How To Evaluate Early-Stage Web 2.0 Companies
Shortly after leaving Google, I ventured into the world of angel investing in 2007. It was a bright new world. The stock market hadn’t crashed yet. The real estate market was just showing signs of weakness. Nobody panicked yet. I remembered my early days of evaluating startups. I joined a few local angel investor organizations here in Seattle. I was particularly impressed with the Keiretsu Forum and made that my home base in learning and connecting with fellow investors.
I learned a lot. I learned how to read term sheets. I learned how startups were structured and what funding vehicles were used. I learned all the things you can do to legally protect your interest. But I did not learn to properly evaluate Web 2.0 startup companies. That only came with experience, after I joined ZoeCity, a Seattle startup as its CEO in November of 2007.
The one thing good of learning from other fellow investors is that you gain insights from them in areas you are weak in. The finance guys in my investor group would give us an interesting take of the financial projections. The attorneys would evaluate the IP. The engineers (myself including) would evaluate the technology. And collectively we’d make a better decision than if any one of us came in individually to evaluate the opportunity.
The bad thing however, is that you also gain biases from the other investors. Particularly, folks who came from other backgrounds. Evaluating a hardware company is inherently very different from a software company. A traditional enterprise software company is very different from a Web 2.0 company. And forget about bio-tech or clean-tech because those are completely different beasts altogether. At the end of the day, subtle nuances of each industry requires an experience player from that industry to provide the necessary insight.
When I first started, I studied business plans. In a typical fund raising process, you start with a simple executive summary. If you like it then you view the presentation. And if you still like the company, you study its business plan. This seemed practical and logical. But for Web 2.0 companies, I’ve learned that it is for the most part, a fairly futile exercise.
Web 2.0 startups are mainly market risk companies. You’re not building a cure for cancer. Your success is not dependent on the successful invention of your product. It is dependent on the acceptance of a market, if there is a market. Facebook did not succeed because it could connect you to your friends online. It succeeded because you and all your friends decided to use it as your primary connecting point.
Hence in a Web 2.0 startup, 18 – 36 month market projections are a waste of time, an exercise in science fiction, of picking numbers to justify a future $10M valuation. The market take-rate? Unknown. The month-over-month growth rate? Unknown. The retention rate? Unknown. Pricing strategy? Unknown. Everything is an assumption. Comps rarely work because most Web 2.0 startups are building products where a market does not yet exist. Hence market validation is the first thing a Web 2.0 startup should work on.
Should a Web 2.0 startup fund raise for 18 months’ burn rate? Why not 12 or 24 or 36? What a startup does need is to anticipate how many iterations it will require to get market validation on its product’s value proposition. If you’re burning $20K/month and you need to iterate 3 times to prove your product and each iteration roughly takes 3 months then all you need is:
$20K x 3 months x 3 iterations = 9 months @ $180K
Now this is obviously very simplistic. It doesn’t take into account the buffer time required for you to do the next round of fund raising. But it does give you a good idea about the only thing you need in your business plan; What are your market assumptions and how do you validate them? Once you get them then re-evaluate the value proposition. If there’s light at the end of the tunnel, then another round of funding is required to take you to that level. And you’ll have enough decent market data to back your assumptions for a more realistic 18 – 36 month growth projection.
Investors, be absolutely prepared for change. The company may totally change its target market and its product many times. Assumptions are created and validated or invalidated. Product feedback and market feedback enables a startup to go from one premise to another to another. PayPal started as transaction encryption technology for PalmPilots. Google started as search service outsourcing company. This is another reason why very detailed 30 page business plans are more of a distraction for startup entrepreneurs. If you can’t whiteboard your first 9 months of existence your plan is way too complicated.
Which takes us to the next question; What is an early-stage Web 2.0 startup’s valuation? Forget about DCF (Discounted Cash Flow), TAM (Total Available Market) or SAM (Served Available Market). If its a market you are about to create, how can you project? Monthly uniques? Some folks start with this. At the end of the day, it really is just a random number. But it has to be one that’s big enough to ensure the founders have enough incentive to work for free or dirt cheap. But not so high the investors will feel ripped off. Your guess is as good as mine. Each situation will be unique in its context.
Just be fair.
Colin Wong is the CEO of Zoecity, a social media company. Properties include zoecity.com, sharein.com, and tr.my.
