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Tuhaye Venture Partners Yellow City

What It Means To Be “Too Early”

Tuhaye Venture Partners | February 18, 2020

“Too Early”. Venture firms tell founders every day for one reason or another that the company is “too early” for consideration, but to please, come back when you’re ready and we can evaluate then.

“Too Early”. Venture firms tell founders every day for one reason or another that the company is “too early” for consideration, but to please, come back when you’re ready and we can evaluate then.

It’s also not the reason they’re not investing.

As an investor, being “Early” typically means you can invest at the lowest entry point, maximizing your potential returns. If investing early can maximize returns, can an investment really ever be TOO early?

“We think this will be a great investment, however if we invested in it today, our rate of return would be too great — and we are not equipped to deliver those kind of returns to our limited partners”

— said no-one ever.

Investments fail because of a poor thesis, an inability to execute, a fracturing of the leadership team, a competitive threat, or literally dozens of other reasons (compiled very well here).

When you’re “too early”, it either means best case that the company hasn’t generated enough data points for that VC to validate an investment thesis, or worst case, they believe one of the aforementioned reasons (poor thesis, leadership, competition) will ultimately be your downfall and they’re unwilling to tell you.

Assuming best case, this may be due to the fact that the company hasn’t been around all that long — and doesn’t actually have any data to provide (ie the “this is our idea for a company will you fund it” pitch). More likely though, the “too early” rationale is validated by the fact the VC firm is not equipped or experienced to help a company at your size.

Using simple math, a VC firm with $1BN under management and 3 general partners likely does not have the ability to dedicate general partner time to help a company where they’ve made an investment of $500,000 succeed. Therefore, if you’re not equipped to spend the kind of money that VC firm needs to invest to justify the general partner’s time and oversight, then that company is truly “Too Early” for that fund.

At Tuhaye, we invest pre-seed. We’re the first investors in a business, meaning companies are never “Too Early”. That doesn’t mean we’ll always invest (to the contrary, we’ve invested in less than 0.1% of all businesses we’ve seen since 2016).

When we’re evaluating companies, we seek to answer two critical questions.

•   •   •

1) Can money unlock growth at the company?

2) Do we have an expertise that can help unlock additional growth at the company?

•   •   •

Since the second question is specific to our firm’s sector focus on enterprise software, I’ll simply focus on the first question, which is more or less easy to evaluate.

With most startups, money solves only one problem: extending the date at which you run out of money. To invest successfully at the early stage, you need to identify companies where cash does not simply extend the runway, you seek out businesses where the constraining factor on growth IS a lack of money.

In practice, this is the MVP that has had successful sales to date, but where it’s clear that by investing in additional product engineering resources, the company can expand the market to which it sells its product. It’s the company with excellent unit economics around sales but is under-resourced to hire faster.

Whatever the case is, the deeper issue is that if money isn’t solving a constraint factor around growth, then it’s usually causing another one: the company is not growing fast enough to meet the investor expectations.

So what’s the best way to avoid the brand of “Too Early”? We’ll share a framework in an upcoming post specifically about what we feel makes a strong pitch — but the above all else, make the case that it’s the money that’s going to make this successful. You’ve pulled every available lever you can pull to this point to help the company grow to this point, now you need a balance sheet to be able to do that much more.

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Tuhaye Venture Partners Yellow City

Teampay Raises $12M Series A: How Enterprise Software Can Further Workplace Inclusion

Tuhaye Venture Partners | September 26, 2019

Over the last twenty years, technology has dramatically increased workforce productivity across every vertical, with advances in computing, communication, and collaboration empowering knowledge workers to do more with less. This innovation has been driving both the rise of high-growth venture-backed startups, as well as disrupting traditional enterprise workforces that value tech talent and skills above all else.

Over the last twenty years, technology has dramatically increased workforce productivity across every vertical, with advances in computing, communication, and collaboration empowering knowledge workers to do more with less. This innovation has been driving both the rise of high-growth venture-backed startups, as well as disrupting traditional enterprise workforces that value tech talent and skills above all else.

At Tuhaye, enterprise software is a core focus of what we do as a fund, and when we look for investments, we are laser-focused on the principle of understanding how technology is further enabling this workforce productivity, which in turn justifies pricing and the underlying fundamentals of the business.

Two years ago, we invested in Teampay, which aspired to build a purchase management system designed around the modern workforce. With Teampay, businesses can empower employees to buy the goods and services needed to drive productivity within a defined company policy, without burdening their employees with those expenses tied to expense reimbursements.

For years, the consumerization of the enterprise has created a massive expansion of the B2B Ecommerce market, with over $1 trillion of spend in 2018, expected to grow by another 10% this year by many market estimates. As a business category, managing and facilitating this spend is a massive billion-dollar company opportunity that many venture capitalists have built theses around.

Opportunity aside though, managing an investment over a 7–10 year lifespan requires passion and focus, and it’s very hard to include “purchase ordering” and “passion” in the same sentence. That being said, we believe Teampay has one of the highest potentials for social good in the portfolio, coupled with its huge potential as a business, due to the fact that its value proposition goes to solve one of the largest systemic inequalities that exists inside of businesses today.

To frame this problem, we’ll use my own history as a lens. In 2013, I graduated Columbia Business School and began working for a small venture capital firm here in New York. While I was extremely fortunate to have the resources needed to undertake a full-time MBA program, the fact remained that I had invested my entire life-savings accrued to this point and incurred a significant amount of debt to attain an education I had deemed critical to follow my passion of investing in high-growth tech-enabled businesses (in hindsight, this sounds like a VERY boring passion compared to my previous career as a professional opera singer). At great expense, Columbia afforded me the ability to learn the craft from some amazing mentors, such as Ed Zimmerman, Bob Greene, Matt Gorin, Stuart Ellman, and Will Porteous (the list goes on of course!), and learn the necessary skills needed to produce the successful investment track record I hold today.

Despite achieving the career of my dreams through dedicated hard work and some fortuitous timing, I faced immediate difficulty at my firm on day one of accepting an offer post-MBA. As the only junior employee for a small firm, my responsibilities of sourcing new investments and performing diligence were not without cost. In fact, my partners would routinely look at my monthly expense reports related to T&E and note that if I wasn’t regularly spending money on coffees/lunches with entrepreneurs, then it was a reflection of the effort I was placing around sourcing and building the firm’s pipeline. This was in addition to the expenses related to brand building at conferences, travel and lodging when doing diligence off-site at portfolio companies, and subscriptions to software products needed to further enable my own learning or productivity.

Without a solution like Teampay, I was bearing these expenses on my personal credit card and was subject to our firm’s monthly expense reimbursement policy and repayment schedule. With the entirety of my small credit limit being tied up in business expenses and no savings to fall back on, I struggled in the way many Americans do, paycheck to paycheck without the ability to make ends meet on a monthly basis. I’ve been fortunate to manage these hardships and get to where I am today, but in hindsight the sad truth of all this was that if I simply had access to more credit (either through the firm, or personally), I probably WOULD have been a more productive employee early in my career.

This is the social good and productivity a solution like Teampay provides the modern knowledge-based workforce. Educational inflation and credentialism have created a world where people are paying off student debt well into their 40s. This mountain of personal debt blunts the productivity and performance of employees, which directly impacts the bottom line of every company. With over $1 trillion in sales measured in B2B Ecommerce in 2018 and growing, firms need to adapt to this new world where employees can spend on the company’s behalf, however firms that allow these expense burdens to be sheltered by their employees rather than by their own balance sheets are doomed to suffer issues related to employee retention, happiness, and most importantly productivity, which drives the bottom-line of every business on the planet.

Today, we’re proud to share that Teampay, a Tuhaye portfolio company since December 2017, has announced a $12 million dollar Series A led by Tribe Capital to continue serving this mission and creating a future of work where employees can succeed as a function of their own skills and dedication and not their access to credit and capital. We’ve already seen this thesis play out over the first two years of our seed capital investment, and we’re really excited to see it continue to grow and thrive over the next decade to the benefit of all employees worldwide.

Keep it up guys!

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Tuhaye Venture Partners Yellow City

The Art of Screening the Deal: What we look for in Venture Capital Associates

Tuhaye Venture Partners | September 13, 2019

In 2018, 2,768 Venture Capital financings of $1–5M were funded in the United States, or roughly 7.5 investment-grade deals per day, on top of the thousands screened and passed. Assuming some 90% of seed deals don’t get funded, that leaves firms staring down a funnel of 27,000 deals/year.

In 2018, 2,768 Venture Capital financings of $1–5M were funded in the United States, or roughly 7.5 investment-grade deals per day, on top of the thousands screened and passed. Assuming some 90% of seed deals don’t get funded, that leaves firms staring down a funnel of 27,000 deals/year.

It’s no wonder most firms lean so heavily on Associates to act as gatekeepers, weeding out thousands of investments before championing a select few for the partners’ consideration. After all, the average Partner’s responsibilities still reach far beyond the investment committee — including everything from portfolio management to fundraising and governance.

There’s only one problem with this model: Associates are generally the least experienced member of the team. Yet they’re the ones to sit on the front lines and determine which companies the Partners get to meet.

“Now go away or I shall taunt you a second time-a!”

At Tuhaye, we believe if our investment committee only discusses the subset of our overall deal flow that our associates subjectively liked, then our firm is upside-down. Therefore, we put a culture in place that empowers Associates to source, research, diligence, and synthesize every deal without unilaterally closing a door on the next Mark Zuckerberg. We also measure performance based on investment-grade deals “brought to the committee”, not by “who sourced great deals”.

In other words, our Associates astutely screen deals; they never pass on them.

•   •   •

Culturally, our firm is rooted in the idea that “saying no” to a venture investment is easy. Take a look through Bessemer’s Anti-Portfolio and you’ll see exactly how easy it can be.

“Price is crazy”
“No one would buy this company”
“The competitors are better”
“This IDEA is crazy”

See, I just passed on 4 companies right there! In fact, passing on companies is so easy, that some of the most notable firms in the VC space have noted that they can pass on investments 100 times a day and in less than 60 seconds.

However, as the Bessemer example shows, allowing the firm to get to “no” quickly, meant the firm lost out on a massive investment return. This is exactly what we strive to avoid, and it starts with our screening processes.

So How Do We Use Our Associates?

It starts at the interview. When interviewing prospective Associates, we present a pitch deck from a well-known venture success story. We then ask candidates to detail five reasons why we should not make an investment, strictly based on materials in the deck.
Give it a try. Take a look at the pitch deck for Airbnb. Forget everything out know about its successes and jot down your 5 hesitations.

Why do we do this exercise?

1) We’ve removed the ambiguous or wrong answer

Too often interviews center around a case study or investment analysis using either a prospective investment — or worse — a portfolio company where the outcome still hasn’t been determined. This can lead firms to reject candidates who think differently than the partnership based on an answer not aligned with the partners’ view, limiting the diversity of opinion on the investment committee. By forcing an answer, we create a standard basis from which to compare candidates on their body of work, removing any bias we might have towards what we might view to be the ‘right’ answer. This is a small, but critical piece of the puzzle.

2) We isolate facts from opinion

In forcing the negative answer (in this case, pass on Airbnb), we know the analysis created will be different than the associate’s opinion of the investment (influenced in hindsight by how successful the investment has been). Since the analysis disagrees with their opinion of the deal, we know we’re going to get a more fact-driven assessment, even if those facts would’ve led to the wrong decision (more on this later!). Long-term, our investment committee will be best served by an associate’s ability to aggregate and present facts, not make their own determinations on what they mean.
Process-wise, this is what it really means to “screen” a deal, vs. “pass” on a deal. Screening a deal involves taking factual items about the deal and demonstrating why it’s not a relevant opportunity to evaluate. Passing involves critical thought and rigor based on an analysis of the opportunity.

An extremely basic approach for screening vs. passing.

We believe associates should be empowered to screen investments, but it requires an investment committee approach that maximize the firm’s research, experience, and unique viewpoints of each of the team members (including the associate – this is where we want to hear “I like it because X” or “I think it will fail because Y”) to pass on a deal.

3) We want to demonstrate how easy it is to be wrong

We know through the benefit of hindsight that not investing in Airbnb here would’ve been wrong. Not only that, the more defensible and well-thought this analysis is, the more WRONG it would be.

The lesson then is that if the investment committee didn’t actually think critically about the investment and understand the weaknesses of the underlying facts found, then the firm would’ve passed and we’d all be the poorer for it. This is the most important lesson any venture capitalist can learn in their career, and the most critical trait we’re trying to isolate for in identifying unique talent.

•   •   •

The sum of these three elements hidden in the case study helps not only identify not just the smartest candidate but the candidate who can best help an investment committee. Lastly, the best interview processes look to determine a cultural fit early on.

Passing on a deal is easy. Holding an optimistically contrarian viewpoint. Taking a risk on a company in spite of consensus opinion. That’s the hardest part of being a successful venture capitalist.

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Tuhaye Venture Partners Yellow City

The Founder Confidence Index: Driving Company-Investor Fit

Tuhaye Venture Partners | June 4, 2019

So far, we’ve only discussed pricing an investment through the lens of the venture investor. While some might argue that the venture investors’ willingness-to-pay for equity should serve as a signal for the true value of a business, especially given the sheer volume of those doing so, this approach completely ignores the supply-side of the market: the founders.

So far, we’ve only discussed pricing an investment through the lens of the venture investor. While some might argue that the venture investors’ willingness-to-pay for equity should serve as a signal for the true value of a business, especially given the sheer volume of those doing so, this approach completely ignores the supply-side of the market: the founders.

Each individual founder has a unique story and set of factors that ultimately determine how much equity he or she is willing to sell in exchange for the capital to get the company off the ground and pursue its potential growth. Therefore, it’s fair to say that the initial valuation a company receives is as much a reflection of the founders’ willingness-to-sell equity as it is a reflection of venture investors’ appetite to purchase it.

So what does this look like? Here’s a few assumptions to build a graphical representation.

Postulate 1: No founder would be willing to sell equity for less than $0. This is represented on the chart at point P1.
Postulate 2: All founders raising venture money have a price at which they would sell 100% of the business for today, if offered. This is represented on the chart at point P2.

Conclusion: There exists a line between points P1 and P2 that implies the dilution a founder is willing to incur in order to reach some future exit greater than P2. This is a founder’s minimum willingness-to-sell (the “WTS”). Any terms presented by investors underneath the WTS line will not be accepted by the founder, regardless of whether or not one of these offers is an indication of the true value of the business.

This WTS line has a slope that we call the founder’s Confidence Index (“CI”). A founder with a steeper WTS line is inherently more confident in the business’ long-term and more willing to incur short-term risk to achieve that long-term goal.

The CI is driven by both objective Company Factors as well as Founder Factors.

Company Factors include:

Revenue Growth
User Growth
Operating Runway (No of mos of Cash)
Favorable Market Conditions

This is pretty straightforward. Series A companies should have a CI than their Seed counterparts, as they’ve presumably proven product-market fit and acquired referenceable paying clients or a strong user base to show the business model is working.

As such, the Confidence Index is also impacted by what we call Founder Factors. These influences can include:

Founder Financial Health
Prior Success
Strength of Advisors
Actual Confidence (naysayers might say Arrogance, though we consider it to be measured conviction) in the idea or themselves

It is possible that two identical companies could have different willingness-to-sell lines depending on their founding teams’ varying Founder Factors. For instance, let’s take the figure below. The green line would represent a company whose CEO is a billionaire from the success of a prior business, and the orange line would represent the same company but with a CEO who’s a new parent and still paying off student loans.

Green CEO is far more willing to take on risk than Orange CEO

These lines are critical for investors to understand, and part of understanding whether or not the investors and the founders are aligned in their desired outcomes. Founders with higher Confidence Indexes may be unwilling to raise capital at valuations the market deems appropriate, creating long-term financing risk, while founders with lower CIs are more likely to sell the business early, blunting potential long-term investment returns.

—

So why do we focus on this?

We believe that founder-investor alignment is critical to maximizing the returns of any business. As equity investors, venture investors join this curve alongside the founding team — and are typically doing so with Preferred investor rights such as the ability to block a sale of the business.

If an investor’s desire for return on investment is too dramatically different than the founder’s, then the founders and investors can never be aligned towards a common goal of success at the business.

This is the basis for “founder-investor” fit, shown in the graph below. While the “Bad-Fit VC” in this case would’ve likely paid a higher valuation for an investment in the founder’s company, seemingly beneficial for the founder, they also bring with them expectations and mandates to sell at much greater values, bringing an added risk profile to the long-term health of the business that is beyond what the founder believes is feasible.

At Tuhaye, a big part of our diligence goes into understanding the founders’ long-term vision and Confidence Indexes towards these outsized returns. As seed-stage investors, we are the longest time-horizon investors in the business outside of the founding team, so alignment to the founders is critical in making our investments succeed. There are mechanisms for adjusting the slope of the founder’s confidence index to reflect such events as secondary purchases of founders’ equity or salary considerations to reduce any financial stress on the team. Both sides of the table should continue to probe each other on these questions over the life of an investment to maintain continued alignment to a mutually agreeable and successful outcome.

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Tuhaye Venture Partners Yellow City

Optimizing the Only KPI that Matters: g

Tuhaye Venture Partners | April 1, 2019

Safe to say, it doesn’t really work for startups. As I’ve said previously, without significant amounts of capital on hand to fund the business over the long-term, a DCF analysis of a startup is likely to return a valuation of zero.

Ever try doing a Discounted Cash Flow analysis on a startup? For those of you who’ve taken Corporate Finance, the equation for determining the present value of a business looks something like this:

 

Safe to say, it doesn’t really work for startups. As I’ve said previously, without significant amounts of capital on hand to fund the business over the long-term, a DCF analysis of a startup is likely to return a valuation of zero.

That’s not to say the DCF equation doesn’t work; but in relation to startups it’s so heavily levered to “terminal value” given the many years of near-term negative cash flows, the exercise becomes relatively meaningless.

 

Despite the weakness of the exercise, the output is no less true:

A seed-stage business is only worth something today if we think “g” is a big number.

Therefore as an investor, all I care about is g. Sure, there’s a lot of important stuff along the way, but at the end of the day, an investment thesis is only as good as the long-run projected growth metrics.

•   •   •

So how do we maximize “g”. If you remember back to your old Economics classes, production output comes in three stages: increasing returns, decreasing returns, and negative returns.

A textbook style representation of production curves

Any given startup lives in Stage 1, at the extreme left end of the curve in hyper-growth mode, and the current state of it’s technology determines where the end of Stage 1 is (the point at which the business begins to see diminishing returns to sales and marketing). Investment in product development — such as new features or product lines — pushes that inflection point to the right, and further investment in sales and marketing pushes a company along the curve generating output (not necessarily revenue).

Over-investment in sales before the product offering expands to meet a wider set of potential customers will lead to diminishing returns on growth capital. Over-investing in product without the customer acquisition to support it, and you won’t generate meaningful output. This leads to an unrefutable fact:

Sub-optimal budgeting leads to sub-optimal growth.

Therefore, a CEO’s most significant unit economic on her dashboard should be the rate of growth. Diminishing returns on sales investment is a signal to shift investment to product and broaden the user base, while increasing rates of return on sales should provide a clear roadmap to investing more in customer acquisition.

Problem is, most KPI dashboards emphasize focus on static metrics, like LTV, CAC, Churn, MRR, ARPU, and Payback Periods. They act very much like true “dashboards”, telling you a snapshot of your current rate of speed, rather than acknowledging whether you’re applying the gas or tapping the brakes. These are all important metrics, but viewed in a vacuum they only tell you what the business is going to look like next month if everything else remains the same.

Growth lives in the 2nd derivative. Investors shouldn’t care what your CAC is so much as how it moves relative to where you’re at today. In understanding that — an investor can better see how a cash infusion will change the business from its current run-rate, and whether or not the environment you’re operating in can sustain long periods of sustained growth.

•   •   •

To give an example, I’ve attached a fictionalized data set that closely resembles a typical growth chart. An investor will typically hear something like:

“We’ve grown our user base by over 2x in the first 10 months of the year, and our CACs are steadily declining. This is indicative of the fact that we’ve found product-market fit and we’re ready to start scaling marketing spend”

Note: For this example, let’s assume $ spent on marketing only has an impact on sales during the same calendar month.

At first glance, we see a user chart is going up and to the right, while the CAC data is trending downwards; two trends that typically mean great things over the long term for the business. However, the CEO’s conclusion that “we’re ready to scale spending” is entirely wrong based on where their 2nd derivative indicators.

The first red flag is that CAC is highly correlated to marketing spend despite relatively low monthly marketing spend (in the grand scheme of building billion dollar businesses).

Correlation Coefficients:
CAC & Marketing: 0.75
Marketing & User Growth: 0.66

Of course this is only a correlation and not in itself damning, but the relationship points to a business highly reliant on paid-marketing to acquire users far more than it’s able to rely on organic or network-based user-acquisition.

With that in mind, you a deeper dive into the data shows an accelerating Marginal CAC rate. The distinction here being:

CAC = The average cost of user acquisition.
Marginal CAC = Cost of acquiring the next user.

The clearest example of this business’s marginal CAC is shown from June to July.

May: Marketing Spend $221,214 Users Acquired 10,534
June: Marketing Spend $163,620 Users Acquired 8,181
July: Marketing Spend $501,797 Users Acquired 16,187
June Marginal CAC = Marketing Delta ($57,594) / User Delta (2,353) = $24.48
July Marginal CAC = Marketing Delta $338,177 / User Delta 8,006 = $42.24

In the case of this company, the business proved that by effectively doubling the marketing spend to only $500k/mo, they’re seeing their user acquisition costs associated with growth nearly double! So despite the declining CAC numbers related to the most recent three months of the business, the company has done more to prove that it’s seeing diminishing returns on investment capital today, rather than seeing increasing returns. To an investor seeking to maximize g, doubling down on highly diminishing returns is not a great way to get there.

—

So if you’re looking for a takeaway here, it’s that every success at the early stage should feel like eating a bowl of chocolate frosted sugar bombs — delicious, but with a diminished pleasure by the anticipation of future bowls. New products, revenue streams, strategies, key hires and best practices should always be on the horizon driving increasing returns, and boards should aggressively push for that increasing growth despite the increasing challenge to deliver it as you scale. Because at the end of the day, growth is the ultimate determinant of terminal value to a startup.

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Tuhaye Venture Partners Yellow City

Equity Leverage And Measuring Risk

Tuhaye Venture Partners | February 18, 2019

At Tuhaye, we strive to quantify early-stage risk so that we can utilize it in our pricing methodology. One of our simple measures to evaluate the underlying Risk at an investment is to look at a company’s Equity Leverage at the time of financing.

Part II of Valuation Theory and the Flawed Premise of “Pre-Money” Valuation.

At Tuhaye, we strive to quantify early-stage risk so that we can utilize it in our pricing methodology. One of our simple measures to evaluate the underlying Risk at an investment is to look at a company’s Equity Leverage at the time of financing.

Equity Leverage is the amount of return a company needs to deliver on invested capital in order to meet an investor’s return expectations.

Let’s consider investing $2M in a concept-stage business priced at a $10M post ($8M Pre, but building off the assumptions in Part I, the non-venture backed value of the business is $0). If as investors we’re targeting a 100% IRR, then the investment needs to be worth $20M in 12 months. Therefore, the team needs to create $20M of value on a $2M investment, putting 10x of Equity Leverage on the business.

Now let’s take that same business, but suppose an investment of $4M at $14M post-money ($10M “Pre, $0M Actual). Targeting the same 100% IRR, the company needs to be valued at $28M in 12 months to merit consideration from the same investor group. However, the Equity Leverage on this investment is a more conservative 7x, or 42% lower from a risk standpoint.

From the founder’s lens, there’s some simple logic to how this translates into risk. The CEO who is under pressure from investors to return 10x on every dollar they spend is more likely to spend it on high-risk initiatives (cheaper labor, experimental marketing strategies for example), than a founder who only needs to return 7x.

A founding team that assumes too much Equity Leverage is more likely to fail through high-risk growth strategies, rather than another business that is spending money more conservatively.

So as the investor constructing a term sheet now, which is the better term sheet to propose? Should you maximize your MOIC and ownership by investing $2M at the lower pre-money valuation, or should you minimize your risk exposure by investing $4M at a 40% higher post-money valuation, but that features less equity leverage? (Recall that despite a lower MOIC, both investments have the same IRR)

What you’ll find is that a portfolio with a 42% reduction in equity leverage (10x to 7x), outperforms the portfolio that has a 40% greater upside on each investment.

This is done by deploying $52M across 26 companies at an $8M Pre-Money ($2M Ea), or deploy twice that capital into the same companies at a $10M Pre-Money ($4M Ea). In both funds, the companies will grow at the same rate (100% IRR), and sell to the same acquirer for $900m**, delivering ~90x or 64x (a reflection of the 40% higher post money paid).

** For simplicity sake, I’ve assumed no new cash into each company post initial investment, but you could also assume both companies experience the same dilution over time from future investment.

As a manager, let’s assume my ability to properly identify risk results in investing in these types of exits 5% of the time, (let’s call it “ALPHA”). If Equity Leverage translates into Risk, then by investing in a portfolio with 42% lower Equity Leverage, your ALPHA would increase from 5% to 7.14%.

In addition to having better portfolio returns, the 7.14% alpha portfolio with 26 investments is much more likely to have multiple unicorn investments (1.86), compared to the 5% alpha portfolio (1.3), which is likely to drive better fundraising cycles for the managers.

•  •  •

So why is this important? Getting back to the focus on “Pre-Money” values from Part I, by showing through investing in the $4M round, not only did we deliver a greater overall return across the portfolio, but we did so by increasing the Pre-Money on the investment.

(Scenario A was $2M on $8M. Scenario B was $4M on $10M. The difference between the two is $2M in invested capital and $2M in Pre-Money value)

This is demonstrative of “Pre-Money” being a function of the risk you perceive the business to have, rather than being indicative of the actual value of a company. If an investment is less risky because it has more available capital to spend and lower leverage on that capital, you should be willing to pay more for the investment.

Keep this in mind next time you see a headline blaring “VALUATIONS SKYROCKETING”. Sure, angel and seed valuations are increasing (11%), but what’s ignored is that the median deal-size is actually outpacing that growth (15%), which is creating a less-risky environment for allocating capital characterized by lower equity leverage per investment. This is great news for the record $55BN in capital raised in 2018, and the record number of $1BN+ VC Funds (11) raised in 2018 to effectively deploy capital.

 

 

The “Brewster” Effect:

Obviously, there are limitations to pricing purely on Equity Leverage. For one, this logic would lead you to justifying higher and higher values on startups with minimal operations simply by virtue of other capital being around the table. In reality, there’s a diminishing return to reducing the equity leverage through additional capital that we call the “Brewster” effect.

For those of you who remember the movie “Brewster’s Millions”, Richard Pryor — having never made more than $11,000 / year in salary as a minor league baseball player, must spend $30 million dollars in 30 days with zero remaining asset value in order to inherit a $300 million dollar fortune. What Steve’s character finds out to our amusement — it’s actually extremely difficult to spend money quickly (in his case, waste it) if you actually have no experience doing so.

It’s not all that different for a venture-backed startup. A business only spending $50,000/month on operating expenses will have a very difficult time increasing their burn quickly AND efficiently. Take for example on hiring. It is much easier for a company of 100 employees to find and hire 9 employees than a company of 3.

Therefore, increases in the burn rate of a company also increases the risk profile of the investment. The higher the increase in OpEx, the greater the risk associated with spending money efficiently (and not hitting your Equity Leverage targets).

At Tuhaye, this is just one of the many ways in which we continue to refine our risk model to deliver returns to our investors. We’ll never eliminate failures from our portfolio given the high-risk nature of our investments, however as a fund if we can perfectly measure risk, then we can fully-diversify our fund to that risk in order to deliver high returns time and time again.

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Tuhaye Venture Partners Yellow City

Valuation Theory and the Flawed Premise of “Pre-Money” Valuation

Tuhaye Venture Partners | February 18, 2019

Since the start of the “unicorn” era, investors, founders, and journalists have all focused on private valuations. Using valuations, markets characterize startups as being either “cheap” or “rich” relative to their size and stage on the relentless slog toward $1 billion.

Since the start of the “unicorn” era, investors, founders, and journalists have all focused on private valuations. Using valuations, markets characterize startups as being either “cheap” or “rich” relative to their size and stage on the relentless slog toward $1 billion.

In order to reach these heights, startups typically raise outside capital from VCs in exchange for an ownership stake in the business. This process creates a valuation for the fully financed business, often referred to as the “Post-Money.” Subtracting the cash invested, this imputes a “Pre-Money” valuation that characterizes the value of a business prior to investment.

But what does a pre-money valuation for a seed-stage business even mean? How can an exceptional team with mere wireframes and intangible indicators of market demand be worth $5M in itself? How can a company that doesn’t have the necessary capital on hand to realize it’s vision be worth anything prior to raising that money?

The answer is simply that a company is never worth its venture-backed valuation. The valuation is a reflection of the investor’s perception of the underlying risk of the investment. The greater the risk, the lower the valuation an investor is willing to pay in order to achieve their desired rate of return.

It would then follow that investors seeking greater rates of return would only be willing to invest in businesses at lower valuations that have the same overall risk profile of similar businesses pricing at higher levels.

Important Note: Funds targeting extremely high IRRs typically can’t offset the high amount of Risk associated with each investment, leading to outlier fund performance in both positive and negative instances.

The independent variable here is Risk. Risk is not the measurement of whether a company will succeed or fail, but rather the probability of the company reaching a defined successful outcome. If investors can perfectly measure Risk, then they will perfectly price investments to achieve a target rate-of-return across a full portfolio. This would create an environmental equilibrium where a founders’ willingness to take on dilution matches an investors’ willingness to take on risk. Comparing two valuations of separate businesses is, therefore, comparing apples and oranges; it only reflects the risk appetites of the investors and founders in each deal.
Of course in the venture capital business, Risk is extremely difficult to measure, which is why so many funds return very little capital and other funds consistently outperform benchmarks — and why so many founders have strained relationships with their investors.

 

 

 

Some investors are simply better at understanding and pricing risk than others.

Here are a few ways that some investors navigate the pricing of Risk:

  1. They are thesis or sector-focused: VC’s investing in specific researched verticals of expertise, better-quantified Risk by through an understanding of the long-term value of the industry (ex. Union Square Ventures, Lux Capital)
  2. They are stage-focused: VC’s investing in specific sized companies, better-quantifying Risk through an understanding of the challenges faced by businesses of that size, regardless of sector (ex. First Round Capital)
  3. They engrain Value-add into their operations: VC’s with additional resources and platform support that are able to de-risk an investment through providing time and services at an additional cost beyond the impact of cash and self-management (ex. a16z).
  4. Incubation: VC’s who start businesses themselves either through the GP or through EIRs, reducing risk associated with investing in an unknown team (ex. Alleycorp).

 

In conversation, these strategies are often answers to the question, how do you differentiate? However, in practice, they are tactics used by investors to measure Risk.

The pre-money valuation is reflective of the investors’ calculated perception of Risk, not the asset value of the business. However, through correctly identifying this Risk, venture firms are able to drive outsized returns, regardless of the valuation they pay. Investors, founders, and journalists should remind themselves of these variables when comparing valuations across businesses.

Now let’s get tactical. To see how Risk can be evaluated in a company’s valuation, click here for Part II.

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