Everyone who starts to invest and study Venture Capital raises the question of how to value investment opportunities and come up with a price for the startups. And when discussing value, we start from the understanding that an asset's value is related to a company's ability to generate value over time. Therefore, we immediately think about the DCF analysis as the only means to calculate an asset's value.
However, as we come across a high level of uncertainty and many hypotheses to concatenate in a company DCF analysis, we realize that DCF is not a proper tool to value an early-stage company. The problem comes with an additional conclusion that value investing or fundamentals are not adequate tools for Venture Capital.
How can we differentiate investment from speculative activities without counting on DCF?
One alternative is to look for a base rate, which means looking at the trajectory and experience of similar companies to understand how much they grew and how efficient they were. Then, in more detail, it is crucial to know how much money and number of rounds they've raised, how long they took for an exit or IPO, the average length of each stage, and how much value these companies created over time.
When VCs think about base rates, we bring aggregated numbers of top performers from similar business models and compare them with the historical number and projections of the opportunity we are evaluating.
Another critical approach for a Venture Capital deal is considering the market's size and looking at the entire journey until IPO to understand what is possible to build in the future and how large the opportunity can become. VCs typically focus their analysis on each round, but the valuation attributed to listed companies indicates how they created value in each stage.
What other elements rather than revenue growth are essential to analyze a startup, and why are they important?
We start with the graduation rates. A successful VC builds a portfolio of companies that brings excess returns to the market average. A scale-up trajectory is path-dependent, meaning that former rounds determine the success of the later ones. Therefore, it is fundamental for every VC to achieve better graduation rates than the average.
A successful round means that its proceeds will be employed and translated into the expected value created that will be compelling enough for a new investor or a buyer to offer a valuation that more than compensates the risk. Therefore, a VC must access the average amount of resources that will generate excess returns for each stage of a startup's journey if efficiently employed.
Then, on top of the quantitative analysis and performance comparison, investors can bring an array of qualitative criteria that help them understand and assess the feasibility of the proposed business plan and the team's execution capacity.
By analyzing the top most efficient and valuable companies in each segment (base rate), we can understand what to expect in terms of maturity and comprehensiveness of their product, processes, and growth strategy.
Most of the resources that a startup needs at the beginning of their journey go to build their product and intangible assets: (i) repeatable and measurable processes - develop knowhow to make their journey predictable, (ii) growth, positioning, and branding strategies - choose the segment and type of client that will make growth more accessible and how to communicate the attributes of innovation compared to the competitors at that space and (iii) their client base.
Therefore, to translate efficiency indicators, one has to access and measure the ability of teams to build their intangible assets and the odds that those assets will bring a return to the capital employed.
The beauty of SaaS and SaaS-enabled marketplaces is the recurring aspect of those business models and the fact that they allow for the construction of predictable sales processes. As a result, every time those companies incur marketing and sales expenses to bring an expected amount of clients, they defer their clients' Lifetime Value (the stream of cashflow that these clients will generate).
How do we define a stage?
Stages are usually defined by a group of milestones that has to be achieved at an expected amount of time - from traction (number of clients or revenue generation) to efficiency metrics (revenue per headcount), as examples. Next, those milestones are translated into the expected value created: the number of clients and the amount of recurring revenue generated. As well as the size of the company and the infrastructure built capable of leading the company to the next stage: strategy, number of employees, maturity of product, processes, operations, and governance.
Finally, we translate maturity into predictability. By analyzing the base rate, we know the average amount of time needed to arrive at the milestones expected for each stage; therefore, the more mature the startup's processes, the more predictable the duration of each stage and the amount of resources needed.
How do we arrive at a valuation at each round?
Our base rate indicates the size of each round - the amount of money - that enabled top performers to arrive at each round's milestones and the average dilution (amount of stake acquired by new investors). Therefore, we arrive at the average valuation expected for each stage.
Do Multiples Help?
Yes. As Michael Mauboussin says, multiples are shorthand for the valuation process. We might pay a premium to historical multiple and then help founders accommodate captable, avoiding a higher dilution if the business plan is bold and the assessed team's execution capacity gives us comfort to justify a premium. Conversely, we might propose a decrease in valuation and a lower premium to compensate for higher execution risk.
How do all of what we discussed translate into VC fund performance?
The upsurge of prices and valuation shown in public markets from 2018 to 2021 significantly impacted valuation in the early stages. Roughly speaking, investors expected higher growth rates and higher returns from tech companies because of a higher speed of technology adoption and a lower cost of capital because of lower interest rates. In addition, the expectation that each dollar invested would generate a higher return because of the factors mentioned boosted the valuation of the entire value chain - from public listed companies to the early stage.
Considering an average duration of seven to nine years from investing until exiting, the funds that initiated investing (vintage) from 2011/2012 onwards and started to divest around 2019-2021 showed better performance than the previous vintages as per the graphs below.
It sounds counterintuitive, but the vintages of funds starting or facing crises or sell-offs in the public markets are the ones with higher returns because it allows funds to invest and buy stakes at lower levels of valuation. Moreover, considering the long-term characteristics of a VC business, the odds that in the eight years following crisis and selloffs, macroeconomics will improve are high. Therefore, a lower entry point because of a crisis can be valuable for vintages with an additional 6 to 9-year period to exit.
Moreover, when an investor commits to investing in a VC fund, the capital will be called over the next five years, which means a lot can change, especially interest rate levels. So the cost of capital called in the first year can be significantly different from the cost of capital called in the remaining years of the investment period.
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