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Follow-up from RRE Post

November 8th, 2008

rre logo Eric Wiesen from RRE was kind of enough to provide some add-on thoughts regarding valuation.  He posted them as a comment in the previous post but because of the wordpress theme that I use I don’t feel like comments are easy to find (I’ll get around to fixing that one day).

Thanks for the additional insight and commentary Eric!

Here’s a reprint of what Eric had to say:

Sanjay – just to clarify a bit of my post on “What we want to hear”, I think you have hit the nail on the head when you ask the question – how do we find ideas that are big enough? It’s not that teams or their ideas aren’t good enough. But one of the first lessons any investor learns (hopefully the easy, academic way and not the difficult, practical way) is that success in a small market just, well, doesn’t matter very much. If you are targeting a $50 million market, even if you are hugely successful and take 50% market share, you top out at a $25 million business. That’s a good business, but if you step back and think about it from the investor perspective, it doesn’t justify the level of risk.

In that example, imagine that you actually get to $25 million in year 5 and can sell it for 4X revenues (in a market where there’s virtually no headroom for growth, this is optimistic, but let’s assume it anyway). You’ve got a $100M exit. That’s a nice exit. If I invested in you at $10M post-money valuation, I’m looking at a 10X return, and that’s a great return.

The problem, as I hopefully communicated at Five Years Too Late, is that we cannot simply assume that you will achieve best-case scenario. We have to discount for the very real possibility that you will not. Further, the rosy scenario where I fund this company at $10M and it exits for $100M and I make 10X assumes that they never need to take additional capital, which is a rare outcome. If another round needs to be raised, I am looking at having to put in more money at a higher valuation (but with the same upside) and probably taking dilution from new investors.

Now this is the world in which early-stage investors live in, and that’s fine. We know that it’s going to take a lot to get a new company to a big outcome, and that the process is fraught with risks. We are making bets on very speculative companies by their very nature. Without the belief in a big exit, it just doesn’t make sense. If you prefer the MBA approach, the discount rate required for this type of investing makes those investments with limited upside of questionable value when you consider the time it will take to get there in most cases.

So ultimately, I think you are looking at this the right way, the way I suggest on the blog. Entrepreneurs who want a firm like RRE to invest should try to have a product and market vision that’s large enough to justify the type of valuation that a Series A venture-backed company requires. Alternately, there are other investors who may be interested in companies promising smaller outcomes, but if they are rational they will need to envision lower risk to make the math work. There are examples of investors who invest in high-IP, post-development/pre-market companies where they believe risk has been taken off the table. These investments can have a lower upside and still make sense.

Hope this is helpful

 

Link:  Original comment here, Five Years Too Late – RRE blog

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