Duration of startup investments
Startups are highly cash flow negative for the first few years and (hopefully) highly cash flow positive thereafter. Fundamentally, this makes valuations highly sensitive to interest rates
I was reading this blogpost this morning which had this line:
Just five years old, Clear Street was recently valued at $2.2 billion. This isn’t a ZIRP valuation: Clear Street did $260 million in revenue in 2023, and it did so profitably.
This started making me wonder - what is the duration of startup investment? (I’m abusing terminology here, by using a fixed income term to describe equities). To put it in English, what is the sensitivity of startup valuations to interest rates?
ZIRP
This is pertinent because unlike publicly traded equities, startups are valued highly infrequently (typically when there is a new round of investment), and so the prevailing interest rates at the time the company was last valued matters.
For example, people talk about companies getting into trouble because they “last raised in ZIRP” (zero interest rate period), and with interest rates now being significantly positive, “there is no way they will get such valuations again”, and “there is no option but to raise in a down round”.
Actually if you think of it - a “down round” is not so much of a negative statement in the wake of rapidly increasing interest rates.
Assuming investors used some kind of a discounted cash flow model (they usually don’t, for startup investments. The cash flows are way too volatile, and negative for too long, for that), they are using a higher rate of discounting now, and since the positive cash flows are only coming several years down the line, the impact of rates on the valuation is fairly big.
From that perspective, if you last raised when US Treasury rates were zero, the valuation you then got was a function of cash flows being discounted at a low rate. The only issue is that you issued preferred stock then, and so the down round is going to hit you double.
(An aside - if you’ve read my old writings on the topic, my inclination is to raise money in a way that I give preferred equity holders as little optionality as possible (and sacrificing stock price in the process). Let’s see how amenable investors will be to that when I hit the market very soon)
Sensitivity to rates
This is one of those blogposts that I’m writing to clarify my own thought - any benefit to any readers is purely incidental. And at this stage, I think I have the answer to the question that I started off this blog post with. Rather, I have a qualitative answer.
Let us assume that the valuation of startup equity happens in the form of a discounted cash flow.
Look at a startup’s valuations in the first few years. As the company grows rapidly, and pumps in money to grow rapidly, the operating cash flow can only be negative.
Rather, in the first year it will be negative. In the second, it will be MORE negative. In the third, even more negative. By this time, some revenues would have started coming in.
Soon, revenues start growing, and even though the cash burn also grows fast, the cash flow starts becoming less negative. Then, maybe ten years down the line, the high growth period is done and the company is ready to go public, the cash flows start hovering around zero.
So if your DCF models cash flows for the first ten years, it is likely that irrespective of what interest rates you use, the value of the company will be negative. The early investors are basically investing on the promise that the cash flows AFTER this period will be significantly positive, and growing.
Two period model
Divide the company’s life into two periods - an initial high growth high burn period where the company starts and grows rapidly, but annual cash flows are all negative, and a later high profit period, where the company makes outsized profits (thanks to all its growth so far), still growing rapidly for a few years.
The valuation of the company can therefore be described as:
Large negative number discounted five years + Larger positive number discounted twenty years (let’s assume the positive cash flows, discounted at the current rate, are on average 10 years into the second period)
If you are looking to build a good business, the latter term needs to dominate (irrespective of rates). Now let me behave like a good maths (or finance) professor and say that we can assume that for a successful company, the first term will be small relative to the second, and so can be set to zero.
What we have for the company is basically one big cash flow (average of lots of cash flows), about twenty years away (actually this twenty is not accurate - it itself depends on rates at the point in time, but we can’t model everything).
I ran a quick simulation. I assumed US Treasury rates can go anywhere from 0 to 8% per annum. I assumed a risk premium of 10% (startups are risky, so needs to be rather high). I assumed a lumpsum cash flow of $1 at the end of either 15 or 20 years. And I calculated the present value as a function of the rates. This is what it looks like:
It’s admittedly a toy model, but the fall is steep. If risk-free rates are around 5% (as they are now in the US), the company is worth half of what it was when the rates were zero. To this, add that the latest round of investors would have been given preferred stock which gives them downside protection, and the loss to the founders, employees and earlier stage investors is much much more.
Because companies raised in ZIRP, and gave significant optionality to investors who put in money then, the rise in rates to “normal levels” has made it virtually impossible for companies to raise again.
Some takeaways for myself from my own analysis here:
I’m going to the market at a time when rates are significantly positive, so I should set my valuation expectations accordingly
When rates are volatile (and there is upside risk), any optionality given to preferred investors can hit you “double”. I need to see what I negotiate on this.
Raising one round when rates are high might make it easier to raise the next round at a time when rates are lower
Before you take my analysis to heart, remember that valuation is always wrong. There are a whole bunch of assumptions I’ve made, some valid (broad shape of cash flow curve), some highly pulled out of thin air (duration, risk premium, using a DCF, etc.). None of what I’ve written here is to be treated as investment, or any other kind of advice.
Just sharing my two cents here:
1. You shouldn’t use the high ERP which you used in the early stage, far into the late stage cash flows. Risks would have changed.
2. More than interest rates, the ability to build a case for a profitable exit is more important. Ultimately profitable exits are of course driven by public markets and hence interest rates. But interest rates are not the only driver. You don’t have to corner yourself because of higher interest rates.
3. I am yet to read your piece on Optionality for investors but liquidity preference is basic boiler plate. I don’t know if you can think of creative models of optionality
4. I have written a 5 minute reader on the first principles of VC investing and valuations. Though it may be rudimentary, I am hoping it will unblock a different perspective -
https://open.substack.com/pub/peelingthelayers/p/peeling-the-onion-on-vc-investing?r=f336v&utm_medium=ios&utm_campaign=post
Would also love to take your feedback on this.