The fallacy of relative valuations • Rude VC


There’s a pattern that tends to play out in startup fundraising, and it usually occurs in early-stage startup ecosystems, where people are still learning, or immediately following a major macroeconomic correction.

Both conditions are present in Japan today, so I’m not surprised to see some familiar themes return concerning startup valuations.

The story typically plays out like this: an early-stage startup raises a round of venture financing in a bull market. Thanks to extensive liquidity of capital, usually accompanied by market euphoria, the startup succeeds in raising venture capital at a healthy (if not outright frothy) valuation. Motivated to rise to the lofty expectations of their investors, startup founders prioritize development and growth, usually reflecting a business plan that counts on raising more capital 12 to 24 months down the road.

Then at some point in the interim, some form of generalized economic crisis hits. The crisis usually does not affect the startup’s operations directly, at least not immediately, but it does have an impact on the general appetite for risk and availability of capital overall in the market.

Meanwhile, the startup maintains focus and keeps executing. Some startups might sense the change in market sentiment earlier than others, and react more quickly, but overreacting to a false positive signal from the market can also be a misstep. Nobody has a crystal ball, so it’s unfair to expect the startup’s founders to make the perfect strategic call.

Almost regardless of how quickly they react, most startups in between rounds will still need to raise more capital. Some might be able to trim their sails, buy some time, and find partial solutions to help weather an incoming storm. But companies that had not yet reached the advanced stage of sustainable profitability – i.e. startups – will need to return to fundraising sooner or later.

This is the point when VCs usually notice a significant uptick in incoming deal flow over the transom, and this period represents a particularly challenging fundraising environment for startups. For one, most VCs have their own portfolio companies which are also facing the same environment of tightened liquidity. Additionally, the shift in the balance of supply and demand results in more startups competing for an increasingly limited supply of capital with other startups, including with the VC’s own portfolio companies, not to mention for a share of VC attention.

In this environment, the startup that is in between institutional funding rounds often finds itself at a disadvantage. They need to raise more capital in a challenging market. Worse, the valuation of their prior funding round often represents a high bar to clear in this new market environment. The startup founders may well have executed on all of their operational KPI targets, and essentially delivered on all of their promises made or implied at the time of their previous funding round. It is thus natural for founders to expect that their new funding around should take place at a higher valuation than the previous one.

The fallacy, however, is expecting a new funding round to be priced on a basis that is relative to the company’s prior round. External investors perform a different calculation. How much capital does the startup need to reach either steady-state profitability or its subsequent funding round ? In the case of the latter, what will the startup KPIs be at that future point, and what are the odds of success in continuing to raise capital ? VCs are reluctant to make an investment if there’s a slim probability that the startup would be able to clear its valuation threshold when it needs to return to the market for subsequent fundraising.

An unfortunate dynamic can emerge for the startup. They have indisputably made progress and created value, but they are competing for increasingly scarce capital from VCs who face two other categories of startups demanding their attention: i) their own portfolio companies who are confronted with similar market challenges and whom their existing VCs may need to bridge with internal financing rounds, and ii) investment opportunities in outside startups that had not yet raised VC money at frothy valuations and thus are able to price their funding rounds at levels commensurate with the new, downsized market benchmarks.

Given the turmoil in global markets these days, exacerbated by the nascent stage of Japan’s startup ecosystem, we are witnessing a rise in startups that find themselves in the above quandary. We are fortunate at Shizen Capital to have fresh funds to deploy. We try to be upfront with founders on the challenging environment, and address the valuation issue head on, even if it is a tough message to hear. We believe that it is a disservice to entrepreneurs to make them spend weeks in fundraising discussions only to discover that the gap in expectations about valuation is insurmountable.

We also try to figure out creative solutions for the startups that do find themselves in the predicament I’ve described above. Sometimes this results in the beginning a fruitful financial partnership where we end up investing. Yet even in the instances where we need to take a pass on the deal, we are genuinely interested to provide any constructive guidance that leads to a successful outcome for the team.

Go to Publisher: Rude VC
Author: mark bivens