8 Capita, the investment partnership I run with a couple of friends, plays in the VC and PE space. Couple of months ago we completed our second buy out deal, acquiring a Sydney-based expense management software company. Here are some thoughts on VC versus PE:
Early stage (pre-revenue) startups in South-East Asia are going out at valuations upwards of $2m. In Singapore, easy access to government co-funding schemes is pushing up valuations – when a startup is raising a $500k seed round, entrepreneurs naturally push for 7 digit valuations to avoid being diluted too much. How is the valuation justified? It’s a question I often ask entrepreneurs when they tell me they are valuing their startup at $2m or whatever, and I’ve yet to come across an entrepreneur who can make a convincing case why their startup is worth a few million dollars.
In private equity, companies are usually valued based on earning multiples. 3-5 times EBIT is common. Taking a 4x multiple, a potential acquirer will offer $2m for a company making $500k a year. Assuming stable earnings going forward, the acquirer knows that he will make back what he paid for the company in four years. Earning multiples seems to me a more conservative way of valuing a company. Granted most early stage startups are not profitable and therefor cannot be valued based on earning multiples, but the point remains that it is often times hard to justify why a startup with a small user base making no money should command valuations similar to a mature software company making hundreds of thousands in profit a year.
Acquisition targets in the PE space tend to be mature companies that have been around the block. Financials are relatively stable, which makes it easy to project into the future. There are of course exceptions such as distressed assets, but by and large it is relatively straightforward to do a fairly accurate 3-5 year financial projection. Early stage startups are inherently risky. It is difficult to tell whether a startup will survive the next 24 months, much less make financial forecasts with any degree of confidence.
In South-East Asia exits upwards of $15m are still relatively uncommon. So say you invested in a startup at a valuation of $2m and along the way you were diluted by new financing rounds – when the startup exits for $15m four years after your initial investment, you may end up with a 4x return on your investment. That’s decent for an early stage investment in this part of the world. In private equity, unless you’re in the business of flipping an asset to a much bigger PE firm, double digit percentage growth in the top and bottom line is probably more realistic. Or to put it another way, you have a better chance of getting a five bagger from an early stage investment than a PE deal, but the risks are significantly higher too.
The startup space seems to be dominated by a relatively young crowd with ambitions to change the world, or if not to at least make their first million before their thirtieth birthday. This is a sweeping statement, but startup entrepreneurs can probably be characterised by three words – young, ambitious, idealistic. The founders we meet in the PE space tend to be older (and wiser?) with more realistic expectations of their business. Often times they have been running the company for years, getting it to a steady state generating stable cashflow, and are now looking for new personal or professional challenges.
This blogpost is not a criticism of early stage investing vis-a-vis the merits of private equity. I’m still an active early stage investor, both in a personal capacity and as a partner at 8 Capita. The point rather is that having seen the type of deals in the PE space, I am a lot more selective about the early stage startups and entrepreneurs I choose to invest in, and the valuations I’m willing to accept.