Tag Archives: valuation

BILLION DOLLAR UNICORNS

Kenneth M. Freeman

The world seems captivated by the growing number of unicorns – private companies theoretically worth more than $1 billion based on their latest round of funding. There are now more than 100 unicorns, led by Uber with a valuation of $66 billion.

unicorn-from-ms-office

If you were an early investor in any of these $billion+ gems, you’re winning big!  But what about investors who got in on the latest fundraising rounds?  Are the bragging rights of an expensive unicorn deal worth losing money on your investment?

The traditional venture capital investment formula is to select promising ventures early, while valuations are still low. Selecting several young businesses adds diversification and improves the likelihood that one or more will become a success.

While many unicorns have achieved notable marketplace success and will undoubtedly survive and thrive, their current valuations strain credulity, leaving late-round investors vulnerable to substantial losses. How likely is a big win when the venture is already valued at $10 or $20 or even $50 billion?

Uber’s annual revenue run rate is expected to exceed $10 billion by year-end. They retain 20% or $2 billion, which, with many markets left to conquer, is impressive.  But do these numbers justify a valuation of $66 billion? Remember, a future value of less than $66 billion for Uber will mean a financial loss for their latest investors.

Airbnb’s 2015 revenues are estimated at $675 million and projected to reach $2 billion by 2020.  Their latest investment round puts their worth at $30 billion. 2014 revenues were estimated at $900 million for Square and $600 million for Palantir. These companies aren’t likely to go away. But do these numbers justify valuations of $5 billion for Square and $25 billion for Palantir?  Is Snapchat (with still negligible revenues) really worth $22 billion?

Many venture capital investors say traditional valuation methodology – the net present value of projected future discounted cash flows – is impractical for venture capital.  They suggest that venture capital valuations rely on perceived potential along with passionate commitment and a dose of hope.

But valuations at early stages appear to implicitly reflect traditional valuation logic.  They recognize the riches of potential success, albeit impossible to quantify precisely, while discounting those values sharply to reflect low success odds and inherent risk.

The problem with unicorns’ soaring valuations is that they seem to assume the stars are perfectly aligned and everything will go right.  That rarely happens.  Yes, it largely did for Microsoft, Google and Facebook, three huge winners over the past 40 years.  But how many of those are there?  Even Apple had to survive near disaster before its remarkable success.

What if governmental regulations block portions of Uber’s or Airbnb’s planned expansion?  What if Uber drivers are ultimately ruled to be employees rather than independent contractors, changing the company’s fundamental economics?  The risks are even greater for unicorns with more limited revenues today (and most with large losses).

We at VCapital, are not interested in ventures already valued at $1 billion+, where a return of 10 or 20 times investment is far too unlikely.  Gambling in Las Vegas might be a better bet.

We believe in the historical venture capital success formula, focusing on early fundraising rounds – after venture potential is qualified through angel/seed funding but before valuations escalate wildly.  For early stage investments in ventures valued at $5 or $10 or $20 million, while most fail, success could mean an exit valuation in the tens or even hundreds of millions of dollars.  A few of the ventures we’ve supported over 30 years have even exceeded valuations of $1 billion, but you can’t count on that.

This has worked well for our team over three decades.  While the VC industry’s average venture success rate (i.e. achieving any positive return on investment) is about 20%, through rigorous due diligence our success rate has averaged 37%, and our investors’ annualized returns have averaged well above industry norms.  Delivering an attractive return to investors requires a few exits at 10, 20 or more times the initial investment to offset the 63% that come in as modest winners or complete loses.

So why are later-stage valuations soaring to stratospheric heights?  We think it’s due to FOMO—Fear of Missing Out.  Getting in on a unicorn round is great for bragging rights, but for late-stage investors, getting out with a profit may be tough. We’re betting FOMO results in lots of loudly bursting unicorn bubbles.

We’re not concerned about a repeat of 2000’s broad dotcom bubble, which devastated the finances of millions of Americans, since today’s soaring valuations belong to companies that are still private. Their investors are primarily institutions and ultra-wealthy individuals who can weather the risk, so impact will be contained.

We are concerned, though, that a series of loud unicorn bubble bursts could cool the flow of investment dollars feeding life-changing innovation.  That would be unfortunate, since conditions for tech-enabled start-ups have never been better. It would also be unfortunate for the 8 million+ accredited investors (defined by the SEC as having net worth of $1 million+ excluding primary residence or ongoing annual income over $200,000), who finally – thanks to the JOBS Act – have access to professionally managed venture capital investing.

We believe that following the historical venture capital success formula will continue to generate attractive returns for investors who stay focused on pursuing strong ROI. In contrast, late-stage investors in pursuit of bragging rights to unicorn deals will increasingly find themselves under water.

Kenneth M. Freeman is the Strategic Marketing Advisor and Member of the Board at VCapital, LLC   http://www.vcapital.com/

This article appeared in NEWS FROM HEARTLAND

Image from MS Office

Chicago Venture Magazine is a publication of Nathaniel Press www.ChicagoVentureMagazine.com Comments and re-posts in full or in part are welcomed and encouraged if accompanied by attribution and a web link. This is not investment advice. We do not guarantee accuracy. It’s not our fault if you lose money.

.Copyright © 2017 John Jonelis – All Rights Reserved

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SOURCING STRATEGIC INVESTORS

Monopoly Investor MS Office clipart TPart I – Funding your Business with Strategic Corporate Investors

by Laurence Hayward

It’s common to think of strategic investors, or strategics, as large established corporations that make equity investments in entrepreneurial ventures (and that is precisely how the Kauffman Foundation defines it). However, the reasons they make these investments vary and are more subtle than the definition implies.

The obvious reason is to gain a strategic or operational advantage by investing in emerging technologies. But let’s give it a bit more color.

  • To serve as a single contact point for emerging technologies, which historically can get lost in the organization.
  • To fill the gap in the capital markets where meaningful innovation needs to occur.
  • To align interests between several technology companies, which bring value to the corporate enterprise.

Corporations also create open innovation programs and becoming limited partners in independently managed venture capital funds. A corporation need not have a dedicated fund division to be actively involved in the world of venture-backed companies.

Monopoly Investor MS Office clipart

 

Corporate VCs

A strategic, in many cases, wants just the opposite of the typical venture capital operation. A VC fund is operated by a team of professional asset managers backed by limited partners as part of a financial return strategy. Much like the average investor in stocks and bonds, one doesn’t tell his mutual fund manager what to do. Like the average investor, limited partners often want little or no connection to the assets managed. They seek capital gains, not strategic or operational benefits.

This distinction was not always so clear. In the heat of the late 90s, corporations caught the private equity bug and many large companies entered the venture game—with or without venture experience. Companies often targeted companies not strategically aligned in product or service. It didn’t end well and many of these initiatives terminated. Today, I see corporate investors making significant efforts to ensure business unit alignment—seeking an operational benefit in addition to a financial one.

Today, corporate venture capital is experiencing a renaissance, but one more circumspect than in the past. This marks the strongest year since the crash of 2000. According to National Venture Capital Association, corporate venture groups invested $5.4B in 2014 accounting for 11% of all venture dollars invested.

Large corporations are playing an increasingly critical role in financing important technologies. There is a distinct lack of non-strategic investment in vital sectors such as Cleantech, Agriculture, Material Science and Advanced Manufacturing. (Cleantech investors themselves want more competition.) Because companies in these sectors tend to be capital intensive, with extended sales cycles, financial venture firms are straying back to traditional areas of focus such as Infotech.

Fortunately, strategic investors have stepped in where financial investors have exited. This is important. Many of these companies are commercializing breakthrough innovations that benefit mankind. Government research dollars alone cannot bring them all to market. I’m reminded of a cover of MIT Technology Review featuring Buzz Aldrin saying, “You promised me Mars Colonies. Instead, I got Facebook.”

 

Types of Strategics

Many entrepreneurs in underfunded sectors ask how to work with strategics. Just like other types of investors (angels, family offices, venture capital firms, etc.) there is a wide spectrum. They don’t all approach deals the same way.

Many strategic investors begin by making investments from their balance sheets through operating divisions within the company. This important activity may not be captured in the industry statistics, which represent more formalized venture funding.

Other firms set up a separate venture capital unit, in some instances as a separate corporate entity or business unit. This is done for a variety of reasons including internal organizational considerations for the strategic, but it is also done to address a key concern of the entrepreneurs, such as, “Will the strategic attempt to tie me up in some way?” Separate venture capital units are designed to avoid these concerns.

In most of strategic transactions, the investor seeks some special rights in addition to the purchase of equity. These can come in the form of distribution and supply agreements, license agreements, exclusive rights to product/technology, right of first refusals (ROFRs) for sale of the acquired company, preferred pricing arrangements and so on. It is critical for the entrepreneur and any co-investing financial investor to understand the implications of the agreement before beginning discussions with a strategic. These terms can make a significant impact on a company’s ability to pivot, its opportunity to exit, and ultimately its valuation.

For example, most venture capital funds will advise their entrepreneurs that ROFRs are a non-starter—and with good reason. A right of first refusal in the sale of the company can make a competitive bid or auction process entirely impractical. Why would a competitive buyer delve deep into diligence if they know the company holding the ROFR can sweep the deal away from them at the last minute? The potential buyer will also wonder how deeply entrenched the company is with the strategic owner and be concerned with competitive disclosure issues. The ROFR can restrict an entrepreneur’s ability to maximize value in an exit and inhibit a true auction-like environment.

Remember the objective of most venture-backed companies is extraordinary returns, not average returns. From the perspective of the entrepreneur and the non-strategic investors, it is not about seeking a fair price in an exit, it is about getting the best price possible.

 

Separating Equity from Everything Else

Many strategic investors in formally run venture capital units do not necessarily seek to become eventual acquirers of the companies in which they invest. And they often avoid conflicts such as ROFRs. Strategic and operational gains can be found in other ways.

For example, the gain can be a customer, distributor, supplier, etc. It can be first to market with a new technology. A distribution or supply agreement can be of great benefit. For example, imagine a small company that quickly gains access to global distribution of a large corporate enterprise. Therefore, a key consideration is the value of any arrangement outside of or in addition to the exchange of equity.

It’s important to account for any exchange of value above-and-beyond the equity. For example, a license provides value via access to technology. Such agreements often include upfront payments and royalties for the value of the technology to the strategic. A company will want to clearly capture and specify this value.

 

Too Many Cooks

An entrepreneurial venture will require multiple types of investors over time. If an angel, a venture capital firm, and a strategic invest in the same company, how do you ensure they have equitable value especially if the strategic is getting “extras”? On the one hand, access to the emerging company technology might provide the strategic a major competitive advantage in the marketplace. Then again, the strategic investor might bring added value that the angel investor can’t. What is one to do?

The answer is to account for each unique benefit with a discrete standalone agreement, separated from the equity arrangement. For example, if there is access to technology, then structure a separate license agreement. On the flip side, if the strategic is providing access to new markets, a distribution agreement might help ensure fair compensation for selling the company’s product. In other words, price “extras” separately where possible.

At some point, equity interest and operational interest may diverge. For example, a strategic may at some point elect to exit an equity position, but might still want to have an operational relationship such as a license with the company. If those are intermingled in the original agreement, separating them may become a challenge.

In short, meticulous accounting is required for operational and strategic benefits. They need to be valued separately from the price of equity. After all, the price paid for equity involves a fair exchange in percentage ownership in the company just as provided to any other investor.

 

GO TO PART II

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Laurence Hayward | lkh2@theventurelab.com | VentureLab | 2100 Sanders Road | Northbrook, IL 60062

This article is abridged from News From Heartland and TheVentureLab.

Copyright 2015. The VentureLab

Image Credits – Parker Brothers via MS Office, Laurence Hayward

Subscribe to Larry’s articles at http://theventurelab.blogspot.com/

Chicago Venture Magazine is a publication of Nathaniel Press www.ChicagoVentureMagazine.com Comments and re-posts in full or in part are welcomed and encouraged if accompanied by attribution and a web link. This is not investment advice. We do not guarantee accuracy. It’s not our fault if you lose money.

.Copyright © 2016 John Jonelis – All Rights Reserved

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