thoughts 💭

Valuation, Valuation, Valuation

2016-08-18

On Monday night I was fortunate to attend an excellent Innovation Bay dinner. Unexpectedly, the most common topic of conversation: valuation. Angels wanted to talk valuations I was seeing in the market, bankers and corporate types wanted to explore my valuation background with EY and how it is translating in startup land, and founders were obsessed with “multi’s”, “pres” and “x on x’s”.


Valuation is certainly an important topic. It is frustratingly opaque. Not only because there is scant comparable public market information. It is opaque because fundamentally, most startups are game-changers and unlike any other business in the market. Why should I peg my valuation for a revolutionary business that is defining alternate use cases and building new markets to an existing player with the only similarity being they share a sector? More frequently, however, valuation is opaque because it protects investor’s blushes. Transparency is not the friend of an under-performing fund manager.
Why does valuation matter? Valuations for pre-revenue companies serve as signalling tools more than anything. Does it matter if EVP invests at $3M or $5M. Kind of, but not really — we can make money either way. What is more important: are they a maniacal product girl/guy with an unfair sector advantage? Can they talk to the blue-sky, game-changing vision and treat this capital raise as a nuisance just getting in the way? At such an early stage, valuation is a signal, nothing more, nothing less. It speaks to the focus, judgement and vision of the founding team. Whether we bet on a founder with all of these qualities in spades is an extremely good predictor of our fund’s overall success. Whether we invested at 3 or 5 is not.


If you’re raising your first external capital, you should be pricing the round at a valuation where the best investors in Australia want in and are willing to contribute, not at the maximum price where you can find investors to participate. The best investors are the ones with deal flow on tap. They aren’t going to pay 2x a fair number for a deal when there are 7 more outside the meeting room offering superior risk/return trade offs.
This is becoming particularly important in an Australian VC market that has added over $1 billion in capital already this calendar year. Even from when I joined EVP, average pre-revenue business valuations have gone from $2M to $3M. I appreciate that our new fund may have helped change the quality of our dealflow, but the trend even before announcing in August was clear.


Founders need to ask what the VC did for their startups lately. When was the last time they spent the day in their portfolio company’s office? Do they carry business cards with “commercial director” on behalf of their startup companies? What was the last connection they gave to a founder that actually resulted in a new hire, a new commercial sales channel or dev talent? Is the fund they represent their primary business or is it just something they do amongst a range of business interests?


As John Henderson of AirTree says:


“I think it’s critical that you do reverse due diligence on your investors to ensure that they have a good reputation, that they’ve delivered on their promises in the past and added value to other companies. Sadly, a really bad investor can poison your company.”


Another important point: this is not the US. We have different market dynamics, challenges and opportunities and we have differing valuations. Don’t expect your series A to be valued at US rates.


In the last couple of months I have spent time with a number of pre-product/market fit businesses that have valuation expectations that are an order of magnitude above a fair and reasonable range. Below I’ve tried to present my own view on early stage valuations. These aren’t absolute. As you can see the market changes rapidly. It’s a cliche we used to roll out in my former corporate life when our valuations didn’t stack up or if they were poking and prodding holes in our methodologies, but still, it’s true: valuation is more art than science.


Pre-product


You are a consultant at McKinsey with the best deck in Sydney. Your idea is rock solid and you have 350 sign ups on your live launchpad you mocked up last weekend. Maybe you’ve wireframed the lot, or maybe you work for Credit Suisse and you have the world’s best financial model showing EBITDA of $56 million in 2021.
Valuation: $0M (you’re a consultant and this is your first startup) — $2M (you were the founder of Pocketbook and this is your next big thing)


Size of Round: $200k to $500k


You should only be raising if this is your second or third startup. If this is your first, then don’t worry about raising, spend your banking bonus on derisking the deal and proving your ability to execute.


Pre-revenue


Congrats you have a product. This is no small feat. It probably took 2 or 3 of you 6 months to build out version 1.0. Maybe you gave the product away for nothing. You have 1,500 free users and 20% of them are logging on daily. You have 100% mom growth (but your first user was two months ago). This is cool. But it’s not a business… yet.


Valuation: $2M — $4M


Size of Round: $500k to $1M


Early revenue generating


It’s amazing to compare the product today to 6 months ago. Your 2 dev guns have covered the walls mapping out their future sprints. Customers are paying and they’re actually sticking around. You worked out it’s easier to sell to a business and you have your first commercial partnership accounting for 20% of leads. Your Angel investor got you a meeting with the founder of Deputy who taught you about LTV:CAC and the magic number. Product/market fit is looming on the horizon.


Valuation: Ask someone smarter! Or read: Fred Wilson, Mark Suster, Roger Ehrenberg


Size of Round: $1M to $5M