I talk with many other founders and investors about the challenges of venture capital. Some in obtaining, other in deploying, and others about what to do once it’s gone.
The biggest mistakes that founders make is in trying to set a price – or valuation – for their great idea.
Something that I’ve come across, both through observing and by being confided in, is the early mistakes founders frequently make in relation to their first investors.
This is often called the Family, Friends and Round. There is also a derogatory version of that, but I choose to refrain from even stating it.
If you get this wrong, the smiling faces around the family BBQ could quickly become a source of family conflict.
There’s absolutely nothing wrong with wanting your nearest and dearest to share in your impending good fortune. In your exuberance to highlight that you are changing the world, it’s natural to want to invite those you love to the party.
Get this wrong and there’s going to be more than a few challenges at your next few Christmas dinners.
Early-stage investors aren’t fools
First-time founders often have little basis, understanding or experience for the parameters of what constitutes the outline of a good funding strategy.
It’s not uncommon for them to consult a lawyer or accountant, which is good.
Commonly, they use some mystical valuation technique they saw at a pitching event (bad), Googled it (very bad), or just winged it (so bad they wouldn’t even qualify as an amateur).
The difficulty with these methods is that almost all don’t incorporate the specifics of:
- Developing a fundraising strategy which must be cohesive at each stage.
- Recognising the external factors of the market that you are in, including the ecosystem, volume, pricing, availability of capital.
- Knowing the internal factors of the venture, such as (e.g. size, speed, process, milestones achieved, experience, competition etc).
Get this first step wrong and you can almost kiss away any chance of getting professional money in at the next stage. So why shoot yourself in the foot?
Houses aren’t always the same
Let’s say I own a 3 bedroom home in Sioux Falls, Iowa, which I want to put on the market. And let’s say that, because my last similar house in Melbourne, Australia was sold for $740,000, makes me believe that I can sell the US house for the same price.
Except I can’t – the market in Sioux Falls is only prepared to pay $140,000.
So, no matter what I think a thing is worth, it’s the market that I am in that determines its real worth at any given time. Definitely not a market that I’m not in.
Now imagine that I have a rich aunt Sharon in Australia, who likes me and decides to buy half my home, as part of her retirement nest egg. Did I mention that she was a bit doddery?
We strike up a bargain for her to buy half the equity in the property for $370,000, which she thinks is fair. I did, however, neglect to highlight that she didn’t get advice?.
What’s going to happen to her retirement nest egg in a few years when she wants to cash in her chips and go spinning off on a cruise around the world? She’ll have done her dough. And who is she going to look to make good on her lost assets?
That’s right – me!
And because she’s family, there’s no walking away from this.
Why didn’t I invite her in at a fair price? Or, alternatively, invite her in just a little later in the cycle while I set about building the value through an extensive renovation or subdivision?
Not that I thought that I was necessarily being greedy – though that may have been the case.
It’s a safe bet that it was because I was uninformed, uneducated, or worse, I took advice from people who had never themselves been down this path, were in my audience, or had my level of understanding.
And the same is true of ‘valuing’ – I use that term loosely – your idea for a venture, based on the perceptions. Or worse, an anecdote of value that I read was available in some other place in the world.
Like Silicon Valley. The prices there might be five or 10 times what is available in my local market, but the competition is also 50 times as fierce too.
A better way to value your venture
Rather than set myself up for failure by setting the price too high too early , it’s better to build the value with early traction. Then invite your family, friends and fans to join in at an appropriate early round.
If you’re not sure why the first strategy is a really, really bad thing, search Google for down-round.
Because the last thing you should want to do is seek investment from family before you have:
- Real validation that your offering is valuable.
- A real handle on what price is fair for the sage that you are at.
10 key questions to ask yourself first
- Is there a local accelerator accessible to you?
- How about grants, prizes & competitions?
- Have you built an advisory board? (coupled with them investing)
- Is there an opportunity for product pre-sales?
- Or crowd funded equity investment?
- How about corporate seed funding?
- Are you able to sell longer term contracts, or generate additional sales in side products?
- Can you delay quitting your day job?
- Might you consult part time to fund your venture the rest of the time?
- Or even funding it yourself from accrued savings?
What I’ve listed above is a series of alternatives – or, in fact, multiple waypoints – in the funding pipeline or funding stack.
By using the market as a way of setting the right price – and multiple activities and growth to help set value growth – you avoid the risks of setting your initial valuation too high. This diminishes the risk of over or under-valuating your venture.
Why having skin in the game matters
This is one of the very early questions – often asked in different ways – you’ll get from almost all early-stage investors: How much skin in the game do you have?
So let me ask: How much actual money – not foregone salary or opportunity cost – have you and your other founders actually put into the venture yourself before asking others to tip in?
After all, it might be considered by some to be a bit rich asking others to risk their capital if you haven’t risked your own.
I always ask this question – and it’s one you should be prepared for: How can I invest in you if you won’t invest in yourself?