What Pre-Money Valuations Does Lateral Capital Look For?
In our view, the question of pre-money valuation gets more attention than it deserves. It is what most investors talk about most. This comes typically from investors who want to “make it on the buy” … investors who feel that their biggest chance of getting a return is to invest in the company at the lowest possible valuation. We are not saying that “buy low, sell high” has gone out of fashion. But this is not our only mantra. Rather, we look to “make it on the sell.” Our objective is to make our return by selling the company sold at a valuation higher than the one we came in at. In that context, the question we ask ourselves is not so much what the pre-money valuation is, but whether or not the company can be sold for at least 5X the price at which we invested. Here’s the logic.
A 5.0X multiple is about twice our target average return of 2.6X. Assuming that 50% of our investments will fail completely, the 5.0X translates to about 2.6X return, or thereabouts. Remember also that this only works because our first round investments are always the same at $100,000 per company. If we don’t believe the company can sell for 5X the price at which we invest, we don’t invest. It’s that simple.
In this context, all the published data around “pre-money valuation trends” is not all that helpful. Data services, including CB Insights, Halo and Prequin capture all kinds of data here, but so much detail underlies these averages that it’s like drowning in an average water depth of 2 inches. Rarely does this data show what percentage of these companies actually had revenue or what industry vertical they came from. For example, valuations on software-based companies are typically higher, but the chances of success are all over the map. MedTech valuations are higher as well, as the outcomes can be extraordinary. Adjusted for the risk and the timeline, however, it’s hard to know how meaningful the next Early Stage pharma valuation really is.
Likewise, we are not too concerned about regional variations. Median valuations for “Angel-Stage” companies (however that is defined) are often half in Texas what they are on the East Coast. This may reflect the fact that there is more money chasing fewer deals in one geography versus another. Or that the mix of investment types differs dramatically. As one example, Texas scores more investments in the Food and Beverage sector than any other Angel Investment market. Does this mean F&B deals are lower valued in general? Or that we should all rush to make investments in Texas? Probably not.
The net here for Lateral Capital is as follows: We try to invest in a valuation range between $3MM and $5MM on a pre-money basis. This is a range in which we can easily envision a sale at 5X our going in position. We typically cap valuations at $10MM since the number of companies which can sell for $50MM is very, very small. Remember that 90+% of Early Stage companies sell for less than $40MM. As we have said repeatedly, we are looking to get the “industry average” return in the Early Stage market: 2.6x our money on average … across groups of 15+ companies where about 50% of the companies will fail, 7-10% will produce a 10x return or more and most of the others will return 1-5x. To get to that average, every company we invest in has to have a 5X return potential.