Have Venture Capital valuations reached their peak? How does it affect me as an investor?

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In the previous article, “Have Venture Capital valuations peaked?”, we discussed how valuations of different assets have been behaving and specifically analyzed the 10-year uptrend in early-stage startups. We wondered what we could expect in 2023, concluding that “2023 will maintain or slightly decrease the valuations of this asset class“.

For this new article, we will analyze the impact of movements in the valuations of this asset class for the investor.

First of all, we must understand two essential aspects regarding returns in this investment class, the type of divestment or exit and the divestment term:

  • Typology of divestment or exit

Once the investment is made, and considering the illiquid nature of this type of asset, investors must wait for a liquidity event to occur. Therefore, a total or partial divestment will allow them to recover the principal and the final return obtained. This liquidity event can occur fundamentally through two scenarios:

  1. Third-party acquisition of the company. In this case, another company, or a private equity fund, acquires the company or part of it. Here is where the drag-along and/or tag-along clauses come into play.
  2. IPO. The invested company is listed on an organized stock market. Investors can thus generate liquidity by selling their shares on the market where the company is listed. These are usually junior markets where liquidity is, at least initially, low.
  • Time to exit

A company’s divestment period is usually directly related to the company’s situation, business model, industry, and the state of the industry. Generally, the average time until a liquidity event occurs in this investment class is high, between 5 and 7 years. However, intermediate events can occur, such as the entry of a significant investor or a merger with another company, which can accelerate these timeframes.

Why are these two aspects so relevant?

As stated in the previous article, valuations with higher volatilities and faster replication of the movements occurring in the listed markets, both declines and revaluations, are closer to a liquidity event.

Considering the long time horizon of our investment, economic cycles may vary during the investment, thus contracting or expanding the valuation multiples. The valuation change suffered by these market movements could also be amplified by maximizing or minimizing the return multiplier obtained if we are approaching the possible existence of a liquidity event in our investment.

This effect is known in Venture Capital as the vintage effect. In other words, very different returns are obtained in investments in which a company may have a similar evolution according to the point in the investment cycle and the time of the liquidity event or disinvestment.

Let’s explain it with a simple practical exercise and consider different scenarios.

We invest €10,000 in company A in year 1. The company manages to evolve satisfactorily and continues to grow until, in year 5, it decides to list on a listed market.

For this exercise, we assume that the company may have an initial valuation of €1,000,000 at a high point in the economic cycle and that, after five years, its valuation is multiplied by a factor of 5 due to its good performance. In the case of a low point in the cycle, we assume the same revaluation but with a 20% lower valuation. That is, depending on factors extrinsic to the company, a company may have one valuation or another.

Company’s valuation by cycle in Year 1 and Year 5

Valoración de la compañía en función del ciclo en Año 1 y Año 5

  Year 1 – Investment Año 5 – Divestment
Cycle peak 1,000,000.00 € 5,000,000.00 €
Cycle low time 800,000.00 € 4,000,000.00 €

When analyzing the profitability obtained within this scenario, we observe a notable difference when the cycle change occurs between investment and disinvestment. There is a difference of more than 50% for valuation changes of 20%.

Cash obtained in the exit
Exit at cycle peakExit at cycle low time
Investment at the cycle peak 50.000,00 € 40.000,00 €
Investment at cycle low time 62.500,00 € 50.000,00 €

The revaluation we can obtain in our startup investment is not unrelated to market movements. Given the long time horizon expected for a liquidity event, it is very difficult to know when making our investment whether we are at a higher or lower stage of the cycle compared to the time of divestment.

It is essential to diversify our startup investment portfolio according to the moment we invest, the time horizon, and the diversified portfolio with investments in different companies and time horizons. This way, this vintage effect will be dampened, and we will be able to achieve returns on average more directly linked to the performance of our investees.

Juan Sánchez Margareto
Senior Analyst

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