Making money when it makes sense


By far, the biggest contention point between entrepreneurs and investors

is valuation. That is understandable as none likes to feel like their loosing Money. What people often overlook are the other sides motivations and the impact that the initial valuation has on their behavior.

Let me go into a simple example, with fake numbers, in order to clarify my point.

Suppose that you are an entrepreneur with 2 competing term sheets on hand.

One values your company at R$7M, the other at R$15 M and both are for R$3M in equity,

Everyone would say, go for the R$15M!  I, on the other hand, would urge the entrepreneur to think hard about the topic.

This is my view:

If a VC is putting in a R$15M term sheet, it is expecting to sell the company at a valuation close too or over R$100M.  How many deals do you, entrepreneur, really think that happen over a R$100M?  I tell you, not many. If you are one of the Lucky few, great! You are putting R$80M in your pocket and can go party.

On the flip side, the more common situation is that you will want to sell the company, say for R$50M (which would give you a healthy R$40M) but your VC wont allow it to happen as a 3X return is less than exciting.  To make it worst, imagine that due to this blockage, you miss the window of opportunity to sell and get stuck with an illiquid asset, having to work for it.

The $7M term sheet, would make a sale much more likely. Say at the same R$50M, you would make R$30M (which is still hell a lot of money for an individual), the VC would make a 7X return, and both would be perfectly happy.

The ugly truth is that the higher the valuation you are raising Money at, the more binary your outcome becomes.  Do you really want to swing for the fences?

Of course you don’t want to sell your company cheap, but you have to be very confident on the BP that supports the valuation in order to push it higher, otherwise you are brewing yourself trouble.

Another important point, is that Series A will normally be a primary investment. This means that you are discussing ownership and not cash. The cash will be tied to the exit, which your ownership structure will decide if you are getting too or not.

At Warehouse, we like to use an earn-out model to reduce this friction. We start valuing the company at a very conservative Business plan, as the company performs, we return to the entrepreneurs some ownership, hence increasing the valuation. This makes incentives more aligned and gives the entrepreneur more freedom to decide when an exit is appropriate.

Lately, to make matters more complicated to the Brazilian entrepreneurs, we have added another variable: Raising money in Brazil or Abroad.

While I think that many companies can benefit of having foreign investors and we do like to partner with them co-investing, having them in your cap table with add ForeX risk to your exit timing.

Let me go back to my simple example. Say you got 1 term-sheets for R$7M from a Foreign investor.  Lets assume the dollar at R$1,50/U$1,00.

Both VCs would be happy to sell the company at R$50M.  But lets play with ForeX 2 Scenarios: 1 – Dollar at R$1,20  and 2- Dollar at R$2,00.

Scenario 1- Investment of R$3M = USD 2M.  Desired Return of 7X, hence USD 14M.  Which at R$1,2/USD would equal R$16,8M. Therefore you could sell the company for R$39,2M (growth of 5.6X) and the VC would be happy.

On Scenario 2 – Investment of R$3M = USD 2M.  Desired Return of 7X, hence USD 14M.  Which at R$2/USD would equal R$28M. Therefore you have to sell the company for R$65,3M (growth of 9,3X) for the VC to be happy…. A lot tougher..

Being Brazilian, the entrepreneurs know that volatility in Brazil, over the 5-year investment horizon can far exceed those sce

narios. Particularly concerning, is that exchange rate is far more likely to go up than to go down (it is already killing the national industry).

To manage that, entrepreneurs can bring local co-investors into de deal, which will have more aligned interests in terms of ForeX in order to balance the power equation with the foreign investors.

My 2 cents: Don’t sell cheap, but don’t try to maximize valuation as it might burn you in the future and bring the right mix investors on board!


Author: Rodrigo

A VC trying to help build up the industry Principal @ Redpoint eventures doing Seed and Series A investments in Brazil

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