Valuation and Investment Decision Making
Brett Munster
Recently there have been investment opportunities that have sparked a lot of debate internally at AITV. The conversations I am referring to were not centered so much on the companies themselves, as we all agreed that we believe these companies are likely to be very successful (though only time will tell), but rather, on valuations. It is undeniable that valuations are frothy and I am seeing it first hand. I should say that during my time here, we have walked away from more than one opportunity because the price tag was too high. However, in the case of these two companies we decided to move forward even though the pre-money is a little higher than we would like because we have such strong of conviction about the team, the tech, the market and the company.
As a young investor, getting to live through these decisions is simultaneously thought provoking and nerve wracking. Admittedly as an associate, while I have influence in the firm, I do not make the final decision. If the investment does not work out, I am not the one the LP’s will look to for answers. But I still feel just as accountable as our GP’s do, so I constantly ask myself, “If it was solely my decision, what would I do?” I often force myself to come to a decision and do my best to articulate my argument during meetings. I do not know if I am right, and will not for a while, but I have found it has been valuable to the firm and has provided me an amazing learning experience that when I am hopefully partner one day, I will be all that more prepared to handle these situations.
While I am still forming my thoughts on the subject of valuations and welcome debate, below is what I believe to be true through first hand experiences.
- A small difference in valuation at the early stage does not matter — Yes valuations are frothy and if you are paying twice as much as you would otherwise would have a few years ago, that will significantly impact returns. However as an earlier stage investor (Seed through Series B), whether you pay $8M or $10M in a Series A or $20M or $25M in a Series B does not make that big of a difference in the long run. If you believe in the company, get the deal done (just ask Paige Craig about his $1B lesson). If the company is a success, you will make great returns regardless of whether you paid slightly more. If it busts, you lose regardless and if it is a mediocre investment, those do not generate the majority of the returns for the fund anyway. As Chris Dixon wrote, its all about the grand slams and if you are early in that kind of company, you will make phenomenal returns for your LPs even if you paid a little more.
- Terms matter more than valuations — I am a firm believer that terms should be simple and straightforward, especially early on. Complex terms early only cause headaches in latter rounds, believe me I have had to work through many of them. I have also seen very predatory term sheets in previous financing rounds from other investors that entrepreneurs got screwed even though they thought it was a great deal because the valuation was what they wanted.
- Ownership matters more than “reported valuation” — Do not be fooled by the valuation reported in the press. Yes it makes for catchy headlines but it does not tell the whole story. I have seen numerous investors that paid a high price but lowered their effective valuation down through warrants, secondaries, and other means. At the end of the day, this is a cash on cash return business and the amount an investor returns is directly correlated to its ownership and terms in the term sheet. While valuation plays a large role in that ownership percentage, it doesn’t tell the whole story.
- Raising too high of a valuation too early does more harm than good — If you can only grow into your valuation by the time next round, that’s not good for the company, investors, employees, or founders for numerous reasons. Not only could it set the bar too high leading to a down round, it can also negatively impact employee morale.
