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The value of venture capital: how do VCs value young companies and is a higher valuation always better?
07/05/2008. Source:Scottish Equity Partners. Stuart Paterson
 Contrary to popular wisdom, venture capitalists consider it vital for entrepreneurs to be comfortable with the valuation of their company so that they are highly motivated to succeed, writes Stuart Paterson of Scottish Equity Partners.
Critical factors affecting valuation are the prospects for returns and the inherent risks associated with getting there. VCs focus on the prospect of a significant capital gain so potential exit value is key. Factors influencing this include the size of your market, your likely share and revenues, and above all, the likelihood of attracting a trade buyer or achieving IPO.
VCs need at least a 3x return on their investments overall to make the economics work. Situations differ, but since some companies inevitably fail, a high risk start-up requires the potential to achieve at least a 5x return. A prospect of 10x can lead to a higher initial valuation, providing that is a credible outcome.
The earlier the development of both company and market, the higher the risk. Valuations take this into account. VCs also factor in how strong and sustainable your competitive advantage is and the experience of the management team. They consider whether the product can be easily copied and how you will take it to market and achieve revenues?
Securing the participation of a syndicate of high calibre VCs at the start of the funding process can help attract other VCs to subsequent rounds. You should focus on attracting investors with a real knowledge of your sector and realistic expectations and time horizons to avoid being pushed into a premature exit.
You may need very large amounts of capital to succeed. For example fabless semiconductor businesses face high costs in designing, developing and marketing their technologies while information and communications technology companies have to offer complete solutions including software and subsystems. VCs will not usually commit total funding requirements up front and will more likely invest in stages once certain milestones have been met, so companies should aim to see an increase in valuations in successive rounds, as well as at IPO or exit.
A very high initial valuation isn’t necessarily the best thing and it is better to take a long term view on building value. Many VCs won’t invest in A rounds because their value hardly increases in the B Round, resulting in limited reward for taking a high risk in investing early.
If initial valuations are excessive, investors may think the next round is too expensive. Worse still, if your initial aggressive assumptions aren’t sustainable, a round with a lower valuation means giving away a lot more equity. Take a realistic view and remember that it is in the interests of the VCs for you to be incentivised to deliver long term value.
Consider carefully the milestones you need to hit to demonstrate that you are making solid progress at each round and remember that it usually takes longer to achieve them than you think. You should prepare for fundraising nine months before you need the cash as being forced into unplanned financing results in greater dilution . Raise enough at each stage to achieve the milestones which will trigger more funds in subsequent rounds and take more than you need if it is on the table.
First round valuation is less important than attracting the best VCs who can add real value as well as capital. It is important to consider whether you can be open and honest with them, whether they have realistic expectations concerning the development of your company and whether they will provide the follow on investments you need. That is the way to maximize your valuation when it really counts – at exit.
“The investment community is necessarily cynical by nature and must be persuaded that the opportunity is real and that you have what it takes to be the market winner. The business plan produced by CSR’s founders convinced the first-round investors that they could make the breakthrough, while the rest of the industry simply rejected the idea that a high-frequency radio could be built in bulk CMOS, let alone integrated with the baseband and memory and turned into a system with endless software requirements. Those first VCs placed their faith in us as a team more than anything. They maintained confidence in us throughout the subsequent rounds and were well rewarded for their trust.
For those companies aiming to follow in CSR’s footsteps, from my experience some of the rules of funding are, first, raise far more money than you think you’ll need to avoid expensive and time-consuming additional rounds. The well-known cliché that “cash is king” is absolutely true, and the CFO needs to be a Scrooge at heart who can ensure that all levels of the organisation understand that each dollar raised can only be spent once.
Second, raise money before you need it and always set up a competitive process to ensure the valuation of a round is set by the market. Securing funding is more important than the source, although VCs and strategic investors with respected names do usefully lend their stature to an enterprise. The price of the money and consequent dilution is less important than getting enough resources to do the job, and it helps to remember that it always takes longer than you expect to deliver on the commitments made," said John Hodgson, former CEO of CSR.
Scottish Equity Partners (SEP) is one of the largest independent private equity groups in the UK, and is currently investing from a venture capital fund in excess of £100m, which is backed by leading UK and European institutional investors.
With offices in Glasgow and London, SEP is one of the most active venture capital investors in the UK and has a strong investment track record. Typically, we invest between £500,000 and £5m or more, in financings of up to £30m in early stage and growing companies in the information technology, healthcare & life sciences and energy related technology sectors. For more details visit www.sep.co.uk.
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