I get asked this question all the time.
The better question may be: how should they be?
There’s no doubt that the SaaS business model has dominated the last decade (do I even need to list out the SaaS subscriptions you probably paid last month?). And we’re all the better for it: SaaS is good for the world - customers can churn, which keeps companies developing new products and providing quality service. With shorter feedback loops comes greater responsibility, and a more efficient market. Meanwhile, by nearly every metric, valuations are up - a lot and at every stage.
For those hoping for a simple, definitive answer, sorry to disappoint: it’s complicated.
I like to start by asking a question back: If a company raises $10M for 10% of the company, what is the company worth?
Time and time again, I hear the same answer: “one hundred million dollars?” There is always a hint of hesitation in the reply. The $100M post-money valuation must be the company’s actual valuation, right?
But no. The answer is not $100M.
The $100M is an implied valuation. If a company sells 10% of their shares for $10M, all that means is that 10% of the company is worth $10M. That’s it. The other 90%? We don’t know. We may be able to make some educated guesses, but usually there is no meaningful market for each share class, so the total valuation remains a mystery.
On a side note, this dynamic is also at play in IPOs. Market cap is not equal to value of a company - just because there is demand for some shares at $X today, does not mean that there is demand for every share at $X. It’s a demand curve, not a demand line. Once float increases and trading volume stabilizes, the market dynamics we expect start to play out properly.
Remember that, until you have money in your pocket, it’s hard to know if something is worth anything at all - there is intrinsic value and perceived value. Intrinsic value roots back to the fundamental valuation method: the DCF (discounted cash flow). Meanwhile, perceived value, especially in the current private markets, is often driven by greater fool theory combined with a strong macro oversupply of equity capital driven by low interest rates.
So how should we value small illiquid companies growing much faster than their public comps? The answer is that they don’t need to and probably shouldn’t be valued using the same methods. In theory, everything should root back to the DCF analysis and more accurate proxies for it. Figuring out the right proxies is the key here and depends on the information available and is the art of investing. The masters of this method for small companies tend to be the middle market private equity firms, who will buy sub $10M ARR software companies. There is some consistency here, and whatever their methods may be, that’s going to be a good proxy for the current intrinsic value of an early stage operating software company.
Large public companies have a liquid market as an anchor. And while markets never lie, it doesn’t mean they’re always right, just that they think they’re telling the truth - which isn’t the same thing (as we have seen over the last quarter as stock prices fall while SaaS companies beat and raise).
Here’s my take on fundraising rounds and valuations for startups: if a company is capitalized at a certain valuation, their purpose is to turn the capital they raised into real enterprise value. So a company that raises $25M on a $100M post is effectively going to be taking $25M and trying to build out the company so that it is actually, in its entirety, worth $100M in a variety of market scenarios. Of course, as soon as that happens, the company will probably fundraise again with a higher bar, say $50M at $300M.
This is why raising $5M at $100M can be dangerous. The founders are effectively giving themselves a steeper hill to climb. Turning $5M of capital into a $100M company in one shot is no easy task, even for the greats. You can hit all of your targets and still have a down round at the end of it - then you’re dead in the water.
How can this happen? Multiple compression. An early stage startup might hit ALL of their lofty Series A goals. Let’s say they started with $500k of ARR, and raised the $5M at $100M post, with a goal of quadrupling revenue. But, by the time they hit those targets, the market had shifted to more sustainable, lower multiples (let’s say 20x rather than 200x). Suddenly, a valuation of more than $100M seems impossible, and the company is left with few options besides a downround. Had they raised $5M at $50M, or even $20M at $100M, they’d have a lot more room to operate. In either of these last two cases, by taking slightly more dilution, the company controls their destiny and stays safely out of the death valley of downround conversations.
Capital is not valued at 1:1
Then there is the matter of valuing capital. Take two common VC terms: pre-money and post-money valuations. They represent two sides of a very simple equation: X dollars are raised at a pre-money valuation of Y dollars, which give a post-money valuation of X + Y. A naive view interprets this as saying that the company was worth $Y before the raise, and now that it has another $X in its bank account, it’s worth $(X+Y).
But the growth potential of a company (and therefore value accretion) is obviously going to be higher if the company has the capital to accelerate operations and/or last longer at the same pace. So a company wouldn’t really have a pre-money valuation of $Y if it wasn’t going to raise $X. So what happens if it raised $2X instead? In theory, the company can now grow faster and last longer, so its net present value should go up. But then you need to take the time value of money into account, as well as the fact that the risk of the company’s failure or success does not scale linearly with the amount of capital it raises. So if you discount the future value back, it should be more than $Y, but less than $(Y+X). (We have entered a world of theoretical, relative, future valuations - it’s fun if you’re a finance and math nerd, but I recognize that it’s probably not fun if you’re a normal human.) The conclusion is that we should not be anchoring implied valuations to either pre-money or post-money because the function of primary capital on the valuation has a different scale slope.
This is also why primary capital infusions are not the same as secondary trades. If a company issues Series D shares at an implied valuation of $1Bn after doing a Series C round at $500M, this probably makes sense as the new influx of capital improves the future valuation prospects of the business, thus increasing intrinsic value. If on the other hand, the company sells Series A/B/C shares via a secondary instead, the price of those shares only reflects the current perception of the buyer - it has no impact on the actual future valuation prospects of the business.
And let’s not forget about share classes. That’ll be the first question if you ever speak with a professional secondary investment fund about selling your shares. Why? Because companies generally issue Senior Preferred shares in each new financing (though sometimes they are pari passu). Each preferred share offering generally comes with a liquidation preference, meaning that whoever is at the top of the stack will get their initial capital back before the remaining capital available flows down to the rest of the waterfall (see some illustrations of this here). Preferred shares work fundamentally differently than common shares and the introduction of different share classes squares the complexity of a valuation exercise.
So although people typically write up Seed investments to the same share price that the Series D was just done at, this isn’t a rigorous method and rather a simplified and broadly accepted hack. While there are rigorous models for outcome distributions and their implication for each share class based on implied valuation, liquidation preference… It is generally understood that in many cases, the increased precision of these calculations does not often result in a more accurate view on the value of shares.
The truth is that the pre-money valuation is a bit of a misnomer - it is not a rigorous valuation of the company and is only distantly related to the intrinsic value of the company operations in its current state. We argue that more primary capital should mean a high pre-money valuation, which implies that it valuation is tied to more factors than the current state of the business.
Remember, the current state in the world of venture is significantly less important than the future state. In fact, you could say we don’t care at all about the current state except for how it might improve our accuracy in projecting the future state. (See for example: investing in a company that does not yet exist at a meaningful valuation). The pre-money valuation exists mainly for the purpose of pricing the new shares that the company will issue in their current fundraise.
All of this is all to say that the pre/post money implied valuations are just that - implied. They are not currently intrinsic but rather a reflection of what the business at hand can do with the new capital into the future. More capital means higher current implied valuation almost universally because of the runway extension and reduced risk of future growth. Lower risk means lower discount rate and with the same prospects ahead, it means that the NPV of the business now is actually higher.
This dynamic has been illustrated with the mega financings of the last few years: a high conviction investor can put $100M+ into an early stage company at an aggressive valuation and do so with sound mind. How? If the team, market and product have a real shot at meaningful disruption, then the war chest of capital can take timing, hiring, capitalization and even competition out of the risk calculation. As a result, this company actually does have a better shot at achieving a multi billion dollar outcome than a company at a similar stage who raises only $10M. It’s also important to keep in mind that fund managers are motivated to generate returns, but not everyone is aiming for the same target MOIC or %IRR. A multi-billion dollar asset management firm is selling a very different product to its LPs than an early-stage focused $100-200M VC fund, and the partners are incentivized differently as a result.
A key takeaway is for founders who need to remain aware: this company that raised so much money at such a high valuation has put its target way at the other end of the field and removed many of the interim targets. As a result, it has a much lower chance of achieving a ~$200M outcome after raising $100M+. $200M outcomes that have raised less than $50M almost universally make their founders very wealthy. From a liquidation preference and board alignment perspective, this is important to remember. If the founders are already wealthy and it’s $10Bn+ or bust, then it’s great that everyone is aligned, but if not, founders should make sure that they can get what they need in the interim… and keep an eye out for their employees.
This is to say a headline valuation represents more of an undertaking for a specific goal than anything else, and is the beginning of a new incremental journey rather than something to be published, shared and celebrated. Terms like “worth,” “market cap,” “unicorn,” and even “valued at” should be reserved for M&A exits and IPOs to avoid the confusion that we have outlined above.
So, to reiterate, if a company is capitalized at a certain valuation, their job is to use this thing called “operations” to turn the capital they raised into real enterprise value commensurate with that valuation. This is why we believe so strongly in the approach of business modeling and instrumentation. The goal has always been the same: to empower founders to effectively allocate resources in order to create real enterprise value. The goal is not to raise money, rather the goal is to build great companies that have intrinsic enterprise value that can weather the ups and downs of a volatile market.
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