Fair Value Exchange: A Framework for Valuations
Originally a thread on X/Twitter:
One of the most critical yet often overlooked aspects of the VC backed Startup ecosystem is the exchange of value between Investors and Founders. This concept lies at the heart of VC returns, especially relative to risk. And based on data being shared about VC performance, it’s pretty clear that it’s an important driver in the erosion of VC returns in recent years.
To better understand and navigate this complex relationship, we can map out a “Value Exchange Framework” that varies based on a Startup’s stage of maturity: Early Stage, Scaling Stage, and Late Stage.
Early Stage: The Option Value Play
At the earliest stages of a Startup’s life, traditional metrics almost always fall short in capturing the true potential of the business. Here, VCs are essentially buying an option on future hypergrowth and betting on the team’s ability to find product-market fit and scale rapidly.
Example: Consider a pre-revenue startup with a brilliant team and promising technology. A VC might invest at a $15MM valuation based purely on the potential of the technology and the team’s track record, even though there are no financials to justify this valuation.
At pre and early revenue stages, it’s normal and acceptable for metrics to be “out of whack.” A Startup might need to grow its (minimal) revenue by 5x or 10x or even more to justify a 2x increase in valuation. This imbalance is part of the high-risk, high-reward nature of early-stage investing.
Key Principle: At this stage, the fair exchange is rooted in potential rather than current performance.
Scaling Stage: Balancing Act
As Startups mature and find their footing, the value exchange should become more balanced. This is where the “2X for 2X” principle comes into play. If a Startup needs to double a critical metric (i.e. – revenue or gross profit) to double its enterprise value, we can consider this a perfectly fair value exchange. Both Founders and Investors benefit equally from the company’s growth.
Example: A B2B SaaS company grows its ARR from $5MMto $10MM, and its valuation in the private markets increases from $50MM to $100MM. This represents a perfectly fair value exchange.
However, if a company needs to grow its revenue by 10x to merely double its valuation, this suggests a disproportionate sharing of risk and benefit that favors the Founders.
There are scenarios where this imbalance might be justified:
1) High-Certainty Momentum: If a Startup has momentum that’s highly likely to continue, future growth might not be reflected in current metrics.
Example: A enterprise software company has $10MM in ARR, but has signed contracts that will bring this to $20MM in the next 12 months with near certainty. In this case, a valuation that appears high based on current ARR might be justified.
2) Network Effects: Businesses with strong network effects might justify higher multiples as each new user increases the value for all existing users.
Example: A social media platform might be valued at a premium because its user base, even if not fully monetized, represents significant future value.
Key Principle: As companies mature, the value exchange should trend towards “perfectly fair”, with exceptions for high-certainty future growth or unique business models.
Late Stage: Bridging to Public Markets
For late-stage Startups, the value exchange needs to connect very closely with public market multiples. Investors at this stage are looking for a clear path to exit, whether through an IPO or acquisition.
Example: A late-stage fintech company with $100MM ARR might be valued at $1 billion (10x multiple), in line with public market comparables trading at 8-12x revenue.
At this stage, any significant deviation from public market multiples needs strong justification. Growth rates, profitability, and market position all play crucial roles.
Key Principle: Late-stage valuations should align closely with historical public market comparables and adjusted based on growth rate, market positioning and other differentiating characteristics. But asking an Investor to underwrite significant multiple expansion or outsized growth to generate a modest return shouldn’t be the expectation.
Implications and Best Practices
For VCs:
– Clearly communicate expectations at each stage of investment
– Be willing to pay for the potential of early stage Startups but underwrite based on more concrete results as companies mature
– Develop a deep understanding of public market comparables for late-stage investments and don’t plan on generating a solid return if and only if a Startup falls into the “exception” bucket.
For Founders:
– Understand that valuation multiples should generally compress as your company matures
– Focus on creating real, sustainable value based on financial metrics rather than chasing unsustainable valuations
– Be prepared to justify valuations with concrete metrics and realistic projections, especially for later stage rounds of funding
For the Ecosystem:
– Cultivate an environment of trust and long-term thinking
– Recognize that both sides need to win for the ecosystem to thrive
– Encourage transparency in dealmaking and valuation methodologies
Conclusion
The fair exchange of value between VCs and Founders is not just about numbers – it’s about building trust, fostering long-term relationships, and creating a win/win Startup ecosystem. By using a disciplined “Value Exchange Framework”, both Investors and Founders can work towards mutually beneficial partnerships that allow everyone to win.
