???????? Hi friends!

With only one day left of my summer in Italy, I will soon revert from complaining about the heat, to… complaining about the grey skies and rain in London.

Maybe I’m just a bit of a goldilocks?! ????

In this weeks Off Balance, I’ll be chatting about skin in the game and some of the numbers behind the barriers to entry for people of colour when trying to build a startup (or any business). I’ll also speak about why mentoring matters and we’ll deep dive into valuations.

All of that will be followed by a look at what else has been happening in the world of tech and venture in this week’s Lowdown.

Also, don’t forget to check out this week’s guest on the Nothing Ventured pod, Matt Jonns. He’s founder of Founder and Lighting, a somewhat non traditional dev agency that invests in and builds tech businesses with non technical founders.

You can listen to the Primer episode here with the main episode out on Friday 1st September.

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (do I really have to start calling it ‘X’ soon?), Instagram and now even Threads and drop me a note 🙂

Don’t forget to like, rate and subscribe to Nothing Ventured on Apple, Spotify or YouTube, it really helps more people see what we’re doing!

Now let’s get into it.

Skin in the Game

I would normally reference an article that had been doing the rounds on social media in this section, but instead, I wanted to draw attention to a recurring theme that I, and my guests, talk about on the pod – often unintentionally.

And that’s representation.

Or the lack there of.

I started thinking about this concept of skin in the game, and it resulted in writing the following post:

You can’t be very serious, you don’t have any skin in the game…

This ‘established wisdom’ within the early stage ecosystem has got me thinking.

A lot of investors, and hence founders, have a belief that if you haven’t put your money where your mouth is, then you haven’t shown the sort of grit / determination / hustle that you should demonstrate as a startup founder.

But here are some facts:

???? Per Crunchbase, funding to Black and Latinx founders in the US peaked at $4bn in 2018, out of a total of $141bn invested in the US that year – that’s 2.8% of total funding at peak.

???? Per Pew Research Center, median household income for Black US households in 2021 was $46,400, a full 40% lower than non Hispanic white households.

???? And as for generational wealth? This quote from Synchrony says it all:

“In the Black community, building generational wealth hasn’t been easy to either attain or maintain, for multiple factors. Comparatively, Black families achieve considerably less wealth than white families, with a median net worth of $24,100 compared to $188,200.”

So let’s think about this… in the US (which accounted for just under 50% of total VC investment in 2021 – $330bn out of $671bn), minority founders are:

– Less likely to receive funding

– More likely to have a lower income

– Less likely to be from families / communities with generational wealth

But yet, we still talk about needing skin in the game.

And this is just one example.

I haven’t mentioned female founders with young children or people from developing nations that are systemically excluded from certain services.

The same could be said for emerging fund managers who are required to fund their so called ‘GP commit’ as part of the total fund.

I am a very lucky individual.

I bootstrapped one of my businesses and, when I ran out of cash in the other, was able to take out debt to leave the business clean. I knew if things fell apart, I’d be able to take myself to my parents place and get back on my feet.

But so many people simply don’t have that option.

So many people can’t raise money from friends, family and ‘fools,’ because their friends and family don’t have money and didn’t go to the ‘right’ schools.

They can’t risk going all in because if they do, they don’t have a parent’s house they can fall back on.

And yet, even though they already come from communities that receive the least amount of funding, they may be further penalised for not having ‘skin in the game.’

This has to change.

Entrepreneurs should not be brought to the brink of bankruptcy, mental breakdown or familial collapse to build a better future.

So how do we encourage more people to take that plunge?

How do we level that playing field and give everyone at least the opportunity to take a risk?

What are your thoughts on this? 

Hit me up in the comments here, or join in on the discussion on LinkedIn – I’d love to get your views ????????

How can did I add value?

I’ve mentioned my friend Rahim before, in fact in one of my first newsletters. And I’m only bringing him up again because, over the years he has been what I can only describe as an informal mentor to me. When I first came back to the UK, he set me on the path I’m now on.

Rahim recently wrote about his relationship with his own mentor who sadly passed a year ago and how, he had found that mentoring – which he does openly and enthusiastically – is one of the core pillars of how he thinks people should build and grow their careers.

OK, so that’s how he was helpful, but what about me?!

Well since that informal mentoring with Rahim, I have acted both formally and informally as a mentor to a number of people myself.

It’s fulfilling being able to help people who are at an earlier juncture in their career than I am. But I’ve also realised that mentoring can, weirdly, help you identify areas where you yourself can also seek more guidance.

One thing that’s worth noting is the difference between mentoring and coaching:
Mentoring – you’re typically giving someone the value of your experience
Coaching – you’re holding a mirror up to someone so they can find the answers they already have

Last week, I was asked to have a conversation with a CFO who had joined a later stage startup.

I won’t go into the details as the conversation was confidential, but here are some of the things we talked about:

How to think about the right metrics for the business

How to manage the stakeholders to get to the right objective

What it means to raise in the current environment

The difference between VC investors that are hands off versus PE investors that are hands on

It was obvious that this CFO was smart and had his head screwed on. But he was in an environment where he didn’t have someone he could easily ask questions of.

Being that person he felt comfortable enough to turn to filled me with so much joy and purpose.

That’s when I realised the best mentors I’ve ever had never feel like they’re actually mentoring me.

And I try to do the same.

Have a conversation, help where you can and show, never tell.

I’d love to hear about your experiences with mentors and if you’d like to have a call with me, just connect with me on LinkedIn and let me know that’s why 🙂

Off Balance

Last week we covered off the last of what I would call the 101’s of VC including:

VC Funding Stage by Stage
What VCs Look For

Today we’re going to get a bit more down and dirty and have a chat about Valuations.

It should be no surprise that this is a topic that most founders will want some guidance on from time to time, not least because there is often no strict template one can follow.

I have to be honest, I was also going to try and tackle Term Sheets in this post as well, but it turns out there is so much to talk about with valuations alone that I parked that till next week – you’re just going to have to hold tight till then I’m afraid.

In the meantime, let’s get into it.

Valuation

If I was feeling cheeky, I would leave this as a one liner – something I have said time and time again on various platforms:

By that I mean, in private markets where there is a lack of liquidity (the ability to find buyers for your shares) valuations are not set by ‘the market.’

I am referring to the market, in this context, as the public market where millions of buyers meet millions of sellers and find an equilibrium price that is satisfactory).

Instead – and I know this is going to blow your mind – valuations in private companies are essentially made up based on a range of factors including some, none or all of the following:

Is this a repeat founder

Is this a massive market

What point am I in in my fund cycle

What’s the next investor likely to pay

What traction has the business achieved

What have others in this sector raised at

What was the last round’s valuation

What business model does it operate

What the cash flows look like and what risk you expect

Essentially valuation in private markets is more art than science. Or as valuation guru Aswath Damadoran puts it:

I personally like to say: if you grab them by the narrative, their hearts and wallets will follow.

But let’s get a bit more specific.

Rather than looking at this on a stage by stage approach, let’s look at some frameworks that you might want to use to figure out where you and your investor may land.

It’s worth assuming that the more progressed your business is, the more reliant on ‘hard’ data the valuation is going to need to be.

Also, as a side note, pre-money valuation means the value of the company immediately before new capital is invested and post-money valuation is the value of the company immediately after new capital is invested.

Berkus Method
Formulated by notable angel and venture capitalist Dave Berkus, the Berkus method takes five elements and prescribes a financial value (up to $500k) to each:

Idea

Team

Prototype

Relationships

Sales

This is a useful framework for when you have low data and want an easily replicable framework to use against multiple ventures at a similar stage.

Scorecard Method
Developed by Bill Payne, another well known angel investor, like the Berkus Method, the approach here is to assign some weightings to characteristics of the startup you’re trying to value. From that, you derive a list of factors and then apply the sum of those factors onto to the average of comparable startups at a similar stage. The method uses the following criteria:

0–30% Strength of the Management Team

0–25% Size of the Opportunity

0–15% Product/Technology

0–10% Competitive Environment

0–10% Marketing/Sales Channels/Partnerships

0–5% Need for Additional Investment

0–5% Other

You would assess each of these characteristics based on being above average, average or below average leading to a range of percentages either below, at or above 100%.

For example, you may decide that the tech stack is below average, say 90%, but the size of the opportunity is massive, say 160%.

You would multiply each of these by the relevant factor:

Size of opportunity = 160% x 25% = 40% = 0.4
Tech stack = 90% x 15% = 13.5% = 0.135

Once you have accessed each of the characteristics in this way, you’d add up the factors (0.4 + 0.135 etc.) and multiply the total by the average valuation of other startups.

In this example provided by Bill Payne himself, you will see that the sum of the factors is 1.0750.

When applied to an average pre-money valuation of surveyed pre-seed businesses of $2m, Bill would value the target company at $2m x 1.075 = $2.15m.

This is a great framework but relies on you having access to valuations of other companies in your target investment’s vertical. still relies on a lot of guess work, gut work and intuition to assess the characteristics.

Comparable Transactions (comps)
This is probably one of the more well known ways of valuing a startup or early stage business.

There are two key factors that are considered when using this method:

The company you are valuing needs to have appropriate metrics to which comps can be applied.

You need to have access to up to date data on comparable transactions – whether that’s for business model (e.g. SaaS), vertical (e.g. fintech) or even stage (e.g. seed versus Series B).

For example it was not unheard of during the feeding frenzy of 2021 for SaaS businesses to be valued on multiples of more than 20x on revenue (normally ARR).

This means that a SaaS business with $1m ARR might have been valued at $20m in those days.

Since the market returned to its senses in 2022, SaaS businesses have been trading at 6 – 8x multiple on revenue (based on my experience). This means that if a business went back to market to raise, it might only be able to raise at a valuation of between 12m and 16m ($2m ARR x 6 or 8). This may even be the case if said business had been able to double ARR. The notorious down round.

Now, traction may not mean revenue only. For example, it may be around downloads for mobile apps. Or for social media platforms, you might consider users and then apply a price per user based on the expected value you can extract from each user based on other competitors performance.

VCs will likely be able to access this data via platforms like Pitchbook or Preqin, but for most startups these resources are too expensive. They will then need to refer to industry reports, blogs, reported transactions in the press and other sources to try and work out how much their business might be valued at.

Whilst seemingly a more data driven method, as you can see from my example, fundamentally there is still a massive element of narrative in the valuation. Otherwise we would not have seen such massive deltas between multiples from one year to the next.

Venture Capital Valuation Method
Understanding this method means getting into the mindset of how VCs think – something I hope you are getting better at doing having read this newsletter.

This method essentially calculates how much a VC would expect to make out of the investment at the time of exit and works backwards from there based on their expected return on investment.

For example:

A $100m fund is considering investing in a Series A venture today, and expects it to exit within the next 5 – 8 years. They would expect to return 10x on the investment.

They are targeting a 10% ownership stake today and expect a further 2 rounds that will dilute them by a total of 30% taking their ownership down to 7% at the time the business exits.

As every investment at a minimum needs to be able to return the fund, a 7% stake at exit would mean the company would need to be valued at $1.43bn ($100m / 7%).

Given that they are looking at returning 10x on the investment, they would divide the exit valuation by 10 to get to the post money valuation of the current round which would be $1.43bn / 10 = $143m.

A 10% stake in a $143m round means an investment of $14.3m.

Behind the scenes there is a fair amount of complexity.

The VC needs to calculate or make assumptions around the resources that will be required to build the business to an exit, it also assumes that an exit at this valuation will be achievable. They also need to be clear on the expected return they wish to make based on the risks involved in the business, competitive situation and other factors.

You can essentially boil the VC method down to the following two formulas:

Value at Exit / Post-money Valuation = Return on Investment

Value at Exit / Expected Return on Investment = Post-money Valuation

Discounted Cash Flow (DCF) Method
Now I wouldn’t be much of a finance guy if I didn’t include the DCF – the go to method for finance pros everywhere – but I also wouldn’t be much of a finance guy if I didn’t include the following caveats.

There are a tonne of factors in calculating a DCF that don’t lend themselves amazingly well to using it to value startups. Not least calculating the WACC (the weighted average cost of capital) which relies on calculating the cost of debt (startups tend to have little or no debt) and the cost of equity (which requires you to know or be able to calculate a stock’s beta).

But the sake of completeness let’s walk through the DCF.

DCFs relies on the concept that the value of a dollar tomorrow is not likely to be the value of a dollar today due to factors like inflation and importantly there is an opportunity cost to me tying up my cash today by investing it in a startup.

Let’s take a really simple example to illustrate this point about opportunity cost.

I’m an investor with $1m available to invest today. My options are:

I could park the money in a bank account earning 6% annually, or

I could invest in a startup with a likely exit in 10 years.

Assuming I don’t withdraw my money and it compounds, over 10 years I would end up with:

$1m x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 × 1.06 x 1.06

= $1m x 1.06^10

= $1,790,847

Given that this is a relatively risk free return (unless I’d parked it in SVB ????????), if I were to invest the $1m in a startup, I’d expect it to at least beat that.

So what?

Well this risk free rate of 6% is what we would use as the discount rate in a DCF calculation. It’s the minimum hurdle that an investment needs to beat to be worth my while given I can earn at least this return in the bank (the discount rate is often called the hurdle rate for anyone that’s interested ????).

So let’s look at how you would calculate a DCF in more detail.

Step 1 – Work out the cash flows associated with the business over the duration of the investment.

Step 2 – Work out the discount rate you’re going to use, you would increase the rate based on the amount of risk you’re expecting to take in the investment. So whilst you might expect a return of 6% from the bank, you may expect a return of 20% from a startup.

Step 3 – Work out the terminal value of the business (i.e. the exit value of the business). This is calculated as {Final Year FCF x (1 + Growth Rate into Perpetuity )} ÷ (Discount Rate – Growth Rate into Perpetuity) where Growth Rate into Perpetuity is the ongoing rate of growth you expect from the business.

Step 4 – Discount each value back to get to a present value and sum together to get a present day valuation.

Let’s take an example where we assume:

Discount rate of 20%

Growth Rate into Perpetuity of 5%

5 year cashflows of:

$10m negative

$2m negative

$500k negative

$10m positive

$50m positive

This gives us a Terminal Value of: {$50m x (1+0.05)} ÷ (0.20 – 0.05) = $350m

Discounting back each of the these cashflows we have:

$350m / (1.20^6) = $117m

$50m / (1.20^5) = $20m

$10m / (1.20^4) = $4.8m

$500k negative / (1.20^3) = $290k negative

$2m negative / (1.20^2) = $1.39m negative

$10m negative / (1.20) = $8.3m negative

And the total of all those discounted cash flows is called the Present Value which in this case would be $132m, et voila, that’s your valuations.

If I thought the business was more risky and upped the discount rate to 30% that would change the terminal value as well as the present value of the cash flows and we would end up with a Present Value of only $51m.

Instead, if I leave the discount rate at 20% but change the Growth Rate into Perpetuity to 7%, we increase the Present Value to $153m.

At the end of the day, the DCF is something that investment professionals use day in and day out, so don’t worry if it takes you a minute (or longer) to get your head around it!

There are a couple of other methods like the Risk Factor Summation method that takes a dozen or so risks and adds or subtracts multiples of $250k based on whether they are risks or opportunities.

Or the Cost-To-Duplicate method which you use to see how much it would cost to replicate your startup elsewhere, but this doesn’t take into consideration intangible (non monetary) aspects of the business.

And finally, the favourite of accountants everywhere – the Net Assets method. This takes the monetary value of the assets on your balance sheet, deducts the value of the liabilities and presto changeo gives you a valuation. Sadly it’s not particularly valuable in asset lite software businesses where development costs are not always capitalised.

And there we have it, some of the basics (yes I really do mean basics) of startup valuation, and for each of these there are many more heuristics that founders and investors alike will use to value a company.

So if you’re feeling a little bit like Homer right now, don’t worry. After all, figuring this stuff out is precisely what I’m here for, right? ????

Next week, I promise we’ll dive into the murky world of economics and control when we speak about Term Sheets, so hang tight, it’s going to be a good one!

The Lowdown

Let’s check in with what’s been happening in the wider tech and venture ecosystem this week…

This thread has been doing the rounds, with one VC (and future Nothing Ventured guest ????) Francesco Perticarari saying:

My simple answer to this was… yes, yes we are.

It was a reminder as to how small the ecosystem actually is and how much cross over there is in content. Especially when that content is good, we sure are quick we are to add our own 2 cents.

So here are mine ????:

This thread from David Clark is an important one to digest, because it took actual data across a long timescale and worked out a returns profile based on that data.

Essentially it is a masterclass in showing the Power Law at work.

Let’s break it down:

Data from 11,350 companies

Backed by 259 funds

Across 30+ years (1986 – 2018)

Includes realised and unrealised investments

6,000+ (53.2%) are at <1x (if liquidated would return less than initial investment)

2,500+ of these (22.6%) are write offs

2,157 (19%) returned between 1x and 2x of cost

1,813 (16%) returned between 2x and 5x of cost

1,342 (11.8%) returned at least 5x

Only 614 (5.4%) returned 10x or more

Only 121 (1.1%) generated sufficient exits to return all the committed capital of the fund (in theory what each startup invested in is expected to be able to do).

And this is the thing that a lot of people struggle to get their heads around.

VC is not a game of averages, it’s not a game of good enough, it’s a game of outliers. And if you’re business doesn’t have the possibility of being a massive (positive) outlier, then this is not the source of capital you should be looking for.

Ladies and gentlemen, see the power law in all it’s glory…

Here’s the original post from David.

I’ve seen a few threads recently about the power law in venture capital and what this means for individual company returns.  We looked at our data on 11,350 companies backed by 259 funds from 1986 to 2018. /1

— David Clark (@daveclark85)
Aug 22, 2023

Next up, the UK is onto another project it hopes to have “world changing impact” with.

Only this time, it may actually have a chance.

The country has set up an Advanced Research and Invention Agency (ARIA) and though it has a small budget, it has some incredible people leading the charge.

After so much (personal) disappointment around the direction the country seemed to be taking after the 2016 Brexit vote, this at least feels like a step in the right direction.

It looks like the IPO market is starting to come back a little bit. The biggest news being ARMs intention to list on the NASDAQ for somewhere between $60 bn and $70bn.

But as this article from Crunchbase suggests, the more interesting transaction is the potential IPO of Instacart which took a hatchett to its internal valuation potentially giving it a more realistic chance when it hits the public markets.

As we saw earlier, valuations are as much about art as they are science, but literally everything gets thrown out the window once you list – then it’s just you and the market baby.

And finally, in other news, India landed a spacecraft on the moon ????????????.

As a proud person of Indian origin, all I can say is that it feels like the moon looks a bit different since we got there…????????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish