Not an unreasonable amount, and consistent with the VC's need to put a lot of money into each deal. “Five million dollars at what valuation?”
“Twenty-five million.”
“Good luck.” I shook my head. Lenny was deluding himself. He was looking for a large valuation so he could raise his financing by selling the smallest percentage of the company possible, thus maximizing his ownership. The Valley calls that minimizing “dilution.”
“Fifty million in sales the second year will make that a bargain. And I can quote comps.”
“Lenny, you have an idea, a cofounder, and a business plan. Nothing earthshaking or inherently valuable like an exclusive market or a key patent. No track record. You need to reset your expectations.”
I had to explain. Valuation is all about risk and reward. Sure, $50 million is a sizable business, but what are the chances for failure or delay? And how much money would he ultimately need to be successful? Future dilution would have to be figured in the mix. The lead VC is more likely to want around 40 percent of the deal for his money at this stage.
If Lenny were to raise $5 million, 40 percent would mean that the post-money valuation, the value of the company plus the new money, would be more like $12.5 million. Subtract the investment, and you have a $7.5 million pre-money valuation, the implied value of the business. Nowhere near the $25 million Lenny was suggesting.
Everybody here brags about valuation, but Silicon Valley really operates on momentum. Many times I caution a company not to take the largest valuation they can in a financing, because it sets the wrong expectations and probably attracts the wrong investors. Peg the round at the highest reasonable price necessary to raise the desired amount from the right investors. The right investors bring credibility, experience, and networks. They support you with enthusiasm in later rounds. They raise your valuation merely by their presence in the deal.
The right amount to raise is a range with a minimum, but seldom a relevant maximum. In a fiery market like ours, raise enough for a year's burn rate, or net loss, assuming the worst. Then add on enough for another six months, and take anything reasonably offered above that. I have never seen a company fail for having too much money. Dilution is nominal, but running out of money is terminal. Set reasonable expectations among your investors, don't gouge them, and then out-perform expectations. Future rounds will be much easier if you are seen as having positive momentum.
If you are fixated on dilution, you can take less cash and focus maniacally on meeting critical milestones in order to raise your valuation before soliciting more investment and experiencing further dilution. But beware that you risk under-performing or, even worse, falling prey to changes in market attitudes or conditions that may make future rounds more expensive or even impossible to raise. If you hit a snag, your precious momentum goes out the window. The current euphoric markets make it advisable to take all the money you can while the bloom is on the rose.
Lenny took more notes. Two friends of mine noisily entered the Konditorei, deep in argument. Tom insisted that eBay was a buy at $150 per share. Steve was incredulous, as always, muttering about the tulip craze in seventeenth-century Amsterdam. Their debate revived itself daily without ever producing an apparent winner. Tom had made millions investing in Internet startups in the past few years. Steve had probably scraped by on a balanced diet of blue chips and mutual funds, but he insisted he'd get the last laugh. They grabbed their takeout orders and waved as they left, aware that the door to my office was, for the time being, closed.
“Lenny,” I said, “you mentioned your exit strategy, selling out or doing an IPO in three years or so.”
“More likely a sale.” His explanation held little surprise, since the way to create a retailing business on the Web has become fairly straightforward. Raise money. Build a site, where you offer attractive, fun, and informative content, as well as a wide choice of steeply discounted products. Focus entirely on growing sales and your customer list at a phenomenal rate. Expand your product lines. Grow even faster. Go public. Profits and margins be damned. According to Lenny's logic, an established e-tailer suffering from negative margins might eventually be interested in acquiring niche lines of high-ticket, higher-margin products like his funeral gear. Most likely, he said, he would sell Funerals.com in two or three years to one of the larger Web retailers.
Personally I could not fathom Amazon selling caskets, but that wasn't important now. There was a bigger issue here.
“That's an exit strategy for your investors. Is it one for you too?”
“For me too?” He seemed confused by the question. After all, wasn't he an investor?
“Is that your personal exit strategy? Are you planning to get out?”
“Yes. Of course.”
“If you raise money and do this,” I asked, “but it doesn't work quite like you planned, and you don't get the gold, or silver, or even brass ring, will you think it was a waste of your time?”
“It would be a disappointment,” he said. He didn't say he would consider it a total failure, but that was the message in his voice and on his face when he spoke.
I thought about that for a second. Lenny was clearly mystified by my questions. “All right,” I said. “I think I have a better sense now of what you have in mind. I'll talk to Frank.”
“What will you tell him? Are you onboard?”
Am I onboard? That was the question. The market is huge and rather unusual. Lenny's plan demonstrated that he knew his beans about the business of dying. Iffy, but who knows? Funerals.com might be a big success.
“I'll tell Frank it's probably worth going to the next step and doing some due diligence,” I said. “He'll raise many of the same questions I did about your people and your ability to build some sustainable advantage. You'll have to see where that leads.”
“That's great!” Lenny leapt up from the table, hopefully. “So you basically like it?”
“I think Frank should go the next step.”
“Then you'll work with us?”
With a “yes” and a handshake, I could show Lenny a faint ray of light, after weeks and months of gloom.
“I don't think so, Lenny.”
His jaw dropped a fraction, and disappointment washed over his face.
Chapter Three
THE
VIRTUAL
CEO
SOME PEOPLE CALL ME AN ANGEL. In the world of startups, angels invest in seed or early-stage deals, and with their money they lend a bit of advice. They pay for the privilege of helping the company. But I'm no angel.
This was a point of confusion for Lenny. He'd assumed I was just some kind of newfangled Silicon Valley investor.
“But your VC analysis suggests that Funerals.com is worth a closer look,” he protested when I declined his invitation. “That's what you're telling Frank. Why wouldn't you do the same?”
“I don't necessarily look at things the way a VC does,” I said, seeing that my comments were tripping him up. I've worked in Silicon Valley since the early ‘80s. I understand how it functions and thinks, but I don't necessarily see things the same way.
“If you're not interested in helping us, Frank won't be,” Lenny said unhappily.
“Did he say that?” I asked. It sometimes happened. A VC, concerned about the lack of experience among a group of founders, might ask them to involve a little gray hair (or, in my case, a shaved head) with some startup management credentials.
“Not in so many words, but I thought if you invested …”
Sometimes I do put money into companies, but generally not in the startups I work with. If I invest, I am prone to think like an investor, favoring my return over what's best for the team and often its long-term business.