"Why is the pre-money important? Don't I just need to look at my eventual exit value?"
Where you start is equally (if not more) important as where you finish
I think of investing as jumping the hurdles or crossing the chasm. The higher the hurdles, the further the chasm, the less likely you are to make it to the other side.
The other side in this case represents your targeted investment return.
Assume same raise of US$1 mil (someone tells you, US$1 mil and we can meet our goals!).
If the exit value is US$20 mil,
- On a US$2mil pre-money: You would have 33% of the final exit value i.e. US$13.3 mil, a 13.3x multiple.
- On a US$10 mil pre-money: You would have 9.1% of the final exit value i.e. US$1.8 mil, a 2x multiple.
A 5x increase in pre-money resulted in a 6.7x drop in your return multiple. This is because the effect of dilution on your starting returns.
Lesson: If you want to invest successfully, don't forget to assess the pre-money.
Where you start is equally (if not more) important as where you finish
I think of investing as jumping the hurdles or crossing the chasm. The higher the hurdles, the further the chasm, the less likely you are to make it to the other side.
The other side in this case represents your targeted investment return.
Assume same raise of US$1 mil (someone tells you, US$1 mil and we can meet our goals!).
If the exit value is US$20 mil,
- On a US$2mil pre-money: You would have 33% of the final exit value i.e. US$13.3 mil, a 13.3x multiple.
- On a US$10 mil pre-money: You would have 9.1% of the final exit value i.e. US$1.8 mil, a 2x multiple.
A 5x increase in pre-money resulted in a 6.7x drop in your return multiple. This is because the effect of dilution on your starting returns.
Lesson: If you want to invest successfully, don't forget to assess the pre-money.
"It looks like a low pre-money is essential to success. Is it as simple as that? To go for the cheapest?
Wrrronnnngggg. What is cheap is not necessarily good.
The best teams, talent & track record won't come cheap - you just need to make sure you are investing at a fair price.
In silicon valley, good quality seed deals can be found between US$2-10 mil post-money. So when you look at a deal next time, ask yourself if you the pre-money valuation seems fair enough.
"How do you determine the fair value of an investment today? I receive a lot of these businesses with lofty projections of discounted cashflows, that translate to a very high net present value (NPV)?"
(Awesome, keep the questions coming.)
Firstly, for the benefit of everyone, there 3 fundamental/inescapable valuation methods:
(i) Present value of discounted cashflows: Cashflows (in/out) are projected and discounted based on the cost of capital and adjusted for probabilities/milestones
(ii) Comparables: Benchmarks are utilized based on actual performance indicators e.g. sales, EBITDA multiples.
(iii) Net assets method: Balance sheet-based method, usually used as a floor valuation.
You might ask... "But... but... how do you handle startups under a discounted cashflow method?"
Well, as renowned investors Andreesen Horowitz and Founders Fund pointed out, the principles of DCF can still be applied to startup valuation. A startup that is pursuing a multi-billion dollar opportunity still has milestones to meet. When they invest in a biotech pharma opportunity with US$10 billion dollar exit potential there might be 4 gatekeeping milestones for them to pass through (e.g. initial drug approval by FDA, 3 field tests). If each milestone is accorded a 10% success rate.
10%^4*10 bil = US$1 mil.
edited
"On to ICO investment structures: What should we be looking out for?
Unfortunately, the reality is that a lot of ICOs today have very large/inflated pre-money value components (discussed below in further detail).
But let's take a step back - what should we be looking out for:
(1) How many tokens will be issued? Related to this, if there were unsubscribed tokens, what is the policy on them? (Usually, they are "burned".)
(2) What is the type of token you are receiving? And ultimately, taking into account the business model and the no. of issued tokens in (1), what is:
(i) The cashflow you expect to receive per token?
(ii) The probability of receiving the cashflows? This is effectively getting to a probability-adjusted cashflow.
E.g. 50% chance of receiving $1, 50% chance of receiving $0.50 means the probability-adjusted cashflow is $0.75.
You need to know the potential value of the token, or you won't be able to relate it to the price per token.
(3) What is the distribution of tokens? They will often have a lot of categories, but this actually splits into public subscription vs non-subscribed/grants.
This is very important. If 2 businesses raise US$10 mil and for:
(i) Business A, this goes to 10% of tokens. This means that the business is according US$90 mil pre-money value to insiders/founders/non-public.
(ii) Business B, this goes to 50% of tokens. This means that the business is according US$10 mil pre-money value to insiders/founders/non-public.
(iii) Business C, this goes to 80% of tokens.This means that the business is according US$2.5 mil pre-money value to insiders/founders/non-public.
Notice how distributions affect pre-money value and what % of value actually ends up in the hands of the public?
(4) What is the total cap? Is there a soft cap and a hard cap?
(5) How will liquidity result for the tokens? This is extremely important! Having cheap, illiquid tokens is pointless. I often say, "I want a path to cash!". Yeah, I am a greedy lil' shit, but I need to look out for my investors/backers :blush:
(6) "Bonuses/discounts for early/large subscriptions - what are they?" For all the talk about fairness and decentralization, here is the simple, single, unforgiving truth. The rich will get richer.
Subscriptions that grant you an edge in value is always better than those at fair market value terms.
Remember: However, bonuses/discount rates are not sufficient to overcome a poor business model.
It is very important to squeeze the edge out.
As usual this is for reference only do your own due diligence as I am not a Professional advisor.
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