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Investment, Start Up

Equity vs Valuation

October 3, 2017

I’ve had a few months off from writing due to some significant goings-on at Pi Labs as well as a summer break. But that has given me plenty of time to reflect on various issues in the sector and over the next few months I will be penning some thoughts on these.


We’re in the middle of a slew of deals and, not for the first time, we are having some lively discussions with entrepreneurs about what the correct entry “price” is for investors for this particular stage of investment in the company’s cycle. In doing so, this has highlighted what appears to be a common difference between investors and founders. In a nutshell, investors care about the equity they get; founders care about the valuation. Of course, there is a strong relationship between the two given the way venture financing works, but it’s the starting point that’s relevant in terms of ambitions, alignment and rationale.


Valuations for companies at an early stage are a vanity metric. As an investor I have almost no interest in what the valuation is on day 1. Instead, I am keenly focused on the following objectives:


·         The potential valuation in five year’s time and ensuring the correct foundations are in place to give the management team and the company the best possible chance of hitting that target.


·         Ensuring the right amount of equity is on offer to reward myself and my fellow investors in the round for the risk they are taking.


·         Lastly, ensuring that the second objective aligns, rather than conflicts, with the first.


  1.       Future Valuation Target


When we analyse the total addressable market, revenue opportunity and pricing model of a potential company, we are doing so to work out how big the potential is. (We are also looking at the efficiency of the business model to see how optimised it is, but that can always be tweaked). Different investors will want different market sizes before they invest, and that is normally a factor of the size of their fund or the stage at which they invest or both. For Pi Labs, that requirement is £100m. That is, we expect every company, should we invest, to have the ability to reach a £100m valuation within 5 years. For a company with the correct tools, this is not as daunting as it sounds. Depending on the market and multiples in use, that is something between £10m and £20m in revenue and I have seen companies priced at much higher multiples than that.


So, we’ve done some preliminary DD and we’ve established that a company is operating in a multi-billion £ market globally. Should it prove successful, it has every chance of hitting the required threshold of £100m. The next issue to tackle is to ensure that the company has the right foundations to reach such a goal. What does that mean? Well, too often companies cut themselves off at the knees because they have taken certain measures which makes this path more difficult, if not impossible:


·         You need an outstanding team, both present and future, to have any chance of success. In practical terms, this means two things: (i) ensuring the founders/senior management team have enough equity day 1 to keep them aligned through multiple rounds of financing. Coming back to my first objective above, it does not matter what equity the founders hold today. What matters is what equity they hold at exit and whether that produces a significant enough outcome to ensure alignment. (ii) Where there are gaps in the team, we certainly need an option pool to attract and retain top talent.


·         For the company to grow, it is almost certainly going to need multiple rounds of financing. This is 99.99% true. This isn’t about cost controls or burn rates (though that matters); its about growth. To grow meaningfully at an early juncture, you need capital to invest in the company infrastructure – marketing, sales, tech, product and so on. And lets assume that requires 5 rounds of funding. A seed round, plus a further 4 rounds. (Note this is the requirement to the £100m minimum threshold, not necessarily beyond). That is not unusual – a larger seed round, followed by A-C rounds. So when thinking about founder equity, this is why we think about what they have day 1 as they will almost certainly go through multiple rounds of dilution and every investor at every stage will want comfort around the alignment and motivation of the key individuals.


·         A second part of this is to ensure the company can attain the milestones to achieve the future fundraises. An extremely common error is not raising enough cash to hit the next milestone, either because you have factored in reaching said milestone unreasonably quickly or you have ignored how much time it takes to raise the next round of financing assuming you have the metrics. Everything being equal, timelines to raise capital are getting longer, not shorter. In my view, it takes 6 months from start to finish to raise a good round – that is from good investors, that is well thought through and results in a deal everyone is very happy with. It could take longer.


This 6 month window creates a problem. Classically, you rarely have the metrics required at the start of the 6 month fundraising window, but are approaching them at the end. So you need to factor in enough time to attain the metrics, then add 6 months onto that to raise and close the subsequent round.


  1.       Risk vs Reward


As a VC, we are financially motivated. We are motivated by soft factors too of course but make no bones about why our investors gives us cash to invest. It is because they believe they will see a strong return on their investment. In order to achieve said return, almost certainly the key factor will be the amount of equity held at exit. Clearly the size of the exit matters too, but this is much more difficult to control at a very early stage. So we need to ensure adequate ownership upfront.


But away from returns, we are very often the first institutional capital a company raises. As an investor, we take the highest amount of risk relative to other investors in the VC spectrum and that risk needs to be compensated. The risk is not linked to the size of the cheque or the size of the round.


  1.       Managing the Conflict


The eagle-eyed amongst you will have spotted that there is a potential conflict between the two points above. We want to protect against founder dilution too early yet we also believe we should be compensated for the risk we are taking with an appropriate amount of equity. To mitigate this, we operate in a 15% – 25% range for total equity on offer in a financing round. We never go below 15% on a priced round and we prefer very strongly to not go above 25% for the round. Where we end up depends on the company’s relative progress in terms of traction, product and revenue. This often requires work on both sides.


You will have noticed that I have not mentioned the valuation of the company once. And that is reflective of our own internal discussions too. So my advice to founders is to move the attention away from that metric and focus on (i) raising the optimal amount of cash to grow your business (ii) from a good group of investors who will assist that progression and (iii) for an amount of equity that does not overly dilute you but yet correctly aligns the interests of your investors. This, at the end of the day, is a great deal for both sides and ultimately what both sides should be aiming for.




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