Investing is a complicated sport, with many conflicting layers: from micro up to macro. A seasoned VC knows how to juggle all the moving parts and numbers. But it’s not an easy task. And although the maths of VC plays an integral part in the investment process, a more balanced approach – looking at numbers, alongside the environment surrounding those numbers – could be the ticket to success. Stanford and VC Catalyst’s Pedram Mokrian joined us for our recent VC Catalyst Alumni Masterclass for a discussion on some of the things he’s paying attention to in the current startup landscape.
Cost of capital
With increasing interest rates, the cost of capital is rising. This impact is felt across the entire startup ecosystem as it reduces investors’ ability to invest. Pedram sees this as both a positive and negative for investors. The negatives are clear, investing has gotten more expensive. But the positives are what interests him most. According to Pedram, we’re sitting in an “investor’s market”. The big plus here is that investors have their pick of startups and ideas to invest in, it means less competition for good deals and more favourable convertible note terms.
Valuing an investment is a challenging task for any VC. What do you consider when making your analysis? What numbers do you look at when making a final decision? There’s a lot of maths involved here, but Pedram also recommends taking a step back. Analysing the macro environment is oftentimes just as important as drilling down into the numbers.
He cites the example of Adobe’s recent (September, 2022) acquisition of Figma. The sale valued Figma at $20 billion. Which, according to Pedram, was a substantial multiple of their current and projected revenues. From a purely numbers perspective, Adobe’s investment may not add up. But as a strategic acquisition – to expand Adobe’s capabilities in digital spaces, acquire Figma’s dedicated consumers or block a potentially more volatile future competitive landscape – it does.
This is particularly true from an early-stage perspective (where our investors spend most of their time). Pedram says: “it’s really not about optimising a particular number, but about trying to absorb as much of the macro environment as you can into your thinking and into your perspectives”.
When you do arrive at numbers, Pedram recommends a simple approach: having a good understanding of what you need to own at the time of exit that makes it interesting for you. He also recommends a return to fundamentals, looking at what makes a startup money, how (and how well) they retain customers and how favourable their contract terms are. With fundamentals in check, you can move forward with more confidence in your future ownership.
They’re often passed over for SAFEs in the Australian ecosystem, but convertible notes are making their return to the investment scene. Convertible notes are short-term debts that convert into equity, unlike loans, which result in the return of funds plus interest. Much like SAFEs however, convertible notes avoid having to determine the valuation of a company too early.
As predominately early-stage investors, our VC Catalyst alumni spend a lot of time dealing with SAFEs and convertible notes. For Pedram, there are two very important numbers: the discount rate and valuation cap. These numbers play an integral role in determining the valuation of your investment when the note converts. At a seed-stage, they seem pretty arbitrary. You’re too early on in the game to know the trajectory of the company. By playing around with these two terms while doing your VC maths, you’ll get a good idea of your future outcome.
Big picture view
1Taking a macro approach is Pedram’s recommended strategy (and for early-stage investing more generally). He says, “the thing you have to do is take a slightly bigger picture view of how the world is tracking, and how follow-on financing has impacted your ecosystem”. He also suggests being a, “little bit tighter in terms of your level of scrutiny and engagement with founders”, but importantly, not so tight that you miss out on good opportunities.
And in terms of outlook? Pedram thinks, “this is absolutely a fantastic time to be in the market”. He concedes that conditions are challenging, rising interest rates and increasing cost of living used here as examples. The most important thing to keep in mind is that we operate in an innovation ecosystem. Focussing on investing in companies that are solving problems will always be the strongest strategy for investors to adopt. It’s a method we teach in VC Catalyst and on the flipside, to our entrepreneurs.
Interested to learn more? Our next cohort of VC Catalyst is now accepting expressions of interest. Download a brochure, reach out with questions or register now.