Part 2: The Hunt for Unicorn Doppelgangers, Corporate VCs, and Non-Standard Valuation Practices

In the previous post, I describe the hunt for unicorn doppelgängers: an investment process involving selection and valuation of startups based on comparable predecessors that have paved the way regarding product-market fit and associated performance-based valuation metrics (i.e., traction, app downloads, etc.). This is a natural, herd inclination of investors who want to invest in hot investment sectors that have proven returns and therefore present lower risk. In this post, I will describe how corporate VCs and non-standard valuation methodologies influence the valuation process.

The Rise of Corporate VCs
The problem of high-financing rounds and valuations is exacerbated by the relatively low cost of capital and growing number of active investors. With increased public awareness of technology and innovation, more wealthy individuals are becoming angels, more angel investors are becoming institutional investors, and more corporations of are dipping their hands into everything. These companies include household names such as Intel, Siemer, Unilever, Google, and 7-Eleven.

According to Pitchbook Research, the number of corporate VC deals has doubled in the past 5 years, from 432 in 2009 to 888 in 2014 (Fig 1). This trend is unlikely to slow, with the value of exits doubling “from 2012 ($15 billion) to 2014 ($31 billion).”

Corporate VC Deals
Fig 1. Corporate VC investment deals have been on the rise since 2005, doubling between 2009 and 2014. “Corporations are VCs, Too.” Pitchbook (http://blog.pitchbook.com/corporations-are-vcs-too/).

Corporate VCs have several advantages over traditional VCs in terms of their extensive industry relationships and resources, as well as vast capital reserves. These advantages position them as ideal strategic partners for entrepreneurs who stand to benefit from affiliated brand-name recognition and much-needed expertise, connections, and R&D resources.

Corporate VCs pull from extensive capital reserves that outstrip the majority of traditional VC investors, giving them a competitive advantage in attracting and securing investment opportunities. Competition with traditional VCs can drive up valuations. This can benefit entrepreneurs who seek high financing rounds, but also opens them to the possibility of corporate investors owning a large percentage of the startup company. A large percentage ownership can lead to corporate VCs demanding board participation rights and may affect the future trajectory, including management, organization and product decisions of the company. Entrepreneurs should always be careful when negotiating with big money. To more fully understand the process of valuations from both the perspectives of investors and entrepreneurs, I recommend picking up Term Sheets and Valuations by Alex Wilmerding.

Non-Standard Valuation Methods
The concept of widely varying valuations between investors depends on the lack of standardization in valuation methodologies. As every venture capital book or seasoned investor will tell you, “Valuations are more of an art than a science.” How can you gauge the future potential of a company promising innovation when they are pre-revenue and still developing their product? So many questions remain: Does the management team have the ability to execute? What is the growth month-over-month? What is the cost of duplicating the company? Is there even a market for this product? What is the competitive advantage?

Despite the sea of nuanced questions, various methodologies have been developed to bucket these questions into qualitative and non-qualitative metrics. The problem with these methodologies is, even when they offer quantitative comparisons, each method boils down to subjective judgment, even if it involves investors choosing the discount rate (which has a surprising volatile effect on valuation) in a probability-adjusted net present value calculation. These more numerical methods can also involve comparing the target company to available price multiples (i.e. P/E, EV/EBITDA) from publicly traded companies.

Other methods, such as the Scorecard method, are more subjective. The Scorecard assigns weight to abstract qualities of a startup including strength of the management team and the strength of the product and technology. These percentage weights are then summed and multiplied by known valuations of pre-revenue companies within the same sector.

Below shows a sample spreadsheet demonstrating the Venture Capital method which takes into account after-tax earnings and the desired Return on Investment (Fig 2).

Venture Capital Method
Fig 2. The Venture Capital method is a common method used by venture capitalists who expect an exit between 3 and 7 years. “How to Put a Value on Your Startup.” SoMN SourceLink (http://www.somnsourcelink.com/resources/blog/blog/2014/03/04/how-to-put-a-value-on-your-startup).

Without reliable quantitative metrics, investors combine multiple methods to reach reasonable valuations that take into account both hard and soft factors. Several funds have even developed unique methodologies particular to an investment sector.  Overall, it is up to the investor to choose a methodology that best suits the target company and financial risk.

The lack of standardization creates a black hole of mystery surrounding the valuation process, with arbitrarily different valuations offered by different investors. Some services, including Worthworm, have developed their own comprehensive system facilitating transparent valuation generation between entrepreneurs and investors. Perhaps, as Silicon Valley and other startup hubs become increasingly wary of inflated valuation, services such as these will form the groundwork of consistent, intelligent and informed valuations.

Increasing Valuations Lead to Increasing Burn Rates
High financing rounds result in increased burn rates, the rate at which startup companies use resources to grow or retain talent. Venture capitalists, Fred Wilson from Union Square Ventures and Bill Gurley from Benchmark Capital, have called attention to the problem of increased burn rates (Fig 3). High financing rounds discourages founders from employing capital-efficient strategies in running their business and consequently present a large risk for investors.

Fig 3. Relative to later financing rounds, Series A burn rates have increased at a more rapid pace since 2012. Series A generally bears greater risk than subsequent rounds.  ”Silicon Valley Venture Survey - Third Quarter 2014" (https://www.fenwick.com/Publications/Pages/Silicon-Valley-Venture-Survey-Third-Quarter-2014.aspx).
Fig 3. Relative to later financing rounds, Series A burn rates have increased at a more rapid pace since 2012. Series A generally bears greater risk than subsequent rounds. ”Silicon Valley Venture Survey – Third Quarter 2014″ (https://www.fenwick.com/Publications/Pages/Silicon-Valley-Venture-Survey-Third-Quarter-2014.aspx).

Fred states in his post, “Burn, Baby, Burn,” that “Valuations can be fixed. You can do a down round, or three or four flat ones, until you get the price right.”

A down round is when a company faces a lower valuation at a subsequent round of financing than the valuation received in the previous round. An example might be a startup receiving a valuation of $8M in the Seed round, only to receive a valuation of $7M in Series A. A flat round would be the same valuation in two subsequent rounds. A down round results in dilution of ownership and is often interpreted as a red flag for investors, who regularly report their track record to limited partners that invest in the fund. A down round can indicate eventual failure for the startup venture; companies that experience down-rounds may have a difficult time in raising future interest and financing.

High valuations, however, increase the likelihood of a down-round, due to higher, corresponding expectations for value creation from the time of the initial round to the following round. For this reason, high valuations present risk to both entrepreneurs and venture capital investors, increasing the potential of a subsequent down-round.

While down rounds and flat rounds are viable solutions for the problem of increased burn rates, they are reactive and costly to both entrepreneurs and investors who lack full-ratchet provisions (provisions which prevent dilution of ownership in the event of a down round). Despite Mr. Wilson’s solution, according to Mattermark, more than a few VC firms are complicit in enabling burn rates through subsequent rounds of high valuations and financings. Could an investor’s fear of a down-round on their track record discourage more accurate valuations? Without a standard, it is difficult to determine to what degree one investor’s methodology is better than another’s guesswork and optimism.

So Are We in a Bubble?
Despite the concerns surrounding high valuation and financing rounds, I would be wary to call our present situation in Silicon Valley, a “Bubble 2.0,” which implies a significant and widespread economic upset. Capital is at a low-cost, and the demand on both sides of investing is still high. Innovation and investment are hitting all sectors, with no sign of interest slowing down. With more people becoming entrepreneurs, and everyone else becoming investors, I believe competition and a few high-profile failures will settle valuations to an appropriate point without requiring a market collapse. Standardization will help too, if anyone can figure that out.

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