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Entrepreneurs running impact businesses can waste a lot of time trying to raise venture capital if they dont understand the full investment cycle model they are entering into with venture investors As a startup entrepreneur seeking funding for his/her company, there are few things more sought after than a great valuation from an investor. Unfortunately this is most often the WRONG point to focus on, and can do more harm than good. I can say this from experience of having been an entrepreneur seeking (and getting) early stage investments, and now being a VC dealing with entrepreneurs in whom I see similarities to younger versions of myself. The fundamental problem is this: a narrow focus on a high valuation distracts from other equally if not more important considerations which include, in no particular order: Other terms of the financing round (liquidation and other preferences, affirmative voting rights, entrepreneur friendly provisions, etc.) Near-term value-add of the investors advice and network, as all money is NOT the same color Ability of the investor to help you close the next round of investment and/or support you if you get in trouble meeting your goals before then The time it takes to close, as time to market in a competitive environment can be substantially more precious than a few percentage points of dilution Ability of the company and early stage investors to see a good step up in valuation in Series A, reducing dilution for all, and avoiding at all costs a down round which is painful and demoralizing to the company and investors.
Many have written about the issues above at length. I encourage first-time entrepreneurs to get deeply educated on the non-valuation issues that come into any financing. For this post, I will focus on only 2014 Unitus Seed Partners LLC Will Poole Page 1
one topic -- understanding early-stage company valuation from the perspective of a VC, and putting it in perspective of a multi-round series of venture financings that would typically span some 5-8 years.
These final three points (operations, IP and gross margins) are vital for entrepreneurs to internalize. Many compare their impact business and expected valuations with high-flying web service businesses that have 60-90% gross margins, no distributed operations, and serious IP that sustainably differentiates them from competitors. The fact is that an impact business and a web service business could not be more different. Web service businesses are relatively inexpensive and quick to develop, they throw off enough cash to become self-financing at a relatively young age, and they typically have some fundamental IP value thats hard to copy. On the on the other hand, impact businesses take longer to grow, require substantially more cash to forward-invest and support the growth, are operationally more complicated, face significant competition over time, and ultimately must get to a very large scale to have the opportunity for a good exit. Its these realities of an impact business that drive many fundamental aspects of the financials and the ultimate valuation.
Getting to 10x
At the simplest level, an early stage VC like us needs to see an opportunity for a 10x cash-on-cash return in any investment we make. Simply put, that means for every $100k we put at risk at an early stage, we need to see a path to receiving $1M in 5-7 years, after the company has had multiple rounds of investment which dilute our as well as founder holdings. We clearly dont expect all of our companies to get there; in fact the majority will not come close. But if we dont make this a condition of selection (and of initial valuation), we will never achieve a high enough average return to meet the financial objectives of the fund.
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In the lowest-case $20M exit, founders plus employees are making a little over $1M, while financial investors are making a tiny multiple or losing money. At the rather optimistic exit valuation of $60M, founders plus employees take home nearly $11M, and each series of investors make a fine total return, achieving overall objectives.
As you can see above, life is pretty good for pre-seed investors in any exit on this chart, and they make 19-52x return between $30M and $60M. Seed investors, on whom we naturally focus on the most, dont make a ~10x return in this model until a $60M exit is achieved. Series A investors who have a similar risk profile and return potential only see a 5x return at $60M exit. So why would a Seed or Series A investor invest at the valuations in this model? Many of them would not; some would only do it if they felt the company had the ability to grow organically after series B, or to out-perform the models expectations in Series B and C rounds.
Conclusions
There have been very few examples of venture-funded businesses achieving over $50M exit valuations in India. The only impact business exit over $50m has been the SKS Microfinance which did an IPO in 2010. What this means for entrepreneurs is that if you want to take on venture capital, you need to be realistic about how your early-stage investors will value your business. Avoid the unrealistic valuation trap which
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will not lead to good results. VCs need to make money for their investors too, with returns corresponding to the risk they are taking. The other important point for entrepreneurs is that taking money from a less-sophisticated investor at a higher valuation will NOT help you succeed. Doing so will all too often lead to a painful reality-based reset and down round which can demoralize and potentially kill your company. Finally, the way to improve return outcomes for both entrepreneurs and investors is to take no more money than you need to grow the business at a healthy clip, and to find non-dilutive financing anywhere you can (affordable debt, etc.)
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