Recently my friend contacted me, asking for a meeting which he will introduce me to his friends who just started a venture, which could be considered as a start-up. He might want to get my comments about that venture.
I met up with them, two young entrepreneurs, and personally I am quite happy that younger generations are now becoming more venturing-spirit and passion to start something from scratch.
They came with a fascinating presentation deck to show me what they are doing. It is after office hour and I was a lot tired to go through that slide deck together with them. So to make my life a bit easier, I just asked them a couple of questions, simple ones, but they are meat.
First, a bit shocking them by politely telling them that I was not too interested in the slides to be presented. To me the real case, is always, about talking with the REAL people, and it means they who are sitting in front of me! They are the ones that are running the business! So it is pretty good to sit with REAL people with the REAL business and with REAL story. I don’t want to skip this opportunity by reading those slide deck.
I casually started the conversation to ask them, whether they sniff the REAL need being present in the target customers.
This first question is so crucial, since if there is no REAL need that the business might not go anywhere. Of course, you could still catch the fish, but only one (joke!).
Putting the word REAL is to emphasize that the product or service of that venture is what the customers really need, are able to pay and more important, they are willing to pay, to provide some returns to the investment being made.
The product or service might fall into 3 categories:
- Must have; or
- Nice to have; or
- So What?
I am trying to reframe my questions: is the product or service just VITAMINES or is it PAINKILLER ones?
Or is it simply better, faster ones compared to what are already in the market?
They claimed to be the first to market to introduce this product/service. I just put down my pen saying that being first-to-market in this VUCA environment, now seldom matters. The more important is to be first-to-market-fit, in most of cases, will almost be the long-term winner. When Facebook was launched in early 2004, there were already other social network sites, such as Friendster and MySpace.com.
We continued our discussion to the investors’ expectation in funding such business.
I stressed out to them that for early stage venture, they might need to rely on 3 Fs’ money : Founders, Families and Friends, or 4 Fs money: Founders, Families, Friends and Fools.
The expectation from the investors might sound shocking to them. For serious early-stage investors, they might target to in between 10x or even 30x returns on their invested capital in risky startups. Which this mean that the investors must be convinced that the venture has the possibility of between 10x to 30x cash-on-cash return (or anticipated ROI, Return on Investment). Of course, ROI concept has no time element and we need to find it out by asking the investors what they are typical investment horizon before they expect their money back to them (either having the venture being acquired by larger strategic company or being exited through IPO to capital market).
Typical early-stage investors might put reasonably that the venture might take 5 to 7 years for a successful venture to get big enough (GROW and SCALE UP) to be seen in the market’s radar for a healthy exit. However, the typical investment fund being raised by Venture Capital (VC, which generally speaking would enter in the later stage of the venture, through their funding series, called Series A, B, B+, C, so on) has a life of 10 years, with money being committed and made during the first 5 years and then the harvest time to be made in the next 5 years.
I am trying to explain this ROI concept using return concept which might be easier to understand and accept.
The anticipated ROI of 10x might scare off the new fledgling business, which might mean, if they got USD 1 million money, then the venture itself is expected to return to the investor’s pocket US$10 million (= cash-on-cash ROI).
Upon knowing that the expected time to exit is 7 years, then we could calculate the anticipated or expected Rate of Return.
So now we have:
- ROI : 10x
- Time to exit : 7 years
With these 2 information, we could compute the rate of return on an annual basis:
The easier way to depict this is to get the help from Microsoft Excel, as shown below.
So with ROI of 10x within 7-year exit period, the annual rate of return is approximately 39%.
This 39%-annual-return rate hopefully might not come as a shocking surprise or eye-popping to those young entrepreneurs. This rate is called “investor’s required rate of return“, and it might read as the investor’s target rate of return in the case that the venture will be a big success. So here we don’t have other scenario for non-success story, or in other words, the probability rate for non-success scenario is nil. In other words, it is binary, either 1 (success) or 0 (no success = failure). Of course, logically, the investors won’t even think to invest their money in the first place if it is 0 (no success).
A side note for those math lovers: However, for those that do not like the idea without considering failure scenario, then it is not too difficult to factor that. Using the simple Venture Capital valuation method, let’s do it:
Post-money value = Exit value (expected, of course!) / ( 1 + investor’s required rate of return) ^ (exit period)
V-Post = EV / ( 1 + r ) ^T
a) probability for survival in each year assuming constant rate = (1- s)
b) d = discount rate without failure risk premium factored in
V-Post = (1 – s )^T * EV / (1 + d)^T
The rest is just secondary-class algebra math, as depicted below.
Here we have :
Investor’s required rate of return equals
discount rate (without failure risk premium) plus [constant] annual failure risk divided by 1 minus [constant] annual failure risk premium.
If the failure risk is positive, then the investor’s required rate of returns will be higher. For example, discount rate without failure risk premium is 25% and assuming annual failure risk rate is at 10%, then we would get the failure-risk adjusted rate being required to be:
(25% + 10%) / ( 1-10% ) = 38.89%.
Continued with the discussions with those two young entrepreneurs:
The investors here are dealing with private company with its private information. They might SPRAY the money and then PRAY, hoping for the money to be returned (at least for its principal). In the market, all investments that are based on public information, such as investing in public company or public bonds, will have only average rate of return. However, investing in private company with private information should have potentially higher return (and of course the flip side of this high-return investment, there is lurking at every corner of the venture path, the high risk of losing money).
Interrupted with the email exchange I made with another friend:
You might also enjoy these articles on how people misinterpret valuations in this context.
I don’t know the fuss about using valuation of startups.
For decades people have discussed and thought about project valuation. What they do in project valuation? They forecast cash flows and discount them to calculate, value, NPV and IRR.
What is the difference for startups? Nothing!
DCF-based method is too early to apply to pre-seed/seed/early stage of such high risky venture. Remember, that probably all those entrepreneurs have is just an idea, a garage to start with and 3 persons (including their 2 dogs). Other than the entrepreneur’s own money (read : maximizing their credit card use), then all he/she has is 3 Fs (Family, Friends and Fools) to rely on.
Market-based discount rate is not there, since this again, a private company. I believe CAPM-based WACC/discount rate could only work for public companies with public information being available to every market participants/players.
So investors that are coming with “sPRAY money and PRAY” have no much choices, other than hinging on their industry knowledge, network reference, and tons of guts, will “punish” such venture with small amount of investment and higher equity participation demand. They are going to apply what we will split into three multiplier discount rate : Dilution, Risk and Return of the Total Exit Value. Exit Value might be guessed wildly using whatever the history in the same industry that they have had, PE x estimated earnings at 5th or 7th year of that venture.
One of the most well-known valuation method for such high-risk venture at its early stage, is Venture Capital Method, introduced by Harvard professor. However, most of angel investors will have their own non-quantitative way to assess the business prospect. Again, here, the investors are betting on the jockey (the founder).
Financial projection which is useful for valuation exercise, becomes an critical instrument for early investors to assess (again, at this seed or pre-seed stage, the emphasis is not on valuation and I had ever read one story from one leading investors that valuation talk will only take 10 minutes max, investor will just say take-or-leave-it, and of course the investors will be quite worried if the entrepreneurs spend more time talking about how the founders could make money out of that venture instead of how to make that venture a successful business), among others:
When the next round financing will come. Usually it could only take 1-2 years after the first round financing. Is there any chance for the venture to attract another investors, and if yes, how much is the ownership retention rate for early investors? If no potential investors are on the horizon, whether the early investors still have “dry powder” to inject for any cash call in order to help the venture to roam thru the valley of deaths until second financiers come.
So my points, the nuances of start-up valuation in many cases are more dynamic. This is why I said that we need to split the discount to whatever the exit value into (1) dilution, (2) risk and (3) return. For example, the dreamed exit value is 1,000. Then the investors will reduce it for (1) dilution to be 500 (assuming he/she will lose half of his/her initial ownership %, and then reduced it for another 200 for risk factors, and ultimately 50 for return expectation. We have end result of post-money valuation which is 250. Dilution, risk and return, the 3 mentioned above, all together lumped into what we call money multiple. (1) x (2) x (3) multiple = money multiple.
Again, this is not perfect, but there is no point to make valuation in this stage for high-risk venture too much. 50% of the ventures will be going belly up, 30% going sideways becoming living deads or zombies, returning if lucky the principal or tiny fraction of that, 19% becoming lifestyle business returning principal plus modest interest and only 1 % to really hit blockbuster exit.
You might notice that the dilution factor is a big reduction to dreamed exit value in my illustration.
From talking with one Finance Professor, I learnt that dilution is like “cost” from the eyes of earlier investors. So though the venture will surely need more investors’ money to coal up the business from pre-seed, seed, growth and scale-up period, the earlier investors will as much as possible try to protect their ownership retention rate to high as possible. There are a lot of ways they put into the agreement to show this intention from fully-rachet anti-dilution clause, conversion with valuation cap, etc. In addition to legal terms, they will make sure that in the ownership cap table, all are reflected on fully-diluted basis to include stock options pool and convertible notes. They don’t want big surprises that could lower significantly their double-digit ownership % to no meaningful %. Again this is back that the exit value is just very rough estimate and 100% no guarantee the venture will eventually reach that successful exit.
Agree! Of course the idea is not to discuss on valuation with the potential investors. The idea is to help the new entrepreneurs to make a decision when they receive an offer, to give her/him a reference point to accept/reject an offer from the investor.
Yes, I agree. Nothing is special for that, just it is more dynamic, since the valuation here is not just about (1) the quality of the founders and the business itself, but it is highly influenced by (2) the market conditions at the time the financing is raised, and (3) whether there is a heated competition from investors to chase up deals flow, or (4) even whether the investors are a quality one or not. It means in seed fund raising, the entrepreneurs are not necessarily aiming a goal to have the valuation is high as possible, but to ensure that they could reach out the quality investors that could have better networking. As it is not just about growing company, but scaling up the company, then networking really matters. Investors with Region playing field will be much better than investors with only local focus. Quality investors might give lower valuation and open the doors and windows of opportunities to the entrepreneurs from their portfolio, network, etc.
The bottom down question is whether it is desirable or not to have an idea of how much value the firm has that others are interested in. I certainly believe yes. Sure that investors will offer what they wish to pay and by sure the valuation will not even be mentioned to them. However, from the point of view of the actual owner there is no doubt that having a reference point as “the value” of the firm before the investors make the offer. If I were one of them, I would like to have an estimation of how much the value of my firm might be.
(to be continued)Categories
Jakarta, 30 May 2021