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July 30, 2007

Valuation Expectations in VC rounds – Unwilling Seller, Unwilling Buyer

In this exclusive article that appeared in the July issue of the US-IVCA/Venture Intelligence India VC report, Rahul Chandra and Ashish Gupta of Helion Ventures, reflect on the valuation-related conundrums challenging VC investments in India.

Valuation! One single metric that both Founders and VCs try to optimize yet whose derivation remains more art than science. While the importance of valuation cannot be discounted (ask a VC after he is invested and a founder anytime) a market driven approach to seek valuation level can ensure a faster track to fund raising, a holistic setting of investment terms and greater discipline in business execution.

VC investments are on the rise since early 2006. In the absence of complete and accurate data, it is hard to conclusively say how valuations have trended with this increase in number of deals done. Let’s look at the four key approaches to valuation: valuing present value of cash flows, accounting value of business, using real options and the last and most commonly used: applying valuations of comparable businesses. For early stage companies with innovative business models, no cash flows and negligible assets, none of these approaches can yield rational results. So there is no avoiding a gap in valuation expectation between Founders and VCs. Having long accepted this fact, Silicon Valley tends to value companies on the basis of adequate ownership to make the risk and efforts worthwhile. By basing valuation for Series A deals around a market-mean, Silicon Valley VCs have minimized this gap.

We, at Helion have seen more than 500 business plans over the last 12 months – based on this first hand experience and through our conversations with other VCs, we can safely say that the gap in valuation expectation between founders and VCs is wide and is tending to widen further as a result of speculation. Speculation (or hard to justify pricing) is a scary beast which appears when the potent cocktail of excess funds, heady economic growth and information inefficiency is mixed. Each of these is in abundance in our current environment.

Let us consider the three downsides of trying to raise capital at unrealistic valuations.

First, deals where the market was entrusted with setting valuation or where the expectation was in the ‘rational’ zone tend to move faster to closure. Deals which came to the market with pre-set pricing in the ‘irrational zone’ are generally knocked around more. Founders spend more time pitching to multiple VCs to find that elusive price and are finally back in the market with a lowered expectation. If valuation was not the key factor for optimization, the founders can go back to building their business sooner with perhaps optimal investment terms and best fit of investor.

Second, valuation inefficiencies tend to catch up over the financing life-cycle. High valuation is a relative term and hard to argue against if there is a willing buyer. As long as the confidence in company’s growth is high enough to justify an up round before capital runs out, we are in safe territory. High valuation can cause good pressure for growth but only leaves room for disappointment if targets slip. As late as Q2 2005, a third of all deals in Silicon Valley were suffering down or flat rounds. This fact should not be lost on Indian VCs and entrepreneurs.

Third, high valuation rounds are generally accompanied by large capital raises. We have often heard the refrain that the environment is good for fund raising so why shouldn’t we raise our next three years of capital need in one round if we get a suitable valuation. This argument holds as long as there is high degree of fiscal discipline in the organization. Bad organizational habits tend to creep in when cash needs are over met.

Valuations are important but some fund raisings make it a sole focus. An ideal fund raise allows market to establish its own willingness to pay and keeps in mind the lifecycle needs for capital. Companies should as far as possible use fundamental measures to establish valuation – which means that the ideal time to focus on valuation is after the company has predictable, measurable cash flows. Until then a large part of the valuation exercise is driven by speculation. In matters of taking emerging companies to success there are no absolute rights or wrongs – but more often than not, widening gaps in valuation would hurt everyone. VCs and founders should work within a narrow gap even at the cost of leaving some money at the table.