My friends at Weekend Fund recently put out a round-up newsletter of some investor responses to the question “Do Valuations Matter?” It’s all worth reading but I’ll excerpt my thoughts here since it’s a discussion Satya and I have often with new VCs.
How Hunter Walk @ Homebrew approaches valuations
Homebrew is an evergreen fund investing primarily in pre-seed, seed and Series A rounds.
Like NEA, Homebrew takes an ownership-driven approach to investing. They view valuation as an important guardrail in evaluating an investment opportunity. Hunter also breaks down their framework for evaluating an investment opportunity when achieving their target ownership exceeds their maximum check size, and the “opportunity cost” of doing so resulting in less diversification.
More from Hunter:
“In our historically concentrated approach to seed stage investing, hitting our ownership target mattered more than valuation *but* valuation was an incredibly important guardrail in evaluating an opportunity, for it has great impact on the company and our portfolio management overall.
We set a ‘max check size’ for our initial investments which was meant to get us, on average, 10-15% ownership and if held to, would overall guide us to an investment period that provided both time and company diversification for the fund. It also drove our reserves strategy. So in any negotiation, whether we wrote our ‘max check’ to get the target ownership was a factor of round size, company stage, and so forth. But we would rarely walk away from an opportunity based on valuation if it fits within that target ownership and check-size box.
In situations where targeting the 10-15% ownership would have required a commitment larger than our ‘max check size’ we had to decide whether (a) the opportunity here was worth 1.5 or 2 slots – ie are we going to make one fewer investment out of the fund in order to do this one or (b) would we stick with our check size but take lower ownership as a result or (c) walk away. Of these three, (c) was the most common decision for a variety of reasons that were about being consistent in our strategy and product offering.”
— Hunter Walk (Homebrew)
Compare your level of conviction to the price the market is setting
“The ‘valuation question’ is one that comes up frequently in our discussions with the emerging managers we back via Screendoor (where we will invest up to 10% of a fund’s target raise and bring them into a community of investors ongoing for these types of questions). While situations can differ, my general rule is that the market determines the price, so you have to kind of decide whether your conviction in a company is equal to, greater, or less than price the market is telling you they are ‘worth.’”
Be disciplined to ensure you can hit a minimum portfolio size
“It’s a power law business so an EM wants to be able to show the quality of their access, picking, and winning. Having hard and fast ceilings on what you’re willing to pay, or trying to over focus on the upper bound of your ownership target too early in your venture lifecycle might make it tougher to prove selection success. So don’t routinely overpay or outbid, especially when you don’t believe in the company as much as the market does, but potential LPs will be more interested in the number of successful investments you picked than your entry price in them. Just maintain enough discipline to ensure you can hit a minimum portfolio size.”
Valuation negotiations can reveal a lot
“Besides the math of it all, valuation negotiations can tell you a lot about what matters to the founders, the type of relationship they want to have with their investors, and the goals they need to achieve to complete successful next financing.”