Please find below key excerpts from one of the most fantastic essay we read by a renowned VC in India by Sajith Pai, Blume ventures.
“Early stage valuations aren’t really valuations. They are the exhaust fumes of a negotiation about two things – the amount raised and the amount of dilution.”
We see countless stories highlighting unicorn valuations for loss-making startups; often in these stories, startup valuations are contrasted with those of old economy companies. This is clear evidence that journalists too see the valuations of early stage startups through the lens of the public market.
The ‘valuations’ are inexplicable given startups are loss-making, and particularly so when profitable listed companies in the domain trade at much lower valuations. Startup valuations seemingly live in the corners of the valuation room that the DCF Roomba cannot reach.
Let us also presume that this is the first time that the startup is raising, and that the VC is a seed fund (typically the earliest institutional investor; and the first to invest ‘other people’s money’, unlike angels who invest their own).
Presume that the startup meets all of the VC’s criteria for being fundable (e.g., MVP ready, early customer validation / pilots underway etc.) and is deemed investment-worthy by the VC. Presume also that the startup hasn’t been able to convince any other VC to invest.
How does the seed VC value the startup? Well, the answer is simple. The startup’s value is the funding amount divided by the equity stake that the startup is diluting. Hence if the startup is raising $1m = ₹7.5crs from the VC, and diluting 20% stake, then the value of the startup becomes $5m, or $1 divided by 20%. (In ₹ terms ₹37.5crs = ₹7.5crs divided by 20%)
That is it. Valuation at this stage (and even for the next 4-5 years and 3-4 funding rounds) is a simple arithmetical calculation.
Valuation, is a derived outcome of the funding amount and target stake. Valuation is never directly targeted or sought after. Rather, the eventual valuation / the share price emerges once the VC and the founder agree on funding quantum and desired stake.
Each VC fund has a sweet spot for its typical preferred cheque size, and its stake target.
For example Blume ventures has a $1-1.5m preferred cheque size, and a 15-20% stake target. We have determined over the previous years of investing, that $1-1.5m is sufficient to cover 15-18 months of burn (revenue less expenses) in the companies we fund, and within this period, they will be able to raise the next round (from a different Series A VC).
A 15-20% stake is what we target because we know that a promising startup’s future fundraises will gradually dilute our stake size. Starting with a 20% stake gives us the ability to hold about 8-10% at the time of an exit of $2b or so, a valuation at which we hope the fund winner (there is typically always one in every fund portfolio; if you are lucky, then two) will exit.
Earlier we determined $500-750k was the amount needed to get the startup to a Series A. Now it is twice that – this is a function of certainly increased competition (demand) at the VC’s end. Supply has risen but not as much as the demand has. Then of course there is the rising cost of customer acquisition as well as the cost of tech talent.
Every fund determines a sweet spot for themselves with respect to primary cheque & stake they want to buy. For example as blume venture has discovered the below
1. Preferred primary cheque of $1-1.5m (primary because this is the first cheque; there will be some money kept for 2-3 follow on rounds as well; this is the reserve)
2. Stake target of 15-20%.
Integral to arriving at the above sweet spot is the split between the primary and reserve.
The higher the reserve, the lesser the amount you are left with for primary cheques. A low amount allocated for primary cheques will impact either the number of primary cheques (i.e., portfolio size), or the cheque size itself. Write fewer cheques and you run the risk of backing a smaller portfolio which in turn reduces your odds of finding a hit. On the other hand, if the check size is too small, you run the risk of underfunding your startup, and reducing its probability of getting to the next stage (unless you fund them again to cover the gap, which reduces the available corpus).
Triangulating between reserve ratio, the number of primary cheques (and thus portfolio), the cheque size (including your future follow on round allocations) – underlies these sweet spot estimates. Over time every VC fund finds its sweet spots, reflecting its investment approach, which in turn determines staffing (the more the number of primary cheques, the more investment leads or Partners you need) as well as its deal flow creation + evaluation system.
The above explained concept of funding sufficient amount that leads a start up to reach next stage of funding is called as Multiparty Staging. Over time, VCs have specialized the formula for the stage in which they play in. The chart below outlines this:
Let us say the earlier start up is now nearing an annualized revenue of $500k (Annualized revenue of $500k-1m is a kind of norm for Series A fundraises). At this stage, let us say the seed VC introduces the startup to a bunch of potential Series A investors, and one of them decides to back this company.
Like with the Seed VC, the Series A VC, too, has its sweet spot – for the Indian market it is $5-10m and a minimum dilution of 15%, though preferably 20%. This effectively sets the ‘valuation’ range from $25m ($5m divided by 20%) to $66.7m ($10m divided by 15%). Let us say in this specific case it is $7m and a dilution of 17.5%, and thus we arrive at the resultant ‘valuation’ of $40m.
Eventually as the startup grows, and as its revenue gets predictable, later stage investors begin to use standard valuation techniques such as DCF, public market comparables with desired adjustments or revenue multiples etc., to ensure that the valuations aren’t too out of whack. Eventually as the startup gets closer to listing, the valuations converge with those of similar listed entities.
This gives us a sense of how startup valuations are determined. They are essentially derived values (from stake and funding amount), resulting from multiparty staging games conducted over 5-7-10 years, until the startup becomes akin to a listed entity.
Concept of valuation and value is notional at the early stage of a startup. Yes, you are a founder holding 20% stake in a Series-B funded co valued at $150m. Yes, you have paper wealth of $30m (20% of $150m), but if you want to exit the company at this stage, and sell your shares to retire, then the value of the company will plummet, and this will prompt the VCs to mark your holdings down to book value (which will be a pittance).
In the venture / startup world where you play long-term multiparty staging games, there is no anonymity. Founders know other Founders, Angles know VC and VC knows PE.
A VC never intentionally pushes down the pricing during his round just so that he can get higher returns when he exits. Let us look at what this signals, and if so what these signals imply for the VC’s brand in the reputation market.
Founders in general will talk about the VC to other founders who approach them as “Hey that VC is no good, they squeeze you hard and are not generous. Stay away.” This cuts off deal flow.
The founder of the company whom the VC has given lower prices to, will also tell founders who approach them, “Hey, look what they did to me. Stay away.”
Series A VCs who are in the next stage will say – “Hey, the last deal these guys brought to me, man, they pushed up the premoney on the deal, and I didn’t get as high a bump up when the Series B guy came in. Hey, I don’t want to work with these folks given what they do. And guess what, this early stage founder who approached me, I told them to stay away from them because they underprice and undervalue deals.”
Hell, if the VC fund is smart they will actually overpay for deals. That signals supreme founder friendliness, and will help them attract more deals. Which is exactly what a commentator is suggesting below (from the comments to Prof Damodaran’s article).
Founder friendliness, and signalling founder-friendliness is key to ensuring access to the best deals. For the highest quality deal flow typically comes from referrals made by founders.
The best VCs play infinite games with other VCs and founders. The best VCs also understand that every action they undertake as part of staging (issuing a termsheet, tranching an investment, playing or not playing prorata) is sending a signal to other VCs and founders (their own as well as the wider founder community).
Access to the mega winners is the single most critical leverage point in venture capital. For once a VC fund gets a few hits going, a virtuous circle is formed. More high quality founders reach out to the VC, on the back of the hits, and growing reputation. This is an ingredient for better returns, which in turn opens the door to even better founders and so on. This is how the VC flywheel spins.
Karthik Reddy, Managing Partner at my fund Blume Ventures, describes“these valuations are ‘entry valuations’ – assigned on paper bolstered by carefully-orchestrated liquidation preferences rather than a measure of real worth in terms of actual cash.” Liquidation preferences are first dibs on exit outcomes, such as say a M&A. They favour later investors (last in first out). So effectively, valuations need to seen / read with liquidation preferences. It is no fun if you are a founder sitting on paper cash of $30m, and all your VCs liquidation preferences cancel out your potential exit opportunity.
Historically, venture ended at Series B or so, after which the startup went for an IPO. Typically it took 3-4 years for startups to go from seed to IPO (Amazon, Google all took similar time frames for their IPOs) but in the last decade or so, timelines have stretched to 8-12 years. A whole new category of late growth investors has emerged including many hedge funds to meet the funding needs of startups,
As we reach later stage fundraising, the more likely that the startup can be valued like their public market counterparts. There are sufficient metrics by now, and reasonable predictability of revenue. At this stage, with the arrival of late growth investors and hedge funds, you begin to see DCF and / or public market comparables or revenue multiples approaches emerge to benchmark valuations. That said, traditional supply vs demand for stock still remains the primary way to set valuations even at this stage.