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Venture capital was built upon the narrative that entry prices don’t matter. Afterall, losing an investment that would deliver 100x is worse than losing 1x capital. However, such narrative relies on large exits typically larger than 10b usd and the reality is that over the last 20 years LatAm has produced one company that has delivered such exit.
The entry price in any round is unarguably the only variable over which investors have some sort of decision-making control. This isn’t the case when discussing which people to hire, features to launch or sales channels to focus on, highlighting the importance of the topic.
However, as per Spectra’s latest investment letter which highlights the 4x entry prices inflation in Brazil for seed rounds when comparing 17’ and 23’ rounds decreasing the gap with the U.S from 55% to 13%, even though exit values are considerably lower. Which inevitably results in a lower interest for the asset class for the region.
Metrics and multiples are used by investors as a way to manage their own biases, aiming to provoke reflections that justify their decisions. However, the toolkit leveraged is scarce for VC investors.
Saying a company was valued at 30x revenue doesn’t reveal much. Is it too little? Too much? What if 30x for some companies is considered cheap and 10x expensive for others? These are questions we ask ourselves daily.
V multiple
As companies move from early to late stage, metrics like the rule of 40 are used to gauge a company's health by considering growth rate and free cash flow margin. Given the distance early-stage companies are from generating cash, this rule is often less applicable.
In search of a tool to help with our own biases, we combined different variables that determine a company’s price into a metric that levels the discussion field. Introducing what we call the V multiple:
- We use post-money as analogous to enterprise value (EV) since debt is not typical for early-stage startups.
- Gross profit for tech companies with low CapEx needs, is a key indicator of a company’s free cash flow margin potential, also as a proof that not all revenue is created equal.
- Last year’s growth is good indicator for companies post Series B, here we prefer to use the last 6 months' annualized growth to accurately capture the pace at which early stage companies move. some text
- Finally, a 2x weight on growth reflects how the market rewards growth compared to margin. A study by Guggenheim in 2022, when efficiency became the focus, showed that the market still rewards growth 2x more than margin.
Ultimately, the metric helps clarify differences that revenue multiples alone cannot, shedding light on variations between companies growing at different rates and those delivering their product at a lower marginal cost.
In a hypothetical scenario of a company with a 20x revenue multiple, we may see different levels of V multiple, as shown in the sensitivity analysis.
But is there an ideal V multiple level for companies? There’s no straightforward answer as the market is not static, and the way it compensates company’s fluctuates depending on liquidity conditions.
We understand that V multiples for companies at seed or later stages should show similar values compared to listed companies in the region, given that their growth rates should compensate for a higher revenue multiples.
When analyzing leading tech companies listed in the region, we see that in August 24’ we’re at a median V multiple of 4.5x:
One of many market realities is that different multiple levels are assigned to companies depending on where they operate. Addressable market size, currency risk, differences in working capital, and stock liquidity are key variables driving this difference.
Therefore, it’s unrealistic to compare companies from the United States and seek similar multiples for companies in Latin America; it’s rare to see a company here with a revenue multiple above 10x.
This point gets clearer when comparing the medians of leading LatAm tech companies with those in the Cloud Index, which in its majority are U.S based companies:
It’s worth noting that many other variables contribute to a company’s valuation, such as network effects, competitive advantages, market/category leadership, competitive landscape, switching costs/lock-in, revenue concentration, demand generation sources, among others.
As Morgan Housel would say “every market valuation is a number from today multiplied by a story about tomorrow, and the stories change much faster than the numbers”. Each of these variables offers different assumptions about potential narratives to be built. The only similarity is that, in the end, narratives should deliver results, whether through margin improvement or growth.
This article was converted into a podcast produced by AI. Check it out below:
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