Scott Lenet
I’m frequently asked by journalists whether I think venture capital valuations are too high in the current environment.
Because the average venture capital fund returns only 1.3x committed capital over the course of a decade, according to the last reported data from Cambridge Associates, and 1.5x, according to PitchBook, I believe the answer is a resounding “yes.”
So when entrepreneurs use unicorn aspirations to pump private company valuations, how can investors plan for a decent return?
At the growth stage, we can easily apply traditional financial metrics to venture capital valuations. By definition, everything is fairly predictable, so price-to-revenue and industry multiples make for easy math.
But at the seed and early stages, when forecasting is nearly impossible, what tools can investors apply to make pricing objective, disciplined and fair for both sides?
For starters, venture capitalists need to stop engaging in self-delusion about why a valuation that is too high might be OK. Here are three common lies we tell ourselves as investors to rationalize a potentially undisciplined valuation decision.
Lie 1 : The devil made me do it
If a big-name VC thinks the price is OK, it must be a good deal, right?
Wrong.
While the lead investor who set the price may be experienced, there are many reasons why the price she set may not be justified. The lead may be an “inside” investor already, committing small amounts or — believe it or not — simply not care.
Insiders are investors who have previously placed capital in the startup. They face a conflict of interest because they are rooting for the success of the startup and generally want the company’s stock price to keep growing to show momentum.
This is one of the reasons why many venture capitalists prefer not to lead subsequent rounds: Pricing decisions can no longer be objective because investors are effectively on both sides of the table at the same time.
Inside-led rounds happen all the time for good reasons — including making a funding process fast so that management can focus on building the business — but because these decisions are not at arm’s length, they cannot be trusted as an objective indicator of market value. Only a test of the open market or an independent third-party valuation can accomplish this goal.
It’s also the case that a relatively small investment can relax pricing discipline in some firms. If a funding amount represents 1% of the fund size or less, it’s possible that the VC team may view the investment as “putting a marker down” and not worry about whether the price offers an attractive multiple. For this reason, it’s a good idea to check the lead investor’s check size against the overall size of the firm’s latest fund.
There are other reasons why investors may not care about the valuation. Some VCs are “logo hunters” who just want to be able to say they were investors in a particular company. If you outsource valuation discipline to a lead investor who doesn’t value financial results, your own returns may suffer.
Lie 2: We are getting a deal because the price is flat from the last round
If the last round valuation was $50 million and the current round valuation is about the same, we tell ourselves it’s gotta be a good deal.
Again, this is faulty thinking, because the last round’s price might have been too high.
It can be demotivating to entrepreneurs to fund a new round at a lower or flat price per share, and that should indeed be a consideration when setting terms. But that doesn’t mean that a step up in price is justified by the company’s progress to date. It might be easier for inside investors to accept this line of reasoning than new investors, since they are already stuck with the investment.
But even inside investors should apply sunk cost fallacy logic to ensure that pricing inertia doesn’t result in “throwing good money after bad,” as the expression goes.
Lie 3: It’s OK because the startup is capital-intensive
The fundamental premise of venture capital is investing for minority stakes in high-growth, private companies. So no matter the size of the round, it’s supposed to leave enough ownership for entrepreneurs.
As venture capital legend Bill Draper taught me, the original idea in the 1960s was “VCs bring capital and expertise, entrepreneurs have the idea and operate the business. We are partners. So the ownership reflects the fact that we are partners.”
That means bigger funding amounts require bigger valuations. If I want $20 million to buy less than 50% of a startup, it means the minimum pre-money valuation has to be $20.1 million. In the current market, a $20 million funding round probably implies at least a $40 million pre-money valuation, so that the money buys 33% of the company at a $60 million post-money valuation.
If the company’s progress justified only a $10 million pre-money valuation, a $20 million funding round would buy more than 100% of the business. The math doesn’t work.
So the lie is that if a lot of capital is needed, the valuation has to be large to make it work. But unfortunately, the startup might not have earned a large round yet.
Per PitchBook, augmented reality startup Magic Leap raised giant amounts of capital: more than $2.6 billion over nine rounds, all prior to launching a product. These were growth-stage investment amounts and valuations for a company stuck at the seed stage. Magic Leap’s hardware business model and ambitious vision necessitated multibillion-dollar valuations, and hindsight shows this was a mistake. So the size of the round on its own doesn’t mean the pricing makes for a good deal.
So how can investors neutralize these sources of confusion to determine whether a startup valuation represents a potentially attractive deal?
- Truth 1: Do your own work. Don’t rely on anyone else to tell you that a valuation is fair or represents an attractive venture capital return profile. Build your own projections and model potential exits against reasonable industry-comparable IPOs and M&As.
- Truth 2 : The last round is over, so price the new round independently. While it’s true that nobody enjoys a “down round” with a lower price per share, that’s not really your problem as a new investor. If the last round was too expensive for the company’s progress to date, and you accept the price because a precedent was set, it could become your problem. Sometimes you have to go backward to go forward.
- Truth 3: It’s not your obligation to provide the startup with the amount of money they’ve requested. It’s possible that they don’t yet deserve the amount of capital desired because progress hasn’t been sufficient. This can be true even if the startup’s model is capital-intensive. In these situations, it’s an option to raise less money at a lower valuation, enforcing lean startup principles.
So is there ever a time when a valuation that seems too high can actually be a good decision? I believe the answer is “yes.”
It’s a good deal if the investors can make a target return over a reasonable period of time with a calculated probability of not losing your capital at risk. So the best justification for a price that’s too high today is that the risk-adjusted return (multiple and IRR) is reasonable, because the upside is there. This requires multiples and exit analyses that are tied to market prices for IPOs and M&A in the most similar companies you can find, matched against realistic estimates for potential revenue and margin growth.
I remember when KPCB and Sequoia seed-funded Google at $50 million post-money in the 1990s. I thought the investors had lost their minds, and I was clearly wrong, because Google has provided investors with phenomenal returns. Why? Because the upside was there. The investors validated the team, the technology and the market opportunity — and they were right.
Is it different for CVCs?
One of the most cringe-inducing critiques of corporate venture capitalists (CVCs) is that we don’t care about valuation or financial return. Corporate VCs should do everything in our power to avoid providing fuel for this fire. No entrepreneur or institutional VC wants to work with a CVC who isn’t aligned to the financial success of the startup — although they might look at you as “dumb money” if they are desperate for more cash and want to keep up appearances with a higher valuation.
But it turns out there’s something CVCs can do if the valuation is too high, but you still want to participate.
In such a case, if the startup and CVC believe there is a mutually beneficial commercial relationship that would make sense, the payment for such a relationship can take the form of performance warrants instead of cash.
Because 1.3x to 1.5x over a decade isn’t good enough to justify the risk and illiquidity of venture capital investing, it’s important for investors to be honest with ourselves about whether private company valuations are appropriate to set up attractive venture returns.
Perform a quality of earnings analysis to make the most of M&A
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