How should founders value an investment firm?

I recently discussed fundraising with a founder who is thriving in Europe and planning a US launch. His approach to evaluating potential investors was thoughtful and methodical. After the chat, I started contemplating thoughts on the topic that I wanted to share.

The Philosophy

Investing is a matching game. Investors buy shares in exchange for future returns. In that trade, founders use the precious currency of future equity to purchase what investors bring. Investors apply intrinsic and relative valuation methods that are widely understood. Founders lack a similar framework. This leads to market inefficiencies, lost productivity, and lost return as many legitimate companies remain unfunded. I don’t have a framework, but below are some considerations for founders to address this value asymmetry.

It’s Not All About the Numbers

How does one choose a life partner? The process for establishing long-term romantic relationships is a good blueprint for founder-investor partnerships. Running a deliberate process of mutual evaluation that balances reason and intuition is crucial to arrive at that bespoke fitting. Numbers alone won't suffice—just watch Along Came Polly. A balanced consideration of emotional, strategic, and tactical alignment is key.
What do you truly value? Focusing solely on valuation metrics overlooks other crucial forms of ownership such as peace of mind from a longer runway, governance, strategic autonomy, pursuit of mission objectives, and cultural fit. These factors can prove vital down the line.
The numbers lie: Reporting bias in early-stage venture can lead to misplaced valuation expectations. Early-stage valuation data is unreliable. Most of it is self-reported, creating a distribution that excludes bad outcomes on the left tail. Additionally, the data doesn’t account for sticker price adjustments such as high liquidation preferences and extreme antidilution provisions. Founders should work out economic arrangements that suit them based on the uniqueness of their business, their preferred partner, and their shared goals.

Understanding Risk

Investing is about understanding and pricing risk in expectation of commensurate reward. Founders should mirror the key risks that investors assess:
Market: Investors evaluate market size, growth potential, and dynamics of product adoption. In return, founders should assess an investor's presence and competence in their markets. This includes portfolio size and AUM, track record, network, including their syndicate – who else invests with them.
Team: Investors assess team capability and cohesion. Founders should examine VC team members’ backgrounds, how the team came together, internal responsibilities and power dynamics, and how the VC will support their organization. Learning about the primary contact, her influence in the firm, capabilities, and bandwidth is crucial.
Product: Investors assess product-market fit and review how a company approaches the development and scalability of its products. Founders should understand VCs’ underwriting policy, reserve policy, and strategy for technical assistance. For VCs, product also means a firm’s vision and values. What do they stand for and how do they prove it? What communities do they belong to? I wrote an article on this a few months ago
Liquidity: Investors evaluate a company’s economic model, cash burn, pricing, and exit landscape. Founders should understand how investors value new investments, their return model and its hurdle rates, policy for follow-on investments, holding period, and where the fund is in its investment cycle.
Culture: Culture is the catchall for what VCs call fit. It encompasses language, personality, and place. For example, language differences can impact communication of risk—American entrepreneurs’ use of hyperbole might appear overly optimistic. And, meanwhile, frustrated by language barriers resulting from direct translation, a friend once expressed reservation with African entrepreneurs’ ability to articulate risk. Place matters because of differences in wealth levels, macroeconomic policies, and cultural environments of countries where companies operate.  

A Mandate to Boost the Global Return on Capital
 
Improved matching of capital and labor in a rapidly evolving entrepreneurship landscape will improve efficiency and drive higher societal returns. This is pertinent because:
Big problems to solve: There is a critical need for innovative capital to fund innovative startups confronting today’s difficult societal challenges.
More capital chasing return: There is a large supply—funds and dollars— chasing fewer great companies. The traditional investor-driven model will struggle to generate alpha.
It’s easier to start: Lower startup costs, growing accessibility of knowledge and remote work enable globally distributed teams, fostering innovation in the format of new ventures. Many compelling new startups don’t fit the traditional venture mold.

I would love to connect with people who are spending time on this topic.