, but sustained world-class execution and resilience.

For both founders and investors pre-investment valuations should reflect the amount of equity the founders need to survive and thrive, not reflect how best to immediately generate huge returns for early-stage investors.

Phillip Kingston is the founder of venture capital and investment firm Trimantium Capital, and a technology entrepreneur and investor. You can follow him on Twitter here.