The FAANMG companies — Facebook, Apple, Amazon.com, Netflix, Microsoft, and Google — are known for their massive global reach and market valuations that outstrip the economies of some nations. However, as quickly as valuations for Facebook and Google multiplied to reflect their exponential growth, these companies also made it a point to pave simple and short paths to profitability.
In addition to heavy fundraising to drive market share, the tech behemoths achieved positive unit economics relatively quickly — five years for Facebook and three years for Google, for instance. They reached sustainable growth rates pre-IPO with relatively high valuation-to-capital ratios (more than 5x), which is an indicator of how a company’s raised capital can increase shareholder value.
|FAANMG||Year of IPO||Valuation at IPO (USD)||Pre-IPO total fundraised (USD)||Valuation-to-Capital?||Profitable in IPO?|
|2012||$104 billion (May 2012)||$2.3 billion (May 2012)||High (45.2x)||Yes|
|Amazon||1997||$300 million (June 1997)||$8 million (June 2020)||High (37.5x)||No|
|Netflix||2002||$309.7 million (May 2002)||$103 million (May 2002)||Low (3x)||No (Yes in 1 Year)|
|2004||$23.1 billion (Aug 2004)||$36 million (May 2002)||High (641x)||Yes|
|(Microsoft’s 1986 IPO and Apple’s 1980 IPO neglected to maintain relevance)|
This disciplined form of capital management may just be what the venture capital industry needs right now. One way to ensure this discipline is to adopt earnout structures, as opposed to the common practice of raising gigantic rounds to scare competitors off.
Profitability on the backburner
Over the last decade, the global race to get startups to ‘unicorn’ status (valued at $1 billion or more) has led many founders, limited partners (LPs), and fund managers to put profitability on the backburner. They prioritised vigorous rounds of fundraising that were highly inefficient when executed.
In the last five years, dealmaking in Southeast Asia has been fueled by large swathes of easy money from investors drawn to the growth story of emerging ASEAN markets like Indonesia, Vietnam, and the Philippines.
Valuations skyrocketed so quickly that ASEAN boasted ten unicorns just last year. In 2021, though, most ASEAN unicorns, including several Indonesian household names, are struggling to get sizable upsides in valuation (meaning at least double those of previous fundraising rounds).
After years of record fundraising and ballooning valuations, the pandemic all but brought ASEAN startups back to Earth. Investors are now crowing about clear ‘options’ to profitability, not just a single ‘path,’ before they plow more money into cash-burning startups.
The ecosystem’s current lower valuations — approximately 20% to 30% less than the year before — have led to significant dilutions for later-stage investors.
Just as gold is seen as a ‘safe’ investment during economic slumps, so too are unicorns viewed in the VC space. But while these big names continue to raise funds, the amounts raised continue to pale in comparison to pre-pandemic funding rounds, with significantly inefficient valuation-to-capital ratios.
ASEAN unicorn fundraising in 2020
|Unicorn||Year est.||Estimated valuation||Total fundraised (USD)||Valuation-to-capital?||Profitable?|
|Grab (Singapore)||2012||$14 billion (Aug 2020)||$10.1 billion (August 2020)||Low (1.4x)||No|
|Gojek (Indonesia)||2010||$8 billion (Mar 2020)||$5 billion (June 2020)||Low (1.6x)||No|
|Tokopedia (Indonesia)||2009||$8 billion (June 2020)||$2.8 billion (June 2020)||Low (2.1x)||No|
|Traveloka (Indonesia)||2012||$2.75 billion (June 2020)||$1.2 billion (June 2020)||Low (2.29x)||No|
This trend has not come without reason. 27 ASEAN-focused funds grabbed fresh capital last year and data from Preqin shows that regional funds went on to raise $400 million in the first half of 2020. Their dry powder is now compounding at 162% of the pre-2020 quarterly rate. As such, all this dry powder needs to go somewhere to bring LPs their returns, whether it’s efficient or not.
If even the biggest names in the region are highly inefficient in driving value for shareholders, what does this mean for the early-stage players? Entrepreneurs and VCs who previously stuck to the playbook of raising gigantic rounds to scare competitors off need to rethink their approach and move into a more disciplined form of capital management. Adopting what we call an earnout structure may be just what the industry needs.
What is an earnout structure?
An earnout is a contractual arrangement in which the acquirer pays a sizable amount of the purchase price upfront, at the time of closing the deal, while the remainder is contingent on the ‘future performance’ of the investee company. This arrangement is typically used during M&A transactions to break negotiation deadlocks. These deadlocks occur most often when the acquirer and target company do not see eye-to-eye on valuation.
But this also happens in early-stage funding rounds. For example, if a startup wants to raise $5 million at $20 million valuation, but the VC estimates its value at $15 million, negotiations can get sticky. To meet in the middle, both parties may agree on a $3 million round at an initial valuation of $15 million. Then, with an earnout clause baked into the term sheet, the startup can easily grab an extra $2 million later, at a higher valuation, provided they hit some specific revenue and traction milestones.
Sometimes, additional options can even be written in that let the startup pocket even more capital and a valuation beyond the original bullseye. This is a sweetheart term, as founders won’t necessarily need to run around town later on pitching to more investors when it’s time for the next round.
A growing number of Asia’s VC insiders are calling for fund managers to act responsibly by encouraging startups to raise smaller rounds at more reasonable valuations, with earnout structures woven into the terms. The underlying idea is that startup management teams will gain more motivation to grow healthily, while also benefiting from more certainty of future capital.
There are also benefits for the investors. VCs can suddenly enjoy an anchor to a company’s fair market value, rather than being at the mercy of sentiment. An earnout structure can also act as a protective buffer against inherently low-quality companies, as founders may be reluctant to accept such terms (they’ll know there’s little chance for reaching the milestones). Meanwhile, dilution exposure can be mitigated all around and ambitious valuations can still be on the table — provided that all parties are willing to ‘earn it.’
Earnouts versus tranches
It’s important to note that earnouts are not the same as investment tranches. The latter is often considered a dirty word in VC investing.
In our industry, a tranched investment is a deal that involves only one valuation, but the actual release of capital to the target company happens in increments. Like earnouts, these tranches are usually based on milestones. But tranches are often predatory because they provide an unreasonable level of downside protection to the investor (e.g. investing without actually investing). They can also create perverse incentives for the startup, such as the sudden need to court other investors just to bank enough working capital, rather than being free to focus on running the business.
To wit, earnouts provide the founder with a ‘carrot’ to help them reach a higher valuation. Tranches act as a ‘stick’ to make founders justify the current valuation. Tranches are bad because they may starve companies of working capital.
More VCs in Asia need to start adding earnout structures into their term sheets. With this instrument, limited partners, fund managers, and startup founders can maintain a baseline of sanity when it comes to dealmaking. The show goes on and at the end of the day, we can all still chase gargantuan valuations.
The author is a partner at Arise Fund by MDI Ventures and Finch Capital. MDI Ventures is a $830 million, multi-fund, venture capital arm of Indonesia’s largest telecom company Telkom Group. It is one of the best-performing tech investment funds in Asia.