Stuart
Paterson, Director, Information
Technology, SEP
The
Value of Venture Capital
How do VCs value
young companies and is a higher valuation
always better? By Stuart Paterson
Contrary to popular
wisdom, VCs consider it vital for entrepreneurs
to be comfortable with the valuation of
their company so that they are highly motivated
to succeed.
Critical factors affecting valuation
are the prospects for returns and the inherent
risks associated with getting there. VCs
focus on the prospect of a significant
capital gain so potential exit value is
key. Factors influencing this include the
size of your market, your likely share
and revenues, and above all, the likelihood
of attracting a trade buyer or achieving
IPO.
VCs need at least a 3x return on their
investments overall to make the economics
work. Situations differ, but since
some companies inevitably fail, a high
risk start-up requires the potential to
achieve at least a 5x return. A prospect
of 10x can lead to a higher initial valuation,
providing that is a credible outcome.
The
earlier the development of both company
and market, the higher the risk. Valuations
take this into account. VCs also factor
in how strong and sustainable your competitive
advantage is and the experience of the
management team. They consider whether
the product can be easily copied and how
you will take it to market and achieve
revenues?
Securing the participation of
a syndicate of high calibre VCs at the
start of the funding process can help attract
other VCs to subsequent rounds. You should
focus on attracting investors with a real
knowledge of your sector and realistic
expectations and time horizons to avoid
being pushed into a premature exit.
You
may need very large amounts of capital
to succeed. For example fabless semiconductor
businesses face high costs in designing,
developing and marketing their technologies
while information and communications technology
companies have to offer complete solutions
including software and subsystems. VCs
will not usually commit total funding requirements
up front and will more likely invest in
stages once certain milestones have been
met, so companies should aim to see an
increase in valuations in successive rounds,
as well as at IPO or exit.
A very high initial
valuation isn’t
necessarily the best thing and it is better
to take a long term view on building value.
Many VCs won’t invest in A rounds
because their value hardly increases in
the B Round, resulting in limited reward
for taking a high risk in investing early.
If
initial valuations are excessive, investors
may think the next round is too expensive.
Worse still, if your initial aggressive
assumptions aren’t sustainable, a
round with a lower valuation means giving
away a lot more equity. Take a realistic
view and remember that it is in the interests
of the VCs for you to be incentivised to
deliver long term value.
Consider carefully
the milestones you need to hit to demonstrate
that you are making solid progress at each
round and remember that it usually takes
longer to achieve them than you think.
You should prepare for fundraising nine
months before you need the cash as being
forced into unplanned financing results
in greater dilution . Raise enough at each
stage to achieve the milestones which will
trigger more funds in subsequent rounds
and take more than you need if it is on
the table.
First round valuation is less
important than attracting the best VCs
who can add real value as well as capital.
It is important to consider whether you
can be open and honest with them, whether
they have realistic expectations concerning
the development of your company and whether
they will provide the follow on investments
you need. That is the way to maximize your
valuation when it really counts – at
exit.
“The
investment community is necessarily
cynical by nature and must be persuaded
that the opportunity is real and
that you have what it takes to
be the market winner. The business
plan produced by CSR’s founders
convinced the first-round investors
that they could make the breakthrough,
while the rest of the industry
simply rejected the idea that a
high-frequency radio could be built
in bulk CMOS, let alone integrated
with the baseband and memory and
turned into a system with endless
software requirements. Those first
VCs placed their faith in us as
a team more than anything. They
maintained confidence in us throughout
the subsequent rounds and were
well rewarded for their trust.
For those companies aiming to follow
in CSR’s footsteps, from my
experience some of the rules of funding
are, first, raise far more money
than you think you’ll need
to avoid expensive and time-consuming
additional rounds. The well-known
cliché that “cash is
king” is absolutely true, and
the CFO needs to be a Scrooge at
heart who can ensure that all levels
of the organisation understand that
each dollar raised can only be spent
once.
Second, raise money before you need
it and always set up a competitive
process to ensure the valuation of
a round is set by the market. Securing
funding is more important than the
source, although VCs and strategic
investors with respected names do
usefully lend their stature to an
enterprise. The price of the money
and consequent dilution is less important
than getting enough resources to
do the job, and it helps to remember
that it always takes longer than
you expect to deliver on the commitments
made.”
John Hodgson, former CEO of CSR
This article was first produced as part
of the National Microelectronics Institute
Private Equity Guide. The guide is available
online and can be downloaded here.
