- August 5, 2022
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
What Is Wrong with VC Pricing – Decoding Pre-Money and Post-Money Valuations
We are witnessing a surge in global inflation, and central banks have increased interest rates to curb inflation. This action from central banks has reset the global equity prices, with the US stock markets bearing the brunt of the Fed’s actions. As of 5th August 2022, the S&P 500 index has declined to 4,152, triggering a concern of slowdown and the onset of bear markets.
When I analyze the post-IPO performance of VC-backed companies against other equities, I observe a steep correction in prices in the VC-backed stocks. This correction is because the market expectations have changed from startups seeking growth at all costs to firms generating free cash flows to survive the next 2-3 years as high-interest rates make raising new funds difficult. For instance, Zomato and Paytm – two decorated unicorns- have declined below their IPO subscription price in India. As a result, Zomato has wiped out $11.8 billion of shareholder wealth and Paytm $13.8 billion.
Decoding Pre-Money and Post-Money Valuations
The contrast between pre-money and post-money valuation in public markets is straightforward compared to a VC-backed firm. In my experience working with startups and venture capitalists, I always sought to find a playbook that gives detailed instructions on the difference between pre-money and post-money valuations. Unfortunately, I am yet to discover one.
In my experience, if startups intend to raise fresh capital and approach a VC firm and the VC firm pays $10 million for a 50% stake in the startup, the pre-money and post-money valuations are as follows:
Post-money valuation = 10/50% = $20 million
Pre-money value = $20 – $10 = $10 million
A VC firm looks at post-money valuation as a matter of percentages, i.e., the stake it is willing to invest capital, provided it obtains a certain percentage of shares in the startup. This percentage (varies between 25% to 40%) is an outcome of intense negotiations between the VC firm and the startup founder. When I asked one VC firm the rationale for demanding a high percentage of ownership of the startup business, his defence was that they deal with firms with minimal operating history. Thus, they must account for high investment risk by demanding a high IRR.
For instance, a startup with a revenue of $1 million intends to raise a financing round. A VC firm decides to infuse $10 million, expects the startup to trade at 10x gains in five years, and demands a target IRR of 50% for the capital infusion.
The cash flows for this deal are as follows:
In the 5th year, if the startup revenues jump to $21 million, VC demands 36.16% of the stake in the startup. However, if revenues are $10 million, the VC’s percentage stake in the startup rises to 75.94%.
VCs demand a higher IRR because the IRR incorporates the conventional risk-adjusted discount rate and includes the survival risk and future cash flow needs. Thus, the target IRR act as a negotiating tool and VCs push the target rate when they have a strong bargaining position over the founder.
Fallacies in the VC pricing
In my view, the VC way of pricing companies has the following flaws:
- First, the entire process is a timing function, which becomes crucial in negotiating reasonable pricing. For example, when VCs are flush with capital at low-interest rates, the founders have a higher bargaining power demanding a higher percentage share of the post-money valuation. However, when the capital supply reduces due to high-interest rates or during an economic slowdown, the VCs will have high bargaining power.
- Incorporating the risk-adjusted discount rate, survival risk, and product/market risk into a single rate-target IRR makes it difficult for startups and VC firms to determine whether they have priced risks correctly or mispriced them.
- When VCs forecast revenues over multiple years, it is unclear if there will be additional capital infusions in the future. Suppose the startup’s burn rate is higher than in previous years. In that case, the founders demand another round of capital infusion before the milestone period/exit period. The VC can either raise a bridge loan convertible to equity at post-money valuation, liquidate the startup, or ask the founder to buy back their shares to trigger redemption or ask startups to seek fresh capital from new investors. Thus, the question for VC firms is whether they have arrived at the target IRR on the assumption of a single capital infusion or multiple cash infusions. If there are numerous cash infusions, would the VC firm provide the capital, or does the startup has to seek money from other VC firms? If the startup aims for capital outside and the VC firm has added this cash to post-money valuation, it has effectively double-counted.
- In VC transactions, the pre-money valuations set the share price of the proposed investment. However, when pre-money valuation is high due to anti-dilution provisions and if the startup intends to raise fresh capital for operations, it becomes problematic when its value has not increased since the last round. In this case, VCs are reluctant to invest, destroying the startup. In addition, the founder’s and employee ESOPs are out of money resulting in a high haircut in their net worth. This action can demotivate founders and key employees, resulting in a further decline in the firm value.
I am not arguing that VC firms should switch to intrinsic valuation when investing in startups because it is challenging to forecast the startup revenues accurately. However, the stakeholders – founders and VC firms get better served if there is more transparency in the process by explicitly describing how they arrive at assessing ownership rights.