Why Silicon Valley Breeds a Better Investor

November 21, 2013 Rami Essaid

Silicon Valley sign

It’s not uncommon for entrepreneurs to say that investors outside of  Silicon Valley undervalue companies and don’t seal enough deals. Some even say that it’s forced them to move to the Valley. Of course, investors outside the Valley have their own complaint: they don’t see enough quality companies, ergo, less investment. So who’s right?

In my experience, there is a little validity to both points. The end result means that companies will get better valuations on average in the valley, and will be more successful at raising their round there as well. If moving isn’t an option, you can however influence your outcome by guiding other investors to think in the same way as their Silicon Valley counterparts.

First, we need to look and see how venture capitalists look at an investment. There are two parts to a potential deal: opportunity and risk. Every VC has a ratio of opportunity to risk they’re comfortable with. Higher opportunity and lower risk attracts more VC’s and seals more deals. I didn’t include valuation. Know why? Valuation is a subset of risk, it is not it’s own category.

How Do VC’s Assess Investments?

In order to quantify an opportunity, VC’s look at the size of the market, the ancillary markets the company could enter, and what potential acquirers might pay out in a sale. A large market isn’t always better; if it’s crowded, this limits opportunity size. Even the most innovative company can’t reach 100% market saturation, and more competition means having to share a slice of pie with everyone. You may be able to snag a bigger piece than your neighbor, but in the end, it’s still less pie than you might get in a smaller market with less competition. That’s the easier half of the investment.

Understanding risk is a little more complicated. First there is technology risk. How well does the technology currently work? Is it easy to replicate? Are there hidden pitfalls the team hasn’t identified? Can the team overcome these problems? Are they even solving the right problem?

There is also executional risk. A founding team with some experience should have some idea of what not to do. Investors feel more secure with teams that have a strong pedigree, whether that’s education or previous employment. These backgrounds increase the team’s ability to solve problems, something that’s necessary to decrease risk.

Finally there is valuation, or the cost risk of investing in a company.

As an investor is evaluating a company, they look at how risky the overall investment is and compare that to the potential reward. Not sure what kind of risk you’re offering? One way to de-risk an investment is to look at traction. This makes the math simple. If the potential investment is growing rapidly, the company is obviously doing something right and VC’s don’t have to think very hard. The investment is far less risky. Without traction to de-risk the investment, lowering the valuation is another lever investors can use to balance out the math.

Well, this is nice and all, but you may think I still haven’t answered the question. Why do Silicon Valley investors give higher valuations and ask for less traction? Actually, everything I’ve mentioned is the answer. It’s not that VC’s outside of the valley are greed-mongering or overly risk-adverse. It’s simply a fundamental difference in how Silicon Valley investors understand and manage risk.

What Makes Silicon Valley Investors Different?

Silicon Valley investors better understand technology and the market place, which lets them de-risk the technology and understand the potential for a larger opportunity. Think about it. If you can get a deep technical understanding of the problem and the solution you are about to invest in, that in itself improves the risk profile of the investment. Better understanding of the market and the potential ancillary uses of the technology will help you see the real opportunity size and a stronger reward. This perspective is what gives Silicon Valley investors the ability to overlook traction and give higher valuations.

So, what gives Silicon Valley investors this heightened perspective? They see more deal flow. The more history you have with successful venture backed companies, the better you learn to vet new entrepreneurs. More deal flow also means an investor can specialize in a specific sector, market, or technology. Smaller deal flow forces an investor to be a generalist. This leads to less understanding of the technology, hurting risk assessment.

Its important to note – above I said that Silicon Valley isn’t more tolerant to risk but that is only partly true. It is not that SV investors accept more risk because they live in the valley, however, they tend to accept more risk because they have larger funds.  This trend is not a byproduct of location, but simply need for bigger outcomes to pay back the fund. If you have a billion dollars to invest, you want to at least get back 1.5 billion in returns and you definitely aren’t going to do it with base hits. You have to get a few home runs so larger funds look to swing for the fences every time. And in Silicon Valley, there tend to be more larger funds.

This all explains why Silicon Valley investors can offer higher valuations while asking for less traction.

What Can I Do?

Move to San Francisco, obviously. Just kidding. That’s not the only answer. You need to understand that the main reason you are getting lower valuations outside of Silicon Valley is because of everything I’ve mentioned above. This means if you can better educate the generalist VC on your business you can help him de-risk the investment in ways he cant do on his own. Help her understand how you’ve managed to solve the technology risks and show how him how big the potential market opportunity is.

First, show them comparables. Don’t assume they know how big your market potential is. They don’t. And don’t be lazy and show them one slide with high-level numbers. Make sure to have multiple pieces of validation you can bring to the table. Too many entrepreneurs use a bottom up approach to market size -they look at how many potential customers they have out there, multiply that by how much they can charge and voila! They’re a billion dollar company!

Yeah right.

In the real world, there’s competition. This also assumes that no one will do it in-house. Not every potential customer is a customer, and it’s foolish to assume that. That’s not to say there isn’t some value in doing these calculations, but you’ll also need to come to the table with the actual numbers of the market. If there’s no data available for your niche, find something similar and pull Gartner or Forester data to show that market size and explain why the numbers are comparable.

Just as important; show them how much money they’ll make from the opportunity. Don’t just assume that you’re  going to go all the way. VC’s, especially VC’s outside of the Valley, know that your chances of survival are slim. Your chances of hitting a home run are even smaller. So show them that you’ve thought of all the options. What does M&A look like for your vertical? Explain to them why different companies out there might buy you. You’ll need to show them specific, strategic reasons. Do you think Cisco might buy you out? Research what companies Cisco bought in the last two years, how much they paid for them, and why your company is just as attractive. VC’s want details, and it’s easy to get data on a company’s acquisitions. Don’t expect investors to do the research for you.

This is what investors want to know: How much revenue was the company making before they were bought out? How much were they bought out for? How long were they incorporated before the sale? Most importantly, why were they bought out? Why will you get bought out, too?

The trickiest part is dumbing down your technology to the point that a Generalist can understand it. It’s tough because you don’t want to sound stupid yourself, or even worse, give the impression that your technology is easy to replicate. You need to be able to explain to the Generalist VC why your technology is the hot, new product the market needs. They need to know why it’s the best thing since sliced bread. A Generalist VC isn’t going to figure this out for him/herself. You need to be the only one who can provide this technology; and they need to know why.

Figuring out how to do this is an art, and it will take some time to learn so make sure to improve from every opportunity.  Every time an investor says no, figure out why. Don’t ask why though, because then you’re just going to get a generic response. Remember, VC’s have to give out a lot of no’s and they after all are people too. Rejecting that many people gets difficult so they create a set of generic responses to not hurt anyone’s feelings. Ask pointed questions about each of the things above to dive down on how well you did in helping them understand your company.

What Does This All Mean?

Moving to the Valley doesn’t have to be the answer to all your problems. It’s true that you might be able to find more investors there. At the same time, you might find yourself running into the same problems if you don’t know how to position your company. Honing the skills necessary to attract investors is just as important in San Francisco as it is in other markets.

No matter where the VC is, they’re looking at opportunity/risk ratios. Don’t make it the job of the VC to evaluate the risks and opportunities. Preempt the questions they may have and you look both educated and more attractive. 

About the Author

Rami Essaid

Rami Essaid is the CEO and Co-founder of Distil Networks, the first easy and accurate way to identify and police malicious website traffic, blocking 99.9% of bad bots without impacting legitimate users. With over 12 years in telecommunications, network security, and cloud infrastructure management, Rami continues to advise enterprise companies around the world, helping them embrace the cloud to improve their scalability and reliability while maintaining a high level of security.

Follow on Twitter More Content by Rami Essaid
Previous Article
Mathematical Ghosts of the 20th Century
Mathematical Ghosts of the 20th Century

This blog post sketches out two major influences on American mathematical education: (1) an early 20th cent...

Next Article
Using Redis and Websockets to Monitor our Data Centers in Real Time
Using Redis and Websockets to Monitor our Data Centers in Real Time

Distil Networks wanted to build a dashboard to monitor their data centers worldwide as close to real time a...