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Over valuations are becoming increasingly prevalent among early-stage entrepreneurs in South Africa and Silicon Valley is to blame.
So, says venture capitalist Clive Butkow of Kalon Venture Partners, who — when asked last week by Ventureburn on what drives over valuations of local startups — blamed the unrealistic perceptions on local startup founders who spend too much time in Silicon Valley where venture capitalists are quick to throw out large valuations without writing out a cheque.
“Often we do find the entrepreneurs coming back to reality and revising down their ask,” he said, adding that over valuations are also driven by founders who raise smaller amounts from angel investors that “totally” over value the business.
In many cases it forces the VC to invest in what he calls a “down round”. This is when a company raises a round of capital at a lower valuation then the previous round.
“Our advice to these entrepreneurs is to raise their seed or Series-A rounds overseas rather than in SA,” said Butkow.
Local venture capitalist blames the unrealistic perceptions on local founders who spend too much time in Silicon Valley where VCs are quick to throw out large valuations
Butkow’s comments follow those made in October last year in which two leading SA venture capitalists charged that inaccurate valuations from SA angel investors are skewing the value of companies venture capital (VC) funds are keen to invest in.
Butkow said there are essentially two types of valuation which venture capitalists encounter — a founder valuation and a market valuation.
In the first — a founder-valuation, the valuation is based on how much a founder believes their business is worth.
The second, a market valuation, is essentially how much a founder’s business is worth to investors when taking into consideration investment risks. “In other words, a startup is worth what someone is willing to pay for it,” said Butkow.
Butkow said he and his team use forecasts from the startup to calculate future cash flows (free cash flow), net present value, internal rate or return with a variable weighted average cost of capital (WACC) which is driven by the level of risk the deal entails.
“Before we use their (startup’s) forecasts we do a stress test in their numbers to assess feasibility based on our experience and the vertical of tech they are operating in,” he said.
A Software as a Service (SaaS) business for example would have a different valuation methodology to a software B2B business, he added.
But while Butkow admits that a valuation is more art and experience then a science, he said entrepreneurs often “drink their own cool-aid”, as few have the experience to know how long it will take to get traction in the market.
As such many entrepreneurs tend to overestimate the revenue their startup is expected to generate, while under estimating the costs that it will incur in doing so. Said Butkow: “Our rule of thumb is to halve the revenue and double the expenses and time to break even.”
Like this, many startups may need to rethink the value of their startup.