Very True by Verissimo

Alex (00:02)
Okay, I'm back with another episode of Very True by Verissimo Ventures. And today I am going to talk about private company valuation, venture capital investment rounds, private capital and why it's unique in the world of finance, what founders should optimize for when they're raising a venture capital round, how to play the long game, doing what's going to benefit everyone in the long term and keep everyone on the same team versus what might feel good in the moment. And of course,

why it makes absolutely no sense to announce your post-money valuation in the media after you raise a VC round. So we'll start with why it's so unique. Most of the money that trades in stocks and in companies is done in the public markets. And public markets are almost always secondary transactions, meaning that there's a buyer and a seller and the company may not be involved at all.

And the dynamic that that creates is basically that you're taking a bet. If you're a buyer, then you're betting that the stock goes up. Now there's options you can buy, including you can short the stock and bet that it goes down. But when you buy it, you're effectively saying, I believe that it's going to go up.

there's this big question about overpaying for a stock and what does that mean? So in general, if you buy a stock today and it goes down tomorrow, that means that you overpaid. And you overpaid for two reasons. The first is that you could have gotten a better deal if you just waited a day. And the second is that the value of company

is now lower than the price you paid for it. So you'll lose money if you sell it. Now, if you hold it for a long, long time, then that won't end up mattering. But in that moment, that is the reality. So both of these reasons why you overpaid are entirely dependent on the liquidity of that asset that you're buying and the relative company stability. If, for example,

the company is growing their earnings per share at 1 % per day, then buying it today for $100 and tomorrow for $101 is effectively the same thing. This comes back down to the time value of money, net present value. And by the way, if a company is doing that in the public markets, then that's incredible and you should load up on it if everyone else hasn't already. But it's super important to recognize that these are transactional trades.

there's a buyer and a seller. And it's a secondary motion. And that is, again, how the entire stock market works. That's how most assets are traded. And it's really important to understand that. So now if we switch over to this weird thing that we call the venture capital asset class, which I'm assuming most of my listeners are well versed in, it's actually more unique than you might think. And there's a bunch of reasons for that.

The two main ones are that in the vast majority of transactions, you're buying primary rather than secondary shares and that it is completely illiquid usually. It doesn't have an open market that it can trade on. So the other big, big difference is that when you have a buyer and a seller here,

By the very fact that you're actually creating shares to sell and the money that those shares is sold for goes into the company's bank account means that actually everyone's on the same side. So the seller is the company. And as a result, the buyer and the seller are actually both expecting that the company grows and there's an accretion of value. Now, how they price it and all of that is a question of how much the company will grow and how quickly the

value of the company will increase. But this does represent a fundamental difference that that concept of primary stock of actually putting money into a company really changes the game. And so when people use terms like trading and buying names and really stuff that comes from the public markets, but when they use it in the concept of private markets and in the concept of primary stock purchases rather than secondary, it's really important to recognize that that this is

a fundamental difference. Now, if you look at the major hedge funds that do crossover I'm not going to name any names, but a lot of them are very famous and they've done extremely well. A lot of them mix in primary and secondary, and they'll trade public markets secondaries. They'll also sometimes do primaries, things like pipes and secondary offerings in the public markets. And in the private markets, they will do

very large late stage secondary transactions or now there's a bunch of employee tenders in some of these late stage companies. But more often than not, they're also just participating in the primary stock deals. And believe me, like these guys are really, really smart and they understand this difference very, very intuitively to the point that I think that it gets glazed over a lot. But for earlier stage entrepreneurs and earlier stage investors, I think it's really important to understand this dynamic of primary share issuance.

and how it impacts how we look at these companies. Now, of course, startups also behave very, very differently. They're much more volatile. We're mapping to a much longer period of growth and we're planning for a lot more change inside that company over the lifetime of your investment, which, by the way, is illiquid. So it behaves very, very differently from a public markets investment in a more mature, more stable company.

so I'm going to double click today on how we value companies at an early stage. And not just how investors do it, but really the purpose of what I'm sharing now is how founders should think about valuing their companies and what it's actually worth and what these different things mean. So I will start by mentioning one other really important thing, which is that generally when you're buying primary stock and investing into a company,

with fresh capital, you are buying preferred stock, which has what they say is called debt-like characteristics. And usually that comes in the form of liquidity preference, which means that in the event that a company gets sold for less money than its last valuation, it assures that the people who put primary capital in get their money back first and in some order of a liquidity waterfall prior to common shares, which

includes founders, employees, advisors, and things like that. So in the case of a private company, we're going to jump into my framework that I use, which is available on the verismo.vc website. It's actually the first thing on the resources page. And it's really just a PDF called, How Much Should We Raise? And I think it's really important for founders and for their investors to

jump into this and focus again on what do we know, what can we control, what can we not control, what makes sense, and how should we consider each of these variables to optimize for the long-term success of the company. So what we do know is the implied valuation of the financing round. We know the amount of capital that gets raised, and then we know also the projections and the budget of the company, and it's what it plans to achieve with that financing.

So pulling these things together and creating a framework definitely is a mechanical thing, but some of it is really, it's art, it's feel, it's instincts. And I actually put that job in a large part on the investors because investors' full-time job is to make investments. Their job is to finance companies, their job is to execute venture capital deals. Whereas founders...

Although some of them are incredible fundraisers and extremely well-versed in structuring and all of these things, that's not really why they have their job. They have their job because they know how to run and build an incredible business. And so you have this mismatch here, which at the early stage often results in, let's say, taking advantage or just misguided terms and valuations and...

all these different psychological games that get played between founders and investors. Later stage, it's usually a little bit more evened out in part because it's a little bit more clear how these things should work and in part because the founders are just more experienced.

So now I'm going to run through this framework and this document that I created to help founders and really their investors understand how to think about the flow chart and the iterative modeling process of how much should we raise. And there'll be a link in the description and the show notes.

how to find this document. So I always say, let's start with what we're really doing here. Why did we do this? We got in this business to build a company. And what does it mean to build a company? It means to grow that company. So I have another post that talks about the financial process, the FP &A process, how you go from building a model to understand the business mechanics.

to developing accurate projections that you can aim towards and then ultimately building the budget that you need to achieve those projections and execute on that model that you've built. So the first step is to figure out what are your goals in the next 12 to 24 months? Are those goals realistic? Will they get you where you need to be? Are there clear milestones? And then the second step is to figure out

what is the budget that you actually need to accomplish those goals? So that's why you have that process of figuring out the mechanics of the model, figuring out your forecast, which is usually where your goals sit. It's often a top line metric. Again, if you're a deep tech company, this stuff all works a little bit differently, but not so, so distinct. And then ultimately figuring out how much money it's gonna cost you and what is the budget that you need to spend. And by the way, if your net burn

which is, you know, your whatever's coming in, netted out of however much money is going out. It's funny because it's completely inverted from how every other company in the world talks about it. In venture, we talk about burn and net burn. Most people talk about profit and loss. So we've inverted this entire thing. But figure out what is that gross burn that you need to spend and then net that against what you have coming in the door on a cash basis.

And that will help you figure out how much money you actually need to raise to achieve those goals in 12 to 24 months. And then I say add a 50 to 100 % buffer on that for multiple reasons. The first is you don't know if you're going to hit those goals. You don't know how long it's going to take you to hit those goals exactly. Again, going back to my point of what is a startup, it's volatile. Things are changing really, really fast. Things can go up and down quickly. And so you need to have a buffer. So that, though, then gets you to the number of

How much money should you actually raise? ⁓ That's a dollar amount. It's pretty straightforward. It's the accumulation of losses over the next 12 to 24 months of your business with that buffer. Step two is you assume a 25 to 35 % dilution for the whole round. Now, we'll get back to how to think about dilution. Dilution is part of the equation. Ultimately, you've got just a couple of numbers here. You've got the amount you raise.

your pre-money and post-money valuation and then it spits out the dilution. Typically, venture rounds have been known to be 15 to 20 to 25 % dilution. The reason I say 25 to 35 % here is, and again, this is something that experienced founders know, but newer founders often miss, is that when you raise a priced round, you're almost always getting pre-diluted with an option pool. Now, if you already have a big option pool that you haven't used up, then it may not be so dilutive, which just means you

took the dilution earlier in your company life. But if you don't have that option pool, you're looking at a eight to 10 to 12 to even 15 % option pool. And this is a point of negotiation and it behooves the investor to get as big of an option pool as possible. Why? Because over the life of the company, you will need it. And it is a pre-money option pool, meaning it just dilutes the previous owners, including the founders, obviously, and employees, and not that new investor who's negotiating with round with you. Then

out of that equation, you get the valuation. So if it's a $25 million raise to keep it simple and a 25 % dilution, that pops out a $100 million valuation. Now again, that's a post-money valuation. So it'd be a $75 million pre-money valuation. Super important to understand safe notes are super vague. Convertibles can be vague and how all this stuff works. When the rubber meets the road and you do a priced round,

It is always pre-money. The share price, and you're using share prices, not just caps and valuations. It is a pre-money share price, and then you raise the additional capital out that on top at that share price is where the new shares are issued. So once you have that valuation number, again, let's say you came out with, we need to raise $25 million. We'll go on the bottom and we'll see 25 % dilution, $100 million post-money valuation.

Now you have to ask yourself this question, does this valuation make sense for where the business is right now? And if the answer is yes, then great, close the deal and get it done. If the answer is no, maybe it's too high, maybe it's too low, then you've got to play with the variables and run back through this whole cycle. So I'll give a few examples of here of, again, this big question of does this valuation make sense right now? And I'll talk about what you're signing up for when you actually

sign up for evaluation. So we'll run through first the case of that the valuation doesn't make sense right now and it's too high. So what would that mean? I'll give an example. A company that is at, let's say, $250,000 of ARR and they again are expecting to raise, they're saying they need $25 million over the next two years.

and $100 million post money. And outside some really unique cases and some really unique business models with funky dynamics, let's say it's, we're talking about like a more down the middle AI kind of software company application layer, know, $50,000 ACVs, four months sales cycles. You're just way off, right? I don't think the market's gonna bear that again, you never know, but the market's probably not gonna bear that. And so you probably need to adjust your goals because

By the way, your goals could have been to go from 250,000 to 25 million. And if you have a clear path of doing that, by the way, if your model is sound and you can sell that to investors, then by the way, maybe it's not too high. Maybe it's perfect. But, if your goal is instead, hey, we need, again, we're planning on burning $12 million in the next 18 months, let's say. And...

is it going to get us where we need to be to grow into this valuation? So I'll jump in. First, I'll talk about now where the valuation's too low. I had this with a company once where they were profitable. Their software solution was just selling like hotcakes, high margin, and they didn't actually need to raise money.

Now it's helpful to raise money and this is where the term growth equity comes from, which is that you're really just raising money to accelerate growth, but they were already in what I call the rarefied air of controlling their own destiny. They had achieved sustainable revenue growth. And I always say sustainable revenue growth sets you free. And they were free. And so when they went to market saying we want $25 million. But the company was already at

15 million of revenue. And so when they did this math and they said, well, 15 million, even let's say 20 % dilution, that's 75 post. And the thing is growing like a weed again, under its own weight profitably. Why would they raise money at a $75 million valuation? This thing should be at a much, much higher multiple. And they went through this and the valuation was too low. And so they increased the goals.

they increased the amount they wanted to raise and then they actually decreased the dilution. They ended up raising more money than that at a higher valuation and only taking 10 % dilution instead of 20 % dilution. So that can work that way as well. But now I'm going to talk about what these private valuations actually mean. And this is a big, big question. And I'll talk about, you know, philosophically what I believe. People may have different opinions, but

10 plus years ago when the big private equity firms started doing these primary venture deal, non-control kind of growth investing, venture growth investing in a lot of cases, And if, Blackstone, let's say put a hundred million dollars into a company and bought 10 % of the company, I always would say, what's the company worth? And the kind of answer that you spit back is,

worth a billion dollars. Now, if it was a public company and someone bought a hundred million dollars worth of stock and ended up owning 10 % of the company, say, yeah, the company's a billion dollar company, right? And, you know, obviously if the stock trades up or down, I'm not going to get into like control premiums for private equity buyouts necessarily, but often that would mean it's actually worth even more if someone tried to take, do a control buyout and would trade at a premium to that. But

Really important to understand that what I always posit is if Blackstone wanted to buy a company for a billion dollars because they thought the company was worth a billion dollars, they would just buy it. They have near infinite capital at their disposal. And if they really thought a company right now was worth a billion and had massively high prospects, then they would just pay a billion dollars for it. And that's not what they did. They put a hundred million dollars of primary capital into the company and now own 10 % of it. And so the answer to my question is

of what's the company worth? The answer is we have no idea what the whole company's worth. We have this issue of share classes. Now we've got primary capital coming in. So I always say the only thing that we know for certain is that the day that the $100 million hits the bank account of that company, that the $100 million is worth $100 million. now I'm gonna make one of my favorite points, which is that valuation for private company when raising primary capital.

represents a hurdle more than anything else. All it is is a hurdle for founders. Likely that whole company is not actually worth a billion dollars. It's probably worth let's say 400 million dollars. And the goal of a company and what companies do is they take capital and they turn it into enterprise value. And that is what a business operation is designed for. And so when someone puts a hundred million dollars into a company,

what they're actually betting on is that that company can take that $100 million of fresh cash, increase the enterprise value of the company so that it's worth at least a billion dollars. And that is the crux of venture investing. And this is also why trying to take a 5 % dilution round when you're not profitable is very, very dangerous. Because if you have a company, let's say again, like the example I used earlier, that's at $250,000 of ARR.

and they raise money at $100 million valuation, that really means that their next round has a floor of $100 million. Now, the market could change massively in that period of time, up or down. You know, we could be back in a hundred X multiple world where really they only need to get to 1 million of ARR. Or we could be in a world where multiples collapse and they could be at,

sub 10X for a company that's doubling or tripling in size every year, which is brutal, but it may be the case. so this is why the buffer is so important is that if you're a founder, you don't want to set yourself up where if you do everything right, the market can make a shift, not an insane black swan event shift, but a shift that represents something that has happened before and therefore could happen again, which again, SaaS multiples for high growing companies in the seven X range.

could very well be the case. And then you're looking at that and going, well, then we need to be at really 15 million of ARR. And let's say, again, we raised $5 million at a hundred posts. We're going to turn it go from 250 to 15 million. It could happen, but like, that's a tough bet to make. this is where founders beware. Also, if you have an investor that's willing to invest a really small amount of capital at a really high valuation,

that might feel good. I gave away this portion of my business. First of all, you didn't give it away. You sold it. There are now shares that someone owns and there is now cash in the bank of the company. And the whole reason to raise capital in the first place is that you believe that taking that primary capital in and having someone else own a portion of the company will result in a significantly larger pie.

to the point that it was worth taking that dilution, we'll call it. But again, it is a hurdle. And I'll pick on some of the greatest in the game, which is YC. They run an incredible model. But what they encourage their founders to do is take a bunch of dilution from YC, and then in their next financing round, take as little as dilution as possible for as long as possible. And it banks on the company being able to continue to raise money at an

outlandishly high valuation for how much money they're actually raising and what they hope to achieve for it. And if you think about what's made YC work, it's these mega successful companies like Airbnb. And so they're doing so many companies that if they get one Airbnb, then the whole thing works out. And their view is we want to own as much of that as possible. let's own, let's give a...

a generous, you know, I think they do 500K and then they own 7 % and have a safe for something else that's uncapped and it's all, you know, you can look up these terms. I don't have them in front of me. And that's very generous. But then they coach the founders to raise three on 30. Okay. The company's got $150,000 of revenue and they're raising three on 30. You know, they got to get to like $5 million of revenue on that 3 million bucks just to grow into that $30 million valuation.

And that, again, it's possible. And if you're a really high flyer, then great. But again, I made this podcast to talk to kind of what I call the rest of us. I'll interject now that I believe that there's a few different segments of companies. Let's say there's a hundred companies and the bottom 90 companies are just garbage. They're never going anywhere. They never had a chance. And that's fine. We'll move on. Then there's the top 10 of the companies. And that's all we're going to talk about.

That top one, and by the way, these percentages are not accurate for how the world actually works, but I think you'll get the idea. That top one, that's that Airbnb. That's that Uber. That's that company that is just absolutely on fire, game changing, incredible, just perfect founders, perfect market timing. Everything goes great. And there's nothing you can do to help that company. And there's almost nothing you can do to even hurt that company, you could argue, because we've seen companies like that.

go through some pretty nasty times and come out stronger on the other side. Companies in the two to five range are the ones where it gets really, really interesting, where they live a more, we'll call it realistic life cycle, which is there's ups and downs along the way. It's mostly up and to the right, but there's some hiccups. Again, maybe these hiccups are just in the market. Maybe those hiccups are operational. You never know. Maybe it's the product needs to be reworked and they lose six months.

These are all things that normal great companies go through. We're talking about two through five here. This is the top five, the four of the top five. And then six through 10, those companies generally don't have as big of upside as two through five and definitely not as one. But if they do a lot of things right, they will make money. Maybe not crazy, crazy money, but they will make money. Going back to the two through five section though, that's who you want to be. You really can't...

force yourself into being that one company. If you're that guy or that woman, like fantastic, go for it, make it happen. Take no dilution, take no prisoners, go for the gold. But most people realistically are aiming for that two to five category and you want to give yourself the margin to actually achieve that. So that is again, the point of the hurdle going back to this point of when you raise primary capital,

your post-money valuation is simply the hurdle for your next round. And the reason that the hurdle is there is that there are very few funds who want to do down rounds. So let's say you take that really aggressive round, you say, well, I might as well just go for it. And if it doesn't work out, like, fine, then we'll recap, we'll figure it out. Not a lot of investors these days want to do recaps. They just don't want to touch it. It's a lot of paperwork. It creates a weird vibe in the company. It's really hard to retain employees because their options usually get crushed and or

completely underwater. People would just rather not do it. And so you miss that hurdle and you're done. Like the story just ends. And so I always say, would you rather have a slightly smaller part of something or a larger part of nothing? And again, if you're one of those YC companies, maybe the answer is you're shooting the moon. You want that smaller portion of nothing because it's go big or go home. But for, again, for most people, it's better to have a little bit of cushion, a little bit of a safety net.

Again, obviously you don't play this startup game to play it safe, but it's still wise to have a little bit of a safety net. So I will talk a little bit more about this concept of now overpaying and what it means to overpay in the context of primary capital. So I participated in a seed round a couple of years ago that raised

$50 million on a $250 million post-money valuation. So you gotta ask yourself, seed? Come on, that's not seed. Well, it was the first money that the company raised. And also, what the heck are you doing investing in a $250 million valuation around that? I see that that just doesn't make any sense. And the way I answer that is it's not really a seed round. What it is, is it's a seed round, an A round, a B round, and maybe even also a C round all at the same time. And the reason that that happens in this market is that there's so much capital.

that if you get these ridiculously experienced entrepreneurs getting the team back together, building in a space that they know really well, you're not saying, this is definitely going to be a $5 billion company. You're saying that I'm very confident, like really, really confident that these guys can get to series C. Okay. They can get to series C. They can build a nice 10 to $20 million, let's say $25 million revenue business. They've done it before. There's every reason that they should be able to do it again. And there's so much capital that

they should be able to do it. And therefore the risk reward might make sense. And so the question is, that overpaying or is that just paying ahead? Now, I always say, we don't know if we paid ahead or if we overpaid until the story ends, until five or 10 years later in some cases. And it's hard to make that call. But what we do know overpaying is, is that 5 million on a hundred post round. I think that's hard to show.

for again, for a company that's burning, for a company that's not at scale. It's hard to say that that's anything besides overpaying. And again, maybe they'll out achieve, maybe it'll work, maybe the market will support it. We'll still have 100X revenue multiples flying around, but it's hard to make that bet. If you think about the percentage chance of that working versus the percentage chance of that not working and what that might look like, it doesn't seem like a wise investment.

But hey, what do I know? I'm sure it's worked out a handful of times.

This is all to say that this primary capital, venture capital investment motion is unique. It can be extremely powerful. There's something extremely elegant and beautiful about the investors on two sides of a trade actually being on the same team. They both want the company to grow and be successful. If you're trading a public stock, again, you buy it, you hope it goes up and whoever sold it is...

kind of hoping that it went, that it goes down, or at least they're expecting that it goes down. They might not be rooting against it, but they might just think that it will. Again, in venture, there's this beautiful thing that everyone can be on the same team. And so the best way to keep teams together though, is to make sure that they are economically aligned. there's always risk that you're not gonna achieve this big long-term exit. You don't know what's gonna happen. The whole world can change. We've had that happen a couple times over the last several years in ways that people really didn't expect.

Some people it was a great, some people it was killer. But what you really wanna set yourself up for is reducing the risk of not just being able to get through your next set of milestones, regardless of what's going on in the market. And that's how you set yourself up for short term, mid term and long term success. Hope this is interesting. Remember to check out the resources page on verisimo.vc. I will share a link below and...

Feel free to reach out with any questions. We've now got a Q &A submission form, so feel free to submit questions there and I can address them hopefully in future podcasts.