Valuation war or searching for the next sucker is over.

Valuation war or searching for the next sucker is over. 

This article is meant for everyone, investors, advisors, founders, employees, and wannabes. For the last few months, we have been busy discussing valuations with founders, investors, advisors, employees, and wannabes. In a previous blog, I described how some founders start the conversation with: “There is a lot of money out there.” Sorry founders, the reality is that there is not a lot of money out there.  In 2022 the diet started, and every company needs to get lean to win. 2023 can be worse. The FTX debacle is still fresh in the mind of investors and even Elizabeth Holmes have recently appeared on the news that doesn’t help your 10x revenue presumptions.

What happened? How is it possible that people were not only telling founders but giving them money at very high valuations 12 or 13 months ago, and now everybody says it is too expensive? I have eight answers and solutions for you:

1. The US public market is recovering slowly compared to January 2022. It is almost on par. That means that some of your angel investors, institutional, and family office investors have lost money compared to what they thought they had months ago. Whatever cash available they have right now will be put to work with the best risk/reward ratio (as usual). They won’t sell public stock to fund your unicorn dreams if the risk is too high. When your public market investments that commonly are 80% of your assets (in the US), are down, the only way that you are deploying capital is when a bargain appears, whatever you have left in cash or in other assets that are producing returns, will be either saved or invested in something that is perceived as a bargain or that will have a quick turnaround. If you are raising early-stage money, series A, B, or even C, you carry many risks. Potentially a chance of disappearing and not creating meaningful returns for investors. Great investors understand that founder economics and investor economics are very different. If I invested in your series A company at a $30M valuation and you sell the company at $50M, I will be getting around 25% return for my investment, and you will, as the founder, make $5M to $10M. $5M is a lot of money, and 25% on top of my investment is not zero, but it is my worst-performing company,  and my performance as a fund is not stellar. I am not even making carry  (True story). If I invested as an angel investor, the return was too low for a high-risk investment; I am investing in startups because they can create triple-digit returns, not because they have a good average. By the way, they don’t have a good average.

2. When discussing valuations, everyone is looking at the public market multiples. Recently, while discussing a term sheet, one company told me:  “Most probably, we will be acquired by META; why are you giving us such a low multiple?” To their surprise, META’s market cap was five times its revenue. I was giving them the exact multiple. When your plan as a founder or investor is to get acquired by a strategic player that is in the public market, a safer bet is to be below your potential acquirer multiples. The acquirer is expecting to make money out of the acquisition. This idea might sound strange, but it is accurate. The Strategic acquirer will present their revenue with your revenue in their belly. The public market probably uses a larger revenue number to make assumptions and reward growth with a larger market cap. If the Strategic’s revenue is $100M and your revenue is $20M, the combined revenue is $120M. If you have the exact META multiple, the Strategic’s Market Cap might grow $100M (5 x 20M)  to $600M, and they will acquire your company at four times revenue; they are winning on the spread.  If you are investing with the idea of being taken out by a Strategic, you should closely follow the public market and invest below their multiples. The Strategic will give you a lower multiple 8 out of 10 times.  If you are investing with the idea of an IPO, you can have more leeway if the market conditions are the right ones, but not that much.  15% over your desired valuation seems reasonable.  And founders, if you are raising money, the 20 times revenue valuations are gone; they started slowly decreasing from February 2020 to 19 and then to 6, 5, 4 times revenue and even 1 to 1. 

3.  We might have a recession. Not only is everyone saving cash.  Everyone is waiting for cheaper investment opportunities in 2023. I heard several times in 2022 from US investors, Mexican investors, and European investors that 2023 will bring unique opportunities for the ones holding the cash, and I agree. They refer that the stock market might be cheaper, and you will be able to invest in great companies at a lower price. Also,  in private markets, most companies will need to lower their valuation if they want to raise money. If you are holding cash, it seems that 2023 will be the year that will bring your next 100x+ investment. Considering a recession, even the soundest businesses might get hit and reduce their revenue. We have already seen hiring freeze initiatives and massive layoffs from the top tech companies. Of course, inflation is not helping, and it is already a systemic problem that doesn’t have a quick fix. The world has been expecting this moment since 2008. The whole planet grew economically at a steady pace for almost 14 years. All the economists agree that every seven years, we should expect an economic adjustment. We lived through two economic cycles without any accurate adjustment, and this one seems compounded. Macroeconomic conditions are unfavorable, and microeconomic numbers are starting to set some alarms. The well will dry but not for everyone. As everyone has heard, many fortunes are made during crises; if you find how to fix systemic problems, you will find the money and an agreement with investors and we investors will find astonishing opportunities. 

4. Financiers are getting back to basics. I won’t say that in the last 14 years, but in the previous ten, at least, we have been jumping from bubble to bubble, mainly speculating how much the economy can grow. From Facebook to Fintech, from China to Bitcoin to Apes, in some cases, the speculation wasn’t about growth; it was about how much the next sucker is willing to pay. Through that process, the industry relaxed on basic company metrics and what value means. What are the fundamentals of a company? It is still about the future, of course, but it is not only about what value will bring the transformational power that a company carries with its technology. It is about 0s, 1s, and execution. The market size tells us how much the company can grow; the founders, C Level, and teams ability and product define what piece of the market they will capture, and the revenue, profits, growth, clients, EBIT, and EBITDA present a tendency or a Snapshot of the company in a moment in time, all together is what determines a valuation. If your revenue is super tiny and you have a young and talented team, don’t expect a high multiple. If you have some revenue, but it is not predictable, and your unit economics are all over the place, you are still high risk. If you are cash positive, with a healthy EBITDA, and growing in a fragmented market with two exits on your back, then the discounts in your projections and multiple are not that steep. From a different perspective, your business is less risky. We are always looking for the unicorn, the company that will make a 100X. As always, we are looking for exponential growth with marginal costs that can create a temporary monopoly where all stakeholders profit. If you are not getting the valuation you expect,  bootstrapping is the name of the game, put your head down and let your KPIs reach your desired valuation. The risk is higher right now. Finding the next sucker is not a strategy you can continue relying on.

5. There is risk in investing over the traditional multiples, as we have seen several times, even in excellent market conditions, receiving money or investing at higher multiples is a predictor of a down round or a quick sale.  In some cases, the famous ones, the down round doesn’t come until they reach the public market. The investors in Uber and WeWork kept putting money at very high multiples, and no one else was investing at the same pace. SoftBank even invested more to save WeWork from bankruptcy and to fund the IPO. As an investor, your risk is that you will need to throw money at the company until someone else buys you out or you sell your shares in the public market. As a founder, the source of capital will be scarce for the next rounds; some might look at it, but even where there is a huge advantage or added value coming from the company, a high price won’t be taken lightly.  Some distortions come from investors with different incentives, a  Strategic investor learning and grooming your company to be acquired, A Non-profit that is not interested in a return, government money that only needs 25% growth, grants, etc. When the incentives are not aligned with your investors, or your investors’ motivations’ are not aligned with returns, you will probably get a down round or be taken out when there is still room to grow. Unless, your investors are deep pockets enough (SoftBank style) to keep pouring money until you are a public company. Sorry, there is no way to justify a 760 times revenue valuation or a zero revenue, launching a product with a $50M valuation. (Both true stories) 

6.  SoftBank and Tiger Global are scaling back. Masa is no longer playing VC. SoftBank in some regions like Latam was part of the unicorn recipe. You scale the company enough to get an investment from SoftBank that, even without the fundamentals, will position you as a unicorn. When you have a lot of dry powder (money waiting to be invested), you need to invest large amounts of cash, and your regular startups won’t need that much; you need to provide them with the Unicorn title to be able to deploy $100M, $200M, 300M even if there is no way their revenue could catch up to those valuations. SoftBank is no longer an active player, which means that the SoftBank recipe is no longer available. Your path to create a unicorn and get a unicorn exit is the traditional one, grow your revenue, be profitable, and grow fast. Of course, if you have $1Bn in revenue, you are a unicorn, and your company is probably worth billions. If you have $100M in revenue or less, there is a fine line to be considered a unicorn; 10x revenue probably can make it if you are growing at a fast pace or your market is growing exponentially. If you have $50M in revenue, you won’t make the cut, and if you are in a region like Latam, there is no other source of capital for you at that valuation. The only path is revenue growth. This distortion also happens at a smaller scale (true story). Someone gave $6M to an early-stage startup with $50K in revenue at a $30M valuation. With those $6M, they will be able to produce $400K in revenue. If you continue with the exact multiple, the next valuation should be $240M (8 x $30M).  My question is, who will pay that price when the revenue is so small? Even if their profit is 90%, $360K is 666 times smaller than $240M. You can argue that the next valuation could be $40M but still is a 100X revenue. If you know an industry that is paying over 100 times revenue or EBITDA, please let me know. I’m suiting up to startup and take your money.

7. For investors, the returns are different. We are diluting as well with new rounds and with fresh money. When calculating returns, it is more critical that companies can survive without raising money and take capital only when it is attached to growth. The same investment amount into a fast-growing, cash-rich company will provide a 4x to 6x return over the next funding cycle. Since cash is only needed for growth, it enjoys a higher multiple and a higher valuation. The same investment amount in the same period with a company that raises capital successfully every 12 to 18 months, but the growth is inorganic. It will reach the same valuation, but the returns for the investors will be close to 2X. So, if you plan to raise money every six months because you are still finding the fastest growth path, this strategy adds risk to the potential return. Sometimes you can break your raise into two or three phases, but remember that your first-phase investor should get an economic advantage vs. the one in the second phase. 

8.  You might be seeing only your side, open your spectrum and information sources. Have a diverse set of people looking at your company, to create a colorful picture. To be clear, the company’s valuation is what the owners of a company and the buyers (including investors that are buying a small piece) agree on when buying the whole or a portion of the company. The company's valuation is also an agreement with the employees when a bit of their compensation is some form of equity. It is only an agreement when pieces of the company are exchanged for money, work, time, services, or products. This group is the one that determines the risk and the valuation. How do you set a valuation?  Technically there are several official methods, the most used one is Discounted Cash Flows (DCF). In this method the company’s revenue projections are discounted for different reasons. If the CEO believes he able to double the revenue every year, the investor might believe half of that. Getting a valuation annually no matter how much you have invested or what is your company size is a good practice and an important piece of a company or investment strategy.

a) Valuation is as important as who is the investor. Getting funded or investing is like getting married, you aren’t looking for one night partner, you are looking for a partner that will be with you for an important period of your life. Sometimes 5 years, sometimes 10 years or more. You will be speaking, getting information or reporting in a regular basis. The best investors are not the ones that are giving you more money, the best investors are the ones that will age well with you. The ones that supports your purpose and share your values. In famous Steve Jobs words, “don’t settle.” Find the right investment or the right investor. The one that will help you achieve your goals, fulfill your purpose and live your values. 

Have a great 2023 and a great year of the rabbit. Leap forward!        

Un abrazo 

Carlos (Wolf) Ochoa