Valuation of a Company | Andy Tang

Pro rata rights. This is kind of interesting. Most investments when they— when companies kind of grow up to the Series A, Series B, C stage, it'll become obvious which ones are good and which ones are bad. Right? At that point, if it's a good company, what happens? Everybody wants in, right?

Yes.

So there's something called the pro rata rights that protects early investors to be able to continue investing. And that actually becomes a very valuable asset for early-stage investors. So it's important to understand as you work with your early-stage backers, right, if you take their money early on and they come back to you and say, hey, we really want to invest in later rounds, you kind of understand why, where they're coming from. Because if they back you, they take a lot of risks, Putting $500K to work and making even 20, 30, 100 times may not be as meaningful as the ability to put in $10 million at the same percentage in Series C. Right?

As long as there's no cap to the valuation, then we'd be driven out anyway. They can't pay.

I'm sorry, what's the cap?

Let's say we are in round C, right, and they really want to keep their status, so what the company will do, she will just raise the valuation until those investors won't care about the pro rata, it's only about if it's worth it or not. You're saying, so if someone has a pro rata of 10% and the company keeps raising the valuation, Yeah, well, pro rata is, as you said, it's only relevant when the company is very successful and everybody wants to chip in the investment.

Yeah.

So, what a good company will do, she will just raise the valuation so the investment will be more expensive and more expensive and more expensive. So, the pro rata rights eventually doesn't mean— doesn't help so much because you can always Push the valuation up and up and up.

Yeah. It depends on the fund. If the fund is well capitalized, in theory, if a company continues to perform, you actually want to keep your percentage. Right? But oftentimes the fund might be too small. If the round is $100 million, your fund size is $100 million. At some point you probably just give it up. Yeah.

Yeah?

What's the market co-invest for VC? I come out of real estate and it's typically a 95/5 or a 90/10. I know you said it's 1+, but what's market co-invest? And what's a typical deal structure look like?

It's all over the place. Really, it's like 1% to 50%.

There's not kind of a set typical deal?

The SIP deal is 1%, but often— yeah. It's 1%. So the leverage is quite high. Yeah. Because we don't have—

Are you gonna go over promotes and carry?

No. So promote basically is carry. It's typically 80/20. In some cases, after the You know, hurdle of 2 to 3x return of the fund, you would give the GP even 30%. So I've seen that. But the average is 20 to 25% to the GP.

And the hurdles are 2 or 3x.

That's a lot higher than real estate. Yeah, right. Because real estate, you know—

We hit 2 or 3x on deals, but that's, I mean—

Not at the portfolio level. 12 over 8, so it's a lot lower for the first set of funds. Which makes sense because it's a lower risk asset class, right? Because this, I mean, if you look at the beta, the distribution, it's all over the map. Okay, so we'll kind of dig in on this. So let's say if you have a fund of $200 million, after fees the investable capital is only $160 million. Right? So the cost of doing business is quite high in VC funds, right? Because you've got to hire these partners, associates doing due diligence. So whatever is left for investing, you know, you're down to $160 million. And if you do the math, if you want to have a cash-to-cash target of $600 million exit, or 3 times your fund, suddenly if you keep doing the math and then if you have attrition of 80%, in other words, 20% of your companies are winners, then your target really becomes somewhere, you know, in the $100 million range for this fund. In other words, 50% of the fund. So if you have a a fund size of $200 million, that means the definition of a winner is a $100 million distribution.

Right.

Then if you keep doing the math, and each company if you own 10%, 20%, then that's where you come up with a number of a billion-dollar target for the portfolio. That's why if you think about why VCs keep thinking about unicorns and $100 million exit. This is the math behind it. Yeah, please.

So the $1 billion exit goal, how are these valuations actually determined? Is it mostly the annual revenue, minimum revenue, or is it user-based? Because there's so many different companies that are valued $1 billion and up, and some of them don't even have revenue that would justify such a valuation. Could you give some framework that helps us to see, okay, how do we need to set up our company to actually issue an equity carryback?

Yeah, there are different ways of approaching this, the valuation. The classic business school valuation methodology is using the cash flow analysis, right? So as you get— if the company gets bigger, you actually will use a cash flow analysis, discount it back, and come up with a valuation. Right? So that never gets used, but it's a framework. Then the next one that's most common is by using some sort of comparable analysis. You know, I'm an e-commerce company raising $1 million and I have 500,000 users. Okay, there's this other e-commerce company that just raised, they have, you know, 750,000 users and they raised $1.5 million. And their valuation was X. So let's do some simple arithmetic and figure out what the comp is. So that's really from a more of a classic finance perspective. But I tell you, valuation is basically a— you should think of it as an auction. In an auction, what happens is you have people start bidding, right? So, in the one extreme, you have 5 people bidding on this asset. Well, what happens is they will start bidding and the auction dynamics will take over. So, they may look at this and say, well, what is the risk to the next round of financing? If I put in the million and you achieve certain milestones, in the next round it'll be $5 million, so I'm going to discount it back. You could do some math to figure it out. The other extreme, you have an auction of one person, right? Then you as a company are a little bit stuck. So then that person has a lot more leverage and they could do something more extreme. Like, so for instance, they can say, well, I need to own— I need to have a $100 million distribution. There you have to work on their math. And I want to own 20% of the company. And I want to invest $1 million. Then you can back into the valuation based on what they want. Does that make sense? So the buyer and the seller, we have different math. And depending on the auction dynamics, you could drive one way or another.

And definitely,