Bringing about a healthy ecosystem through the Venture Capital Method
There’s an epidemic of overvaluation raging in Southeast Asia’s entrepreneurial community. It appears to be highly contagious, as most entrepreneurs I meet seem to be infected. Overvaluation is dangerous for startups and can even be fatal in extreme cases.
Most SEA startups that pitch to my investment firm Expara Ventures do well until they get to the valuation slide, at which point their presentations quickly go off the rails. One of my favorite examples is a Thai fintech startup that seemed to have it all: an innovative product, a strong team, and good initial market traction. They were raising US$3 million, which I felt was exceedingly high for a Seed-stage company, but this number was nothing compared to their valuation. In fact, I wasn’t sure I had heard the founder correctly.
“Did you say $16 million?” I asked.
“No, $60 million,” he replied.
Game over. The product helps investors value publicly traded companies, and when I asked the founder if he saw the irony in this, he replied: “Everyone has their view on valuation.” Indeed they do.
This example is extreme, but most startups we meet are improperly and significantly overvalued. Investors will naturally lean toward lower valuations than founders, but the discrepancy I am seeing goes well beyond polarization. It’s not just founders who struggle; I also see investors valuing startups at levels that virtually guarantee they will not be profitable, even if the investment ‘succeeds.’
Let’s take a look at traditional valuation methods that may be causing these inaccuracies, and compare them to a startup-focused method that actually makes sense. There are three commonly used methods:
- Price to earnings (P/E): The company is valued as a multiple of its earnings, with the multiple reflecting the company’s expected growth rate. Higher-growth companies are valued at higher multiples, and lower-growth companies at lower multiples.
- Comparables: The company is valued by comparing it to companies with known valuations, adjusting for differences between the two.
- Discounted Cash Flow (DCF): The company is valued based on the discounted net present value (NPV) of its projected cash flows.
These methods are popular and well-understood, so why do they all fail when applied to startups?
Traditional methods are primarily used to value publicly traded companies, which create value for shareholders through capital appreciation and dividends. But startups create value through trade sales or IPOs, so they focus on growing revenue rather than earnings.
For a high-growth startup, earnings represent capital that was not invested into growing revenue, which is why even successful startups can still be posting losses every quarter. Since startups will usually have low or no earnings by design, they cannot be fairly valued by P/E.
The Comparables Method can theoretically be applied to startups, as it does not rely on cash flow or profits. However, its problem lies in the application, as it assumes valid comparisons can be made from a large group of similar companies, which does not hold for the startup world. Startup valuations are typically private, unknown transactions. Additionally, known valuations tend to be the outliers, as they are usually the ones that attract attention.
I often hear this from overvalued startups: X was recently valued at $40 million in its Seed round; we are just like X, so our Seed round should also be at $40 million. Nevermind that X’s valuation made it into the news because it’s a freakish outlier or the fact that it’s based in Silicon Valley (where the valuation is still an exception) when you’re based in Bangkok (where this valuation is ridiculous).
This example highlights another problem with the Comparables Method: what constitutes a comparable company? Should a Thai fintech startup be placed in the universe of U.S. fintech startups (which will have lot of data), or Thai fintech startups (which will have sparse data), or Thai startups overall (which will have a reasonable amount of data)? There is no easy answer, but generally, geographical comparables are more meaningful than sectoral ones.
The DCF Method values companies based on future cash flows, so it’s possible to value startups using this method if they are projected to become profitable during the forecast period. The method uses a pro-forma model to forecast the company’s cash flows, which are then discounted back to their NPV. It must make assumptions about revenue growth rates and the discount rate used for the present value calculation. In a DCF valuation, the discount rate should be the company’s weighted average cost of capital (WACC).
We give more credit to founders who use the DCF method, but almost all DCF valuations still use the wrong discount rate. Since venture-invested companies are usually 100% equity-financed, the company’s WACC should be its equity cost of capital, which is equivalent to the investor’s ROI or annual internal rate of return (IRR).
A venture investor’s cost of capital is around 100% per annum, but most DCF valuations we see have a discount rate between 10 to 15% because it’s the WACC for many publicly traded companies. But those who use the DCF method should understand that the discount rate needs to reflect the company’s actual cost of capital. Since discount rate and valuation in a DCF model will be inversely correlated, this much-too-low discount rate results in a much-too-high valuation.
The last problem with using valuation methods designed for publicly traded companies is that they are relevant for liquid shares markets, so the same valuation should apply for buyers and sellers. But for venture investors, the valuation today is only the valuation they will buy because the investment is typically highly illiquid and cannot be sold for years.
Startup valuations need a method that captures a meaningful value for investors. Enter the Venture Capital (VC) Method, which encompasses the following:
- A venture firm’s return is equal to the exit valuation, divided by the investment valuation and adjusted for dilution. Setting aside dilution for a minute, if the exit valuation is $100 million and the investment valuation is $5 million, then the VC’s return will be 20 times (X).
- For early-stage investments, the firm’s required return is 30X (so this example is already a failed investment).
- We assume the investor will be diluted by 50% in between their early-stage investment and their exit.
- The investment valuation is then equal to the exit valuation divided by 60.
- If we assume an exit valuation of $100 million, then the fair investment valuation is $1.67 million.
The first question most entrepreneurs will ask about the VC Method is: why is there a 30X return requirement as seen in the second point? 30X comes from (a) the firm’s cost of capital, which is equal to the return required by the fund’s investors, and (b) the failure rate of portfolios.
Venture fund investors, especially for early-stage funds, expect a return of at least 20% a year (accounting for net of fees, expenses, and carried interest) over ten years (the average life of a fund). This annual return translates into a 6X overall return after ten years. The required return is 30X instead of 6X because only 20% or less of the average portfolio will deliver a meaningful return.
Each early-stage investment that returns less than 30X is, therefore, returning less than the firm’s cost of capital. Now we can see where the 100% per annum discount rate we posited for a DCF valuation comes from; assuming an average five-year holding period for each investment in a ten-year fund, 100% return per year will yield an approximate 30X return after five years.
The most likely exit for venture-funded startups is a trade sale, which makes up 90% of all exits in the U.S. Given the average exit valuation of startups in a trade sale is around $100 million, we should expect to see average early-stage valuations between $1 to 2 million. The vast majority of early-stage startups we meet in SEA are valuing their companies at $5 to 10 million, suggesting they are overvalued by 5 to 10 times.
You might wonder: so what? If investors are okay with overpaying, then why can’t startups accept the investment and run? Well, overvaluation is okay until it isn’t. It’s unlikely for a startup to be overvalued until exit because the market is good at correcting itself in the long run. Typically, they will face one of several unpleasant situations:
- The additional dilution will be shifted to the founders in a down-round, especially if the investors who overpaid are not entirely clueless and included an anti-dilution clause in the agreement.
- Their next round will be blocked by investors who don’t want to do a down-round at all.
- A reasonable exit for founders will be blocked by investors who will not receive their required return at a reasonable exit valuation.
- Founders may receive little or nothing in an exit if investors have liquidation preferences, which is likely, given the overvalued investment.
Overvaluation is not in the interest of investors or founders, but the good news is that it can be rectified if and when the correct method is applied. Let’s try to stop this epidemic before it spreads any further, and help to create a healthy ecosystem for all.
About the Author
Douglas Abrams is the Founder of Expara, Southeast Asia’s leading early-stage venture capital firm. Founded in 2003, Expara now has offices in Singapore, Bangkok, Ho Chi Minh City and Kuala Lumpur. He has launched five venture funds in SEA since 2007. Prior to coming to Singapore in 2000, Douglas managed information technology at JP Morgan for 14 years.
He frequently lectures about entrepreneurship at universities throughout the region and is an Adjunct Associate Professor at the NUS Business School, (entrepreneurship) since 2001 a Visiting Professor (venture capital) for Sasin at Chulalongkorn University in Bangkok since 2007, and a Visiting Professor at RMIT in Ho Chi Minh City. He is a former Chairman of the Business Angel Network of Southeast Asia (BANSEA). He has a BA in Communications from the University of Pennsylvania and an MBA from The Wharton School.