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Valuation Divergence

Luis Villalobos, Managing Director, Angel Venture Partners

Return for an equity investor in an early-stage venture is based on the increase in valuation of the shares the investor received. But as the valuation of a venture increases, the valuation of the shares increases at a much lower rate or might even decrease. This disparity in valuation increase is what I call "valuation divergence."

How divergence affects investors. Most entrepreneurs and investors assume that as the venture valuation increases, the value of the shares will increase proportionately. A typical funding proposal from an entrepreneur says, "I will sell you 10 percent of my venture for $1 million, and in five years when I sell my venture for $150 million, you will receive $15 million (10 percent of $150 million). That is 15x what you invested and a terrific return."

In reality, even if the venture achieves an exit value of $150 million in five years, the investor will be fortunate to get back $3 million to $5 million—a 3x to 5x return. More typical, this return is clearly far below what entrepreneurs generally anticipate for investors. Entrepreneurs who understand the concept of "divergence" usually expect more modest valuations.

Gadzoox investment. The investment that led to my epiphany on valuation divergence was in Gadzoox Network in 1996. It was part of a $2 million angel round with post-money valuation of $6.6 million and pre-money of $4.6 million. By late 1998, the company had done a venture-capital round at $25 million post-money and then successive rounds with strategic investors at post-money valuations of $79 million and $156 million. Gadzoox had already increased 24x, so I daydreamed it wouldn't take that much to increase another fourfold in valuation and be sold for $660 million.

That would have provided that near-mythical 100x return.

Epiphany on divergence. In fact, at the close of the Gadzoox IPO, my shares were worth 101x what I paid for them, and I was elated. Then I realized the company valuation at the market close of its IPO had increased not by 101x but by 284x—almost 3x more than my shares. So I compiled the data and had my epiphany. The table reflects the details of Gadzoox's valuation, round by round, from my angel investment to close of IPO.

The columns represent the data from five funding rounds. In the first round angels (including me) invested $2 million and received 30.3 percent of the equity, with shares at $0.74. At the close of the IPO, the venture's valuation was $1.876 billion, an increase of 284x ($1.876 billion ÷ $6.6 million), and the price per share was $74.8125, an increase of 101x ($74.8125 ÷ $.74)—both keyed to the post-money valuations of the angel round. The "divergence" is the ratio of increase in respective valuation of the venture versus investor shares. In this case, the divergence was 2.8 (284x ÷ 101x).

Expect divergence, even in successful investments. Although Gadzoox is just a single example, it's a powerful one. After all, how many early-stage investments are in a company for which the valuation goes from less than $7 million to nearly $2 billion in three-and-a-half years? The data I am compiling for my book strongly suggest that divergence for successful exits is usually between 3x and 5x.

Dilution causes divergence. Another way to look at divergence in Gadzoox is that the angels' ownership was diluted to 10.8 percent from 30.3 percent (30.3 / 10.8 = 2.8). Although investors and entrepreneurs are generally familiar with the concept of "dilution," few consider how it affects the valuations of company and investor shares. I developed the concept of divergence to emphasize how these valuations change from investment to exit.

The "no dilution" illusion. Entrepreneurs often believe that subsequent financing won't be needed to reach their five-year plan numbers, so dilution won't occur. But optimism is part and parcel of the entrepreneurial spirit and, in this case, only masks reality. Most ventures lose money for the first couple of years. Even those few that are immediately profitable rarely grow to $50 million or $100 million in three to five years without substantial infusions of capital. A company that does $100 million in its fifth year, for example, can easily need $10 million for cash balances, $20 million for receivables, and cash to finance capital expenses. In addition, non-financing issuances of equity need to be considered.

Summary. An understanding of how divergence works can make negotiations between entrepreneurs and investors more productive and less contentious because expectations on both sides will be more realistic. In nearly all cases, between an early-stage investment and an exit divergence the valuation of investor shares will likely increase by 3x to 5x less than the company valuation.

© 2007 Luis Villalobos. All rights reserved.

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