From the VC’s corner (17): It’s all about the risk (when negotiating an early-stage company’s valuation)
By: Ciprian Ghetau
Tags: Early Stage Startup, Risk, Startup, Leverage, Valuation

When talking about early-stage startup valuation, some journalists characterize them as either cheap or rich; have also noticed some founders putting price tags on their just-born startups. To grow, most need outside capital, and the great ones raise it from VCs in exchange for an equity stake in the business. This process creates post-money and pre-money valuations. On the flip side, many/most bootstrap, and this is great as well as long as they cover their costs and there’s a demand for whatever they do; also gives founders the liberty to do it their own way, with no “pressure” for constant double-digit growing, reporting KPIs, having weekly meetings or so with the investors and potential further disagreements down the line in terms of strategy and rest.

What does the pre-money valuation for a seed-stage business mean? Assuming there is an outstanding team of founders, and they’ve all cooked a nice product/service, assessed the product-market fit and talked to the prospective clients, how can this business be worth a few millions, let’s say, when they don’t have the necessary capital to make their vision real?

Being a private valuation for an early-stage company, it’s not about future cash flows, obviously; neither is about comparables, nor about the assets value. And to be frank, it might be the case that company might not even be worth its venture-backed valuation. It’s all about the investor’s perception of the underlying risk of the investment. The rule is clear, the greater the risk, the lower the VC’s valuation; and the VC thinks at desired rates of return.

”It would then follow that investors seeking greater rates of return would only be willing to invest in businesses at lower valuations that have the same overall risk profile of similar businesses pricing at higher levels,” concludes Todd Breeden of Tuhaye Venture Partners in a post you can here.

Browsing a few regional funds’ performance and portfolios, one would easy note that those targeting high IRRs typically can’t offset the high amount of risk they’ve taken with some investments, and here are the outliers. Hey, but it takes only a few great investments, and even a great one, to return the fund, so, it may be worth the risk in the region, right?

Risk, the independent variable under spot, and the probability of the company reaching an envisioned successful outcome: VCs are pretty good at measuring risk, and, with the valuation on the table, closing the deal means they’ve all reached the equilibrium where the founders’ willingness to take on dilution matches investors’ risk appetite.

Some VCs are simply better at understanding and pricing the risk. Usually, these are the ones investing in specific verticals and having niche expertise, stage-focused, adding value into the startup’s operations, dedicating time to support the founders, making connections and introducing clients, and even incubating businesses through General Partners or Entrepreneurs in Residence.

The pre-money valuation reflects the investors’ calculated perception of risk (and not the founders’ dream value.) One simple measure to evaluate the early-stage risk is to look at a company’s Equity Leverage at the time of financing; it’s “the amount of return a company needs to deliver in order to meet an investor’s return expectations.”

In a Medium post which you can browse here, Todd Breeden gives an example. Considering an investment of $2m in a concept-stage business (valued at $0 non-venture backed) at an $8m pre-money valuation ($10m post-money), if the investor is targeting a 100% IRR (in one year), then the company needs to be worth $20m in 12 months; this means a 10x equity leverage on the business. With the same business valued at $10m pre-money, and an investment of $4m while targeting the same 100% IRR, the company needs to be valued at $28m in 12 months to be considered by the same investor; the equity leverage in this care is 7x.

To deliver a 10x return, the CEO would probably assume more high-risk initiatives (than the one who only needs to return 7%.) Todd’s conclusion is: “A founding team that assumes too much Equity Leverage is more likely to fail through high-risk growth strategies, rather than another business that is spending money more conservatively.”

Assuming you’re good at portfolio management, a reduction in equity leverage (such as 7x vs. 10x in the above ex.), may lead to a higher alpha, blended MOIC and blended IRR. That’s one reason why many VCs prefer to invest more and have higher pre-money valuations (with lower risk.) When you hear/read that valuations are skyrocketing, it’s about perceived risk and return. Beware though of the “Brewster” effect, when there’s a diminishing return to reducing the equity leverage: the founders have more money, but it’s actually hard to spend them quickly and efficiently/wisely if they have no experience doing so. Increasing the burn rate also increases the risk profile of the investment, and the risk is not hitting the equity leverage target.

The pre-money valuation is a function of the risk the VC perceives the business to have, rather than being indicative of its actual value. Being aware of the potential failures and high-risk nature of their investments, VCs will continue to diversity.

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