Flat is the new 40% Markup

Stuart Ellman

I was in a board meeting yesterday and somebody was talking about selling some shares. He just wanted to sell his shares at the same price as the last round of financing. No problem, right? Actually, yes problem.

This is an issue with mark-to-market pricing of private companies. The assumption tends to be that, since no new round has been done, the company is worth the same as it was the last time money was raised (and hence a valuation was determined). That just isn’t reality, although during normal conditions it tends to be close enough. Today, however, most of the major public indices are down 40% or really close to it. Some of the tech indices are off even more, but let’s stick with 40% since it is a nice, round number.

You might reply (and some do) that because there is no IPO market, the public market pricing has nothing to do with venture valuations. This is totally wrong. Everything is priced off of public market valuations eventually.

Not a pretty picture...

When a VC invests in a company, many factors are in play, but there is one overriding consideration: at what IRR (Internal Rate of Return) can I exit this deal? We work for our limited partners. We can be the greatest guys in the world, but if we don’t make money for our limited partners, we are out of business. So, we invest assuming there will be a public market.

Well, you may ask, what about acquisitions? The answer is that the best acquisitions happen when the alternative is going public. For example, if I can go public at $500 million, I might be willing to take $450 million from an acquirer to save the risk of an IPO. However, when I cannot say to the acquirer that my alternative is to go public at $500 million, what is he going to offer me? What is his incentive to offer $450 million? More likely than not, he will put in a low-ball offer because I have no liquidity alternatives. And, by the way, when I do want to go public, the bankers will value the company against public market comparables. In the end all pricing derives from where the public market comparables are trading – even when using typical discount models from recent private transactions.

So, the number is 40% down. What does that really mean? It means I can buy 5% of a public technology company for 40% less than I could have one year ago. It also means that private market valuations — all other things held equal — need to come down 40%. Thus, if you have a company that has grown so much that it warrants a 40% markup in valuation in a normalized market, you should expect a flat round in this market. If your company has a few issues and would likely have a flat round in a normalized market, then it should have a 40% down-round in this market. You get the idea.

The reason that it usually takes 12 to 24 months for private market valuations to adjust is because of our necessity to mark to the last round and the way that VCs can play with that. Whenever I teach my class at Columbia Business School, I explain that VCs can only mark to the most recent round. Students typically yell out that it is not fair (or clunky at the very least). But, there is no better way. There is no liquid market. If we try to mark down to an arbitrary marking, then we also need to mark up to one. Since VCs don’t like to take write-downs, they will sometimes starve a company that needs a new round so that it doesn’t take in new money at a lower price. Or, they put in a bridge which is un-priced. Both of those scenarios are simply stalling tactics where people are hoping that markets will improve. We at RRE try not to do that. More often than not, we push for the washout rounds to “right price” the companies, even when that means we hurt ourselves a bit in the process. We refer to this discipline as ‘living in the present’.

So, everybody in startup land, pay attention. Pricing is down 40% right now. Until the markets come back up, that is the reality. If you want to raise money, take a realistic look at yourself. You might not like the pricing being offered, but it beats the alternative of running out of money.

Why You Might Want a Lower Valuation for your Startup

The most obvious point of negotiation in any venture financing is the valuation of the company. The first-order logic is pretty simple: Founders want the highest possible valuation and investors want the lowest. Pretty straightforward. Founders want to go high because it minimizes dilution. Investors want to go low because they get a higher ownership percentage.

For those who aren’t familiar with this math, it works pretty simply. Investors are going to put money into a company. More accurately, they are going to buy shares of stock from the company at a certain price. The higher the price of the company, the fewer shares the investors get for a given number of dollars.

What this winds up meaning is that at a higher price (price = valuation), the money put in by investors (let’s say $5 million) buys a lower percentage of the company. If you say that the company’s valuation walking in the door is $10 million (the “pre-money valuation“), the $5 million put in by the investors buys one third of the company (because the company will then have the $10 million of presumed value plus $5 million of cash in the bank, resulting in a $15 million “post-money valuation“). If, on the other hand, you say that the pre-money valuation is $20 million, the new money will only buy 20% ($5M out of $25M) of the company rather than 33%.

Just to do the simple arithmetic, if you assume this is the first money into the company, the outcome of these two scenarios looks quite different for the founders. In the first scenario, the founders own 66% of a $15 million company. They are worth $10 million on paper. In the second scenario, they own 80% of a $25M company and are worth $20 million on paper. In both cases their company ends the financing with $5 million of cash to grow the business.

So you are now asking why I’m suggesting that you might not want to raise the round at the highest valuation you can possibly get. And a good many of you are rolling your eyes at the obvious self-interest we as investors have in this negotiation (which is undoubtedly true – we are interested, but bear with me).

There are at least two very good reasons why you might not want to go for the highest possible valuation.

1. You are probably going to have to raise money again.

2. The valuation you get today impacts your exit possibilities.

The first is critical, and many first-time entrepreneurs miss this. When you raise money, you should have it in the back of your mind that you will probably be raising money a second time. While most companies (especially web companies) come in with the idea that the raise being done today gets them to cash-flow positive, realistically it often doesn’t turn out that way. We understand this and it’s ok that you will need more money, but you should understand this too. When you go out to raise that next round, recognize that your current investors are going to want a step-up in valuation and so will you. Secondly, new investors are going to want to see momentum in the business.

The critical point is this: If you raise money at too high a valuation, you are going to have a very hard time raising money the next time around. Your current investors are going to balk at taking a flat or marked-down valuation, and they will almost assuredly have anti-dilution protection that will keep them whole while diluting YOU, the founder (and your team). New investors are going to be wary of investing in a company that has to be marked down from its previous price. Either way, your overpriced first round is going to be a huge headache when you go back out to raise money, and new investors are likely going to re-price the company anyway.

The second reason is equally important. Simply put, if you raise money at a high valuation it will be very difficult to sell your company for anything less than a significant multiple of that valuation. When your investors purchase a portion of your company, they do so with the hope and expectation that they will earn a multiple on their money when you eventually sell the business or take it public. Put in more concrete terms, if you raise money at a given valuation, you should assume that in the near term and in a success situation, you will be expected to get more than 4x that valuation in an exit.

So when you go to raise money, think about both of these factors. Think about what proof points you will likely reach when you go out to raise more money, and be wary of a valuation that puts you in a difficult position when that time comes. And try to be mindful of what constitutes a successful outcome for you. If you raise money at $50M post-money valuation, you are implicitly saying you can build a very large business and you are taking a good (but not huge) outcome off the table for yourself. Make sure this is a decision you make consciously.

Why Venture Firms Tighten the Purse Strings in a Down Market

Anyone who has raised money during a down cycle like this one has noticed two significant changes in the fundraising climate.

1. Valuations come down
2. VCs make fewer investments

The first is probably fairly straightforward even to those entrepreneurs who don’t like it. When we’re in boom times (like the late 90s, 2005-6 for Web 2.0 or today for Cleantech), deals get bid up and investors pay high prices to get into great and even not-so-great deals. The inverse is also true – in tough times, the leverage shifts and investors hold the upper hand, often getting better terms and lower prices for good companies. That’s just the operation of what is, at the end of the day, a capital market.

The second of these is probably counterintuitive to some and deserves some attention. There is reasonably good evidence that firms are best-served by investing when prices are low and there is less competition for deals. It’s classic contrarianism. Well, aside from the basic truth that most people aren’t contrarians (by the definition of the word), there is another force at play here: When things are good, VC funds invest their funds as quickly as they can and go out and raise another (typically larger) fund. When things slow down, however, venture funds also slow their pace.

Why? Because it’s harder to raise that next fund. Venture funds are hit by an indirect consequence of problematic public markets.

Here’s how it works: Let’s say that you are an institutional investor (like a pension fund) with a $1 billion fund. Part of your fund is invested in venture capital funds. Your allocation to venture capital and private equity is set at 20% (for example). Now further imagine that the other 90% of your portfolio (equities, fixed income, real estate, etc…) goes down by 20%.

So prior to the market going down, you were invested like this:

Equities/Bonds/Real Estate             $900 million 90%
Private Equity/Venture Capital        $100 million 10%

Now, however, you are invested like this:

Equities/Bonds/Real Estate             $720 million 87.5%
Private Equity/Venture Capital        $100 million 12.5%

You are now over-allocated to PE/VC. The problem is that your public-market investments are “marked to market”, meaning that their value changes as the market provides a signal as to a new price. With a publicly-traded security, those signals are provided every business day via price quotations. Venture capital investments, by contrast, are marked to the most recent valuation, and that typically only comes with a new round of financing. There is a significant delay in the marking-to-market of these investments. They will eventually be marked down in this kind of environment, but it takes longer.

The way that most institutional investors respond to this situation is simple and devastating – they stop investing in new funds until their allocation returns to plan. Sure, if a top-tier VC fund comes calling, they’ll find allocation for them, but newer funds raising their first or second fund, funds that haven’t performed particularly well, and other less well-known investors will have a hard time raising capital.

In addition, there is a reduction in the velocity of money that flows through a portion of the Limited Partner base for venture funds. Many wealthy individuals, family foundations and other potential investors in funds use the distributions they receive from successful exits to fund their participation in new funds. In an environment where there are fewer and smaller exits, these investors’ money is locked up in their existing funds, and hence unavailable for new funds. To compound the problem, many of these individuals are technology founders and CEOs who make substantial money from big technology exits, typically IPOs or large acquisitions by public companies. When these types of transactions aren’t taking place, these individuals aren’t potential players as VCs look to raise new funds.

All of this combines to compel venture firms to be more patient and slower-paced with funds, because the bar is set higher for us as well, and we want to make sure that in a climate where fewer venture funds are getting funded, we’ve done only the very best deals that fit closest to our firm’s capabilities.

We know you need the money more than ever in times like this. It’s not personal.