The shine has definitely come off the early-stage space as investors begin to question whether the reward is worth the risk. There's a significant difference between the valuation a company raises capital at (driven by milestones and dilution) and the valuation it can be sold for. I recently wrote about the divergence of public and private market valuations, and it's essential to highlight the opportunities that exist in public markets compared to private markets by comparing early-stage opportunities to micro-cap opportunities.

The Valuation Disconnect

It’s crucial to understand that the valuations early-stage companies raise money at don’t necessarily reflect their exit value. While this sounds like a simple assumption, it’s often misunderstood. This has been made abundantly clear by examples like Instacart, where the valuation at which the company raised capital and its eventual IPO valuation diverged significantly.

A year ago, it wasn’t uncommon for early-stage companies to raise at a 10x revenue multiple. Today, that multiple may have dropped closer to 5x, but it’s still higher than some opportunities in public markets. In contrast, there are companies trading at <5x earnings in public markets, where investors maintain control over their capital and can sell shares whenever they choose.

My Investment Perspective

I started my career as a public equity analyst, transitioned into private equity, returned to public markets, and finally moved into the early-stage space full-time. When I evaluate opportunities, I compare them across the broader opportunity set, including start-ups, public equities, debt, and property. Capital can move between these asset classes, and I’m not tied to one. I’m also aware that the price a private company raises capital at doesn’t always reflect the market clearing price, and this becomes more evident when looking at the listed space.

Small-Cap Example

Recently, I came across a listed small-cap with a USD100m valuation. Liquidity is low, with only about USD50k worth of shares trading daily, but the story behind it is compelling. The company was burning over USD10m p.a. while operating a few mining sites sub-optimally. However, after acquiring a new site, it’s now producing 5500-7000 oz of gold monthly with an All-In Sustaining Cost (AISC) around AUD2500/oz, while selling gold for AUD3000/oz.

This results in AUD500/oz in free cash flow, or around AUD39m p.a. (USD25m) from one site. You could acquire shares in this company for less than 4x earnings. Not only that, but you also get the benefit of liquidity, meaning you can exit your position if sentiment changes.

Public Market Comparisons

Opportunities like this are fundamentally different from many technology companies with lower marginal costs of production, but it’s important for investors to realize that they can acquire shares in operating businesses at low single-digit multiples of earnings in public markets. In contrast, paying mid-to-high single digits on a revenue multiple for an early-stage business with uncertain prospects is riskier.

Convergence of Private and Public Valuations

In a previous article, I discussed how the valuations of private companies tend to converge with comparable public companies as they mature. This occurs because the growth profile normalizes, and the risk associated with early-stage businesses diminishes.

Conclusion

While we’re not exactly comparing apples to apples, that wasn’t the intention. Investors need to consider the entire opportunity set when making investment decisions. Today, investors can pick up public equities for similar earnings multiples to the revenue multiples being demanded in early-stage private markets.

There will always be investors restricted by mandates from exploring different asset classes, but capital flows to where opportunities arise. As venture capital investors begin questioning the return assumptions made over the past decade, it’s clear we’re entering a more challenging period for VC compared to the opportunities available in public equities.