I have worked in technology and finance for 20+ year. I started my career in Tech M&A at Lehman Brothers, raised money for my own start-up, launched AngelList in Canada and have invested in 30+ companies at N49P. One thing that has been consistent over those 20 years, is that early stage founders are wondering if now is a good time to raise and if so, what valuation should we raise at?
The answer to both of these questions have fluctuated greatly throughout 2020 but I feel comfortable saying that now may be the best time to raise that I have seen since the late 90s.
In this post we will explain what is going on and what actions founders may consider taking.
How are early stage valuations determined?
Hypothetically the valuation of a start-up are determined using either a discounted cash flow model ("DCF") or by looking at comparables.
DCF looks at future cash flows and discounts them to a present value using a discount rate. The discount rate is a rate that reflects how risky an investment is compared to a risk free rate (usually the US tbill rate). For startups the DCF is heavily dependent on the terminal value or the valuation when the company gets acquired or goes public.
The comparables method analyze public companies to determine multiples that can be used to price private startups. For example many Software As A Service ("SAAS") investors look at the Market Cap to Sales multiple of public SAAS companies to determine multiples for early stage SAAS companies.
In reality Venture Capitalists ("VCs") don't explicitly perform these analysis on early stage companies but the value of publicly tech companies does impact early stage valuations.
What drives terminal valuations?
My guess that 99.9%+ of returns for venture investors are from exits. It is extremely abnormal for start-ups to issue dividends prior to exit. This means the valuations for early stage companies are based upon the price they will eventually get acquired for or the value when they go public. How do VCs determine a potential value for these exits? They look at historical data.
To get an idea of what they look at it is good to understand what % of start-ups have an exit and how they exit.
CB Insights did an analysis of the VC Funnel for 1,100+ companies that raised seed rounds in the US between 2008 and 2010 (you can see the article here). By September 2018 the following happened:
67% stalled. They either failed or didn't raise additional funding.
30% had a known exit. They were either acquired or went public.
3% had recently raised additional funds.
30% represents 341 exits. The median term to an IPO is 8 years so most of these exits were most likely acquisitions. Assuming the other 30 companies that recently raised fundings go public, the majority of the value is determined by acquisitions.
Acquisition price is determined by how much competition there is to buy a company and how much they can pay. The how much they can pay is determined by the valuations multiples of public companies. Typically they want to buy companies that are accretive to earnings. They can do this by determining the impact the acquisition will have on specific metrics and the multiple that will create. The companies that are in best position to buy start-ups over the last decade have been "Big Tech" (Amazon, Apple, Facebook, Google, Microsoft).
To get a better understanding of how important Big Tech is, I analyzed the M&A activity of 5 of the largest tech companies in the US (data was taken from Wikipedia)
At face value this means these companies accounted for 88% of exits. Lets assume this analysis overstates the importance of these companies for exit by 100%. They still account for ~50% of acquisitions. I didn't perform a similar analysis for the leading Chinese companies (e.g. Baidu, Alibaba and Tencent) but I would not be surprised if that Chinese tech companies account for another 5% of the exits during this period.
The impact of politics & SPACs
The ability for Big Tech to purchase start-ups is in part determined by their valuation and the freedom to purchase startups. Current politics have had two positive impacts on valuations of Big Tech:
Over the past 12 months the fed rate has been reduced by 90% from 2.25% to 0.25%. The discount rate for public and private companies have fallen as the fed rate has. This has increased the value of companies.
"Shelter in place" mandates resulted in people turning to technology companies to get the goods and services they need which increased rates and valuations.
Not only do Big Tech companies have higher valuations but they have more competition to purchase large venture back companies. Special Purpose Acquisition Companies, better known as SPACs, have emerged as a new set of acquirers. Since the start of 2020, 86 SPACs have been launched and have raised $34.4b for future acquisitions (according to spacresearch.com). There are now 122 SPACs seeking targets and they have a combined $40.9b amount in trust. These SPACs are looking for high growth potential companies. In other words they are looking at tech companies.
These trends have increased potential terminal valuations and therefore are driving up early stage valuations
Clouds on the horizon
Just as politics have helped increase valuations they can help decrease valuations. American politics is highly fractured right now but there appears two things that the Democrats and Republicans agree on: Big Tech is too powerful and China should have less influence over the United States.
While it is not clear what restrictions the US government will eventually put on Big Tech and Chinese tech companies but you can be confident that it will lead to more scrutiny for each and every acquisition. This will increase the time and costs of acquisitions and make larger acquisitions more difficult to complete. End results will be fewer and smaller acquisitions by Big Tech and China. Given how important these companies are to acquisition this could have a significant impact on valuations.
What should founders do?
Valuations are most likely as high as they can go. As a founder you should take the following actions:
Raise enough money now* to provide 24 to 36 months of runway. With current valuations and terms very founder friendly it is worth taking a bit of extra dilution. The extra cash will enable you to survive any economic turmoil (e.g. second wave of COVID, contested US elections, etc) and to take advantage of unforeseen opportunities (e.g. great hire, acquisition of competitor).
Stretch your company to hit better than expected milestones. Given that valuations will most likely decline over the next 24 to 36 months, you will need better metrics or to have achieved better than expected milestones to raise your next round at a higher valuation.
Understand the changing acquirer landscape. The best companies are purchased not sold. Traditionally having strong relationships Big Tech would be a great way to get purchased. These relationships may not be as fruitful going forward. The good news is there are a bunch of "emerging" public tech companies that you can build relationships with. Zoom, Datadog, Twilio and Shopify among many others are highly valued. Figure out who may be the right partner in the future and start building relationships with them.
If you are a Canadian founder and are ready to raise please feel free to reach out to me at firstname.lastname@example.org
*There are a few sectors which have suffered significantly due to COVID making it hard for startups to raise. If you are in / your customers are in travel, hospitality or retail it may be hard to take advantage of this advice.