The VC Conundrum: Distorted Valuation Methodologies and Misaligned Incentives in the Startup World
Venture Capitalists (VCs) are vital to the startup ecosystem, providing the essential capital and guidance needed for startups to succeed. However, the prevailing valuation methods within the VC industry are often misunderstood and may have unintended consequences. This article explores the challenges posed by the current valuation practices and makes a case for the need for a new paradigm.
VCs’ reliance on the current valuation method is closely tied to their own fundraising dynamics. VCs generate income through management fees and carried interest. The larger the pool of capital they manage, the more significant their earnings from management fees and, ultimately, carried interest. Consequently, many VCs aim to raise additional funds as soon as it’s feasible.
Naturally, a strong track record of success significantly facilitates the fundraising process for VCs. But how is this success determined?
Measuring VC Success: ROI for LPs
VCs’ performance is assessed primarily in terms of the return on investment (ROI) they deliver to their Limited Partners (LPs). This performance is intrinsically tied to the valuation growth of the companies within their investment portfolio. It’s crucial to note that evaluating performance during the fund’s tenure, especially when some portfolio companies have not yet exited, is a complex challenge.
Valuation Determinants
Contrary to common belief, performance is not solely dictated by the underlying financial metrics of the portfolio companies, such as revenue growth, profitability, or other key performance indicators. Instead, the cornerstone of VC valuation practices is the reliance on subsequent equity fundraising rounds to determine a startup’s worth. While this approach has been traditionally followed, it introduces certain biases and shortcomings that merit reconsideration.
Consequences of Valuation Based on Fundraising Rounds
First, it’s important to recognize that all company valuations are subject to the whims of subsequent investors and the broader fundraising environment. Second, and perhaps more critically, if companies do not seek additional equity capital, their valuations remain stagnant until they ultimately exit. Consider this scenario: highly successful companies experiencing rapid growth may finance that expansion through their existing cash flow or through the use of debt, without the need for additional capital. Does this mean their valuations have not appreciated? Quite the opposite.
Valuing Companies Beyond Fundraising Rounds
For instance, let’s say I invest in a company with an annual recurring revenue (ARR) of $1 million, burning $100,000 per month. A year later, that same company achieves $5 million ARR, becomes cash-flow positive, and has not raised any additional equity capital. Does this imply that the company’s worth remains the same as when I initially invested? Absolutely not. In the event of an acquisition, the company would command a significantly higher price than it would have a year earlier. This underscores the genuine value of a company — the price at which it would exit. Furthermore, because the company has refrained from raising more capital, investors have not experienced dilution, thereby increasing their ultimate ROI.
The Challenge for VCs
However, VCs must confront the typical 10-year fund lifecycle. They cannot afford to wait for portfolio companies to exit before raising a new fund. To secure new funds, they must demonstrate strong performance within their current fund portfolio to potential investors. The market demands insight into the value of these companies before they exit. Consequently, VCs frequently adopt a straightforward yet problematic shortcut to ascertain valuations — they rely only on valuations from subsequent equity fundraising rounds. This method does not accurately reflect the valuations of companies that may be incredibly successful and do not require additional equity capital.
Impact on VCs’ Investment Approach and Incentives
Regrettably, this approach can distort VCs’ investment mindset and misalign their incentives. As they strive to secure additional funding, they are compelled to prioritize meeting LPs’ demand for performance data before the conclusion of their current fund’s lifespan. Rather than solely concentrating on companies with the highest chances of success, VCs are driven to invest in businesses with the greatest likelihood of securing additional equity rounds at higher valuations. Ironically, the most successful companies — defined by the highest return on investment (ROI) for investors — are often those that require minimal or no additional capital.
Our Investment Strategy: Capital Efficiency Pays Off
In our capacity as investors, we have consistently achieved the highest ROIs from the successful companies in our portfolio that require minimal or no additional capital. This approach shields us from dilution, and these companies exit the market at significantly higher valuations compared to startups that continue to burn cash. Acquirers value their success and profitability, whereas the valuation methods employed by VCs prior to an exit may not adequately capture this value.
The Ramifications for Capital-Efficient Companies and Patient VCs
This prevailing valuation practice disadvantages capital-efficient companies, including those that are cash flow positive or financed through debt, by making it more difficult for them to raise capital in initial rounds. VCs are more likely to pass on these deals because they would be unable to benefit from the mark-ups allowed by future rounds. Furthermore, it poses fundraising challenges for those rare VCs who maintain a patient investment approach and support capital-efficient companies. Forgoing the short-term advantage of higher valuations in subsequent equity rounds makes it more difficult for them to raise a new fund. It is time to find a better way to measure VC performance.
Phil Nadel is the Co-Founder and Managing Director of Forefront Venture Partners. Follow him on Twitter: @NadelPhil or on Medium at https://medium.com/@pnadel or connect with him on LinkedIn.
