Valuations are a complex subject and at the same time they are simple. How so?
There are different types of entrepreneurs when it comes to valuation:
- The uninformed optimist/nutter – these entrepreneurs haven’t done any research into what’s “market” in terms of valuation. They have deep conviction in what they are building, viscerally feel the blood and sweat that has gone into their company, typically have not hired many people yet (which would help give them a dose of reality) and spend too much time reading about West Coast valuations. They come to us with a pre-revenue startup asking for a Series A like pre-money valuation or an early revenue startup asking for a Series B like pre-money valuation. Out the door they go with some of our frank feedback, pleasantly delivered
- The informed optimist – they know what kind of valuations are being achieved in the market and they ask for the very top of the range as a pre-money valuation. Some of them will get it, most won’t. For us we look for a great team, great product, great market AND a good deal. Chances are we will pass and wait until we get all 4 rather than just 3 because we can and it materially improves our chances or generating a great reaturn for our limited partners/investors.
- The informed realist – these entrepreneurs are a pleasure to deal with, and that very point is important. Investing in an entrepreneur means commencing what is likely to be a long and close relationship. We love working with open-minded, reasonable people with whom we feel comfortable. When an entrepreneur comes to us and doesn’t talk about valuation until we bring it up, who isn’t fixated by the number, who understands that we have certain requirements as a VC fund for our economic model to work and who value our experience as much as, if not more than, the money, then we are likely to reach a deal easily and without much fuss. We can be flexible too, but only if we feel that the sentiment is reciprocated.
SO, how do we think about valuation. This is the simple bit. It’s quite easy. Keep point 3 in mind and read on.
As a VC fund, we know we won’t pick winners every time. In fact, though we hope we’ll do better, realistically we can bet on 10% to 20% of our investments doing extraordinarily well and the rest less well. In our current fund of £37.5m we want to find 3 “Dragons” (a Dragon is a fund-returner – i.e. our stake of 15-20% will return £37.5m). we expect to lose money on 25-50% of the companies we invest in (not on 25-50% of first rounds, but on 25-50% of the companies where we may invest in several rounds). The other non-Dragon companies we might make 1-3x say. Then our aim is adding this all together we need to make about 4x on the companies we invest in across the whole portfolio resulting in about 3x back to our investors over 10-12 years. When you do the maths, aiming for 20% of a company and a £250m exit gives us the potential dragons in our fund (it’s not £200m as we are likely to be diluted at least a bit over the rounds of investment)
SO, each time we make an investment we want to buy as much of the company as we can at the best price we can – typically a 20% stake. How much is that worth in a very early stage company? Here’s how we go about calculating that – bit of science, bit of art, bit of circumstance:
- The best thing for an entrepreneur is NOT to go fund-raising for as long as possible so to raise as much as possible. BUT they don’t want to dilute too much. What has turned out to be a practical rule of thumb is to raise enough cash to last 18 months assuming little commercial progress. That typically turns out to be somewhere between £0.5 and £1m if pre-revenue/MVP stage and £1-2m if post-revenue with up to half a dozen recurring customers, assuming your are an enterprise/B2B business. Divide that number by 20% and you get the post-money valuation. That’s simple, isn’t it. And it works 90% of the time with the informed reaslists. To use round numbers, our 1st round cheque size to date has ranged from £300k to £1m depending on the stage of the company, and given the stake we shoot for is 20% this implies a post-money valuation of £1.5m to £6m & a pre-money of £1.2m to £5m assuming no additional investors (which there usually are, but investing much smaller amounts so this doesn’t affect those valuations by much). We also expect there to be a 10% EMI option scheme in place before we invest in order to have the option fire power to attract some great hires over the course of that 18 months.
- When does it not work? The most common situation is when there is a bidding war. We don’t like those, for obvious reasons. We don’t partake. When an entrepreneur starts playing us off against another VC we tend to give a simple response: “This is our price. If you want to work with us, that’s the deal. If the valuation is more important, then go with the other party.” Sometimes the entrepreneur will choose us despite a lower valuation and sometimes they won’t . We don’t regret losing the latter as we don’t want to work with entrepreneurs who don’t really want to work with us. It’s important to note that we aren’t stingy on price, we just have our approach and if we feel something is too expensive it would be irresponsible for us to invest our Limited Partners’ money into the deal. It’s a discipline which works for us. It doesn’t “work” every time – we turned down Deliveroo because it was too expensive when they came to us for their first institutional round. We offered a price and it was £2m below what they wanted. We gave a bit but not enough for them. Was it a mistake – no, as we followed our process and having a through process and strategy is proven to work. Yes, because we missed out on a great business, but we could not have known that at the time. Do we regret it – professionally yes and no, but personally, absolutely, every time I swerve to miss a Deliveroo delivery bike on the way home on my bike, sure I do!