Valuation and Primary Capital

The capital markets are starting to settle down after the most aggressive venture investment environment ever. The amount of capital deployed in 2021 was absolutely astounding at over $300Bn… and that is just what got announced. As with any massive influx of supply into a market, price goes down. In this market, the supply is capital and the price is the inverse of the valuation of deals. Looking at it simply, we saw deals that previously would have been financed at $25M now being financed at $100M valuations. It is a massive increase in valuation, but as I wrote previously, valuation as it pertains to primary capital investment is not so simple. It is much more nuanced than public market valuations and associated valuation multiples. The market liquidity and secondary characteristics of the public stock transactions makes them much more straightforward and very little of that approach applies to primary venture investing.

One of the biggest differences is the idea of a “trade” versus that of an “investment.” While any investment is technically a trade, focusing on the deal rather than the company makes the world of a difference. When companies are growing and changing rapidly and their stock is multi-class and illiquid, the transactions are mechanical and focusing on the deal rather than the company is usually a recipe for failure. Hoping for a quick writeup for validation became the norm in 2021 for many, but without liquidity this vanity metric means very little.

When you buy a share of stock in Salesforce you are buying it from a seller via an exchange. That seller likely has nothing to do with the company and the total number of shares outstanding stays in the same - only the owner of those shares changes. Put very simply, the seller is betting that the stock price will go down and the buyer is betting that the stock price will go up. In addition, money changes hands between the buyer and the seller of the stock, but the company itself does not see any of it. Of course, if the stock price goes up, then the company has a higher value. The higher value stock is currency for the company - they can use it for acquisitions and employee compensation. In addition, public companies can also raise primary capital to fund operations through the issuance of new stock. This generally will decrease the stock price - more shares and the same value of the company means that each share is worth slightly less. As a result, the higher the market capitalization, the less it “costs” to raise cash for that company. Liquidity is critical here because short, mid and long-term holders can all trade the stock together. You might have a high frequency trading operation buying shares from someone who just saw quarterly earnings who then turns around and sells it to a mutual fund who plans to hold the stock forever. We have all unfortunately seen how this dynamic can play out with consumers on Robinhood and Reddit making a meaningful impact on stock prices based purely on trading dynamics and not on the company itself.

Investing into a typical venture round of primary capital is a very different dynamic. Company stage, share classes and illiquidity are the biggest difference makers in the asset class, and their combination adds another layer of complexity. Series Seed to Series B companies are still very nebulous and usually have a long way to go before they achieve the scale and stability to consistently generate meaningful cash flows to drive value. The result is quite a bit of complexity, approximation and nuance in their capitalization strategy. Often the complexity and nuance gets swept under the rug of the “if it’s the next Uber, then who cares?” ideology.

In general, there is not a reliable secondary market for shares in early stage companies - they are not liquid. As a result, it is very hard to understand the current price of a share of stock in a private company at any moment. Add to that the lack of clarity in the intrinsic value of the company because of the variety of possible operational trajectories. Add to that preferred share classes and liquidation preferences: a share of Series C stock is worth more than a share of Series Seed stock because it has preference on liquidity. Meaning that if the company sells for less than the sum of capital it has raised, the proceeds from the sale do not get split up evenly - they generally go to the most recent investors first to cover their full investment amount, then the earlier investors and then the founders and employees (more on that subject can be found here). These compound factors make nailing the valuation of an early stage company almost impossible, but I believe that understanding these factors and their interplay gives you a much better chance of making a good guess in any given situation.

As mentioned above, in a public stock trade, there is a buyer and seller - the seller is betting the stock will go down and the buyer is betting that the stock will go up. (Of course it is not always that simple because we can’t know the detailed opportunity cost calculations or cash needs of the buyer and the seller). So if you buy a stock today and it goes down tomorrow, you overpaid. You overpaid for two reasons 1) you could have gotten a better deal if you waited a day and 2) the value of the company is now lower than the price you paid for it, so you will lose money if you sell. Both of these reasons depend heavily on liquidity and relative company stability: if, for example, the company is growing EPS 1% per day, then buying it today for $100 and tomorrow for $101 is effectively the same thing. (If you find a company doing this in the public markets, please send my way). Reason #1 is also emotional - it is reflective of the transactional nature of the trade.

Now let’s switch over to the venture capital asset class. There is a big technical difference: buying primary rather than secondary shares. And there is an emotional difference: the seller of the shares (the company) is not betting that the price of the stock will go down. Everyone is expecting growth and accretion of value - the question is rather how much. There is a bunch of really complicated and precise but inaccurate modeling you can do to try to figure out exactly how much, but it is much more valuable to understand conceptually than it is to try to calculate.

Instead let’s take it back to what we do know:

I believe there is an art and science to pulling these three things together into a financing round, and that it is primarily the job of the investor to guide this process (because financing companies is their full time job) and it is the job of the founder to build a great business (because it should not be the full time job of a founder to raise capital). I have outlined the method I use here:

Share

As I mentioned earlier, the alignment for growth of the buyer and seller of primary stock is a unique feature. Overall it’s great - everyone can win, it’s just a matter of proportions. One of the biggest challenges is that you can’t really know if you overpaid until the time of exit - which could be very soon in a downside case or in many years in an upside case. Especially in a business with some expected failure rate, this is difficult to properly quantify in the moment. Of course, you can build a portfolio or fund model and assume entry price, ownership and exit size, but it comes back to exit size being a mystery based on so many operational and market factors far into the future.

This is really all to say that investing into a Series A deal at $100M post-money valuation for a company with $100k of ARR may or actually may not be overpaying. It may just be paying ahead. If you assume the company will continue on its growth trajectory, then the question is not what is the company worth now, and rather can it use the primary capital raised in order to grow into the implied valuation of the financing. We can all understand that raising $5M rather than $25M at that same $100M implied valuation creates a very different dynamic for the company and drastically changes its chances of success. I would argue that raising $5M at $100M is overpaying and raising $25M at $100M is (hopefully) paying ahead. Making this judgment in any specific case is very difficult.

In a world where multi billion dollar funds are writing $10M+ “seed” checks, this pay ahead dynamic is important to remember. It may be called a “seed round” but that is simply the name of the stock issued. With great entrepreneurs, they may actually be raising their Seed, Series A and Series B all at the same time. While the risk of achieving a big long-term exit is always there, the risk of getting the business through the next few years of operational milestones may be very low because of the team and the market. And if that is not the case, that is just fine! Raise a reasonable seed round from a seed fund and get to work on achieving those operational goals.

https://alexoppenheimer.substack.com/p/valuation-and-primary-capital