Assuming you are already convinced that there is something here, the next question is which startup should you invest in and under what terms. The key term you are probably wondering about is the ‘V-word, Valuation! One of the questions I am asked most often is how do you value a startup? How can you tell that the valuation is correct? My answer, I really do not know and am not even sure it’s a question that can be answered. There are several methods that are used to value startups; if this is what you are looking for, unfortunately, this blog will not answer your question. However, this piece will help you decide if the deal at hand makes sense from an expected return perspective.
Public companies are valued. Private companies are priced! I did not coin this phrase. I do not know who did, but credit to one of the leading early-stage investors in the African ecosystem Eghosa of Echo VC, for bringing it to my attention. Once this statement sinks in, you will see the valuation of startups in a different light. For me, it boils down to a few points:
- On day one, startups are not selling you anything tangible. They are selling you the future! As you probably know, thanks to Covid for the lesson, the future is the future.
- You should look to get a sense of what the startup’s value will be in the future, but remember, what you are really asking is whether, with the information available, team, market, competitive advantage, level of traction, etc. do the proposed terms make sense?
- This being the case, what you can do during the early days is not to value but rather to price.
- When pricing services or goods, two things are essential: the cost and the margin. In ‘valuing’ startups, the margin is the margin of error!
- If it is too high, you overpay and may end up with a down round in future and not meeting your returns. If it’s just right, you may be in for some decent returns!
- With the different investors who follow you, the VCs, PEs and even strategics, the pricing needs to be just right to ensure that there is enough value that you can keep and sufficient value remaining for subsequent players. Otherwise, they will not invest, and if they do, the exit may never happen.
What then is the right question to ask? I think the question should be, should I invest with the terms on the table and with my return expectations/target? The VCs have thought about the problem and have developed systematic ways to answer this question.
The good part is that luckily for you, we have developed a tool that will help you to use this method to find out if you should be investing based on the terms provided to you by a startup. The bad part is that it will require some heavy lifting. The tool helps you think about the startup’s pricing the deal terms and ask what kind of returns you should expect under different scenarios. One of the key due diligence (DD) aspects every investor should carry out, assuming everything else checks out, is the deal terms DD! Here you ask, is this good business a good investment?
Let us make this tangible; in 2020, amidst the chaos and suffering Covid caused, one story that made me smile was Paystacks acquisition by Stripe for USD 200 million (mio). At the time, we had not seen all the billions currently getting raised and this acquisition had the same impact as Flutterwave’s USD 3bln valuation.
Let us assume that you were an angel in this deal and that you invested USD 10,000 at a valuation of USD 1,000,000. From various case studies, we know that the company did not raise many rounds of funding, but let us assume that your exit happens at Series B for our illustration. Let us also assume that they had raised a Pre-seed, Seed, Series A, and finally, you exited at Series B by this time. That would mean you invested in the first round and there were two other rounds before your exit Let us also assume that you did not participate in subsequent rounds of investing as a new angel, which means that after your initial USD 10k investment, you did not invest in any of the other rounds. This means you were diluted in each of these subsequent rounds but thank God at higher valuations as the exit would show.
For ease in calculations, let us assume that Paystack took the following path to exit (which is achievable, a pricing lift of 5 – 10x between different rounds). Let us also assume that each round happened after 12 months with 10 – 15% dilutions per round.
- Seed – USD 10 mio
- Series A – USD 50 mio
- Series B – USD 200 mio
With this in mind, we can determine the kind of returns you would have gotten at the exit, but that is not the fun part. The interesting part is asking yourself what kind of returns you would have posted had the entry valuation been different. We assume a pre-seed post-money valuation range for this blog starting from USD 1 mio – USD 25 mio.
The table below summarizes the return scenarios.
A few key takeaways from these return numbers:
- In each of these scenarios, you make a good return, 7.7X is not bad by any standards, of course, 153X is much better ?
- While no one knows what the right ‘valuation’ is, overpaying for a startup at entry will surely cost you more than the icing on the cake!
- If you had gotten in at USD 1mio this return alone would probably make up for any other investments you had done, whatever their outcome. At USD 20 mio you would surely need your other portfolio companies to post a good return
Conclusion: valuation, pricing or whatever you want to call it matters. Amid this frothy valuations market, do your analysis, not only on the company but most importantly, on the deal!
By Stephen Gugu, Founder Viktoria Ventures
