Getting Ready to Raise Series Pt. 2: How do Venture Capitalists Value Companies?

You may be wondering how investors come up with valuations as well as the number of shares to be included in a financing round. Much of this is determined by the market rate as well as incentives and “venture math.” As you can imagine, it is important that your company get the valuation right, but it’s more important to understand how this all comes into being.

Investing comes down to a simple premise—risk vs. reward. The higher the risk, the greater the expected reward. Venture capitalists (VCs) and seed investors typically require 10X for invested capital, but growth equity investors look for 5X, and private equity investors often seek 3X returns—with more visibility and fewer unknowns, the risk is far lower and therefore the return expectations follow suit. The art is often found more in the structuring of the deal rather than just the valuation, but the valuation needs to be taken into consideration foremost because getting it wrong can have dire consequences for the company, founders, and investors alike.

“VENTURE MATH” AND HARSH REALITY

Before we get deep into our discussion, let’s first start off with an example and some key terms that will help us navigate our analysis.

EXAMPLE

In the following example, we are going to start by making a few assumptions:

• The VC was provided $100 million dollars to invest; the investors that give VCs money to invest are called limited partners (LPs).
• The VC must return at least a 10X return which would be at least $1 billion.
• There are 10 companies in the VC’s portfolio; these companies are called “portfolio companies.”
• The VC invested $10 million in each of the 10 companies (we are not going to discuss carry and management fees in this example for the sake of simplicity).
• All but one portfolio companies fail in this example. That one shining star needs to be so successful that the VC will receive $1B for its stake in the company.
• The VC invested $10 million at a $30 million pre-money valuation (equating to a $40 million post-money valuation after adding the invested capital to the pre-money valuation), so the VC owns 25% (($10 million invested capital) / ($40 million post-money)) of the company at the time of exit (we are going to assume there were no more financings for the sake of simplicity). Somehow the company needs to grow so that 25% of the company equates to at least $1 billion.

Key Terms

Let’s introduce a few key terms you should be aware of when discussing valuation:

Enterprise Value – this is what your company is worth today, generally calculated using the following formula:

Enterprise Value = (Equity Market Capitalization) + (Debt Outstanding) – (Cash)

New Money – this is the money of the new raise.

Old Money – this is money put into the company prior to the new raise.

Pre-Money Valuation – this is the value of the company before new money is added to the company.

Post-Money Valuation – this is the value of the company after new money is added to the company.

Following our earlier example, we know that the VC added $10 million to a company and the post-money valuation of the company is $40 million. This means that the $10 million was new money, and to find the valuation prior to the investment, we must subtract the new money from the post-money valuation in order to determine the value of the company prior to the investment—the pre-money valuation.

Pre-Money Valuation = (Post-Money Valuation) – (New Money)

Pre-Money Valuation = ($40 million) – ($10 million) = $30 million

Determining Exit Value

Using standard corporate finance methodologies, valuation is often calculated using a set of comparable multiples. One set is based on a set of companies that resemble your company in terms of industry or business model and are currently publicly traded, and the other set is based on similar companies that have been merged or acquired. In both instances, the same sets of multiples will be used to determine valuation:

(Enterprise Value) / (Trailing 12-Month Sales) aka (EV) / (Sales)

(Enterprise Value) / (Trailing 12 Months EBITDA) aka (EV) / (EBITDA)

An example of the exit values of comparable publicly traded companies:

The exit value in this case will be calculated by multiplying the EV/Sales multiple for the public companies by your company’s past year’s sales (let’s assume $500 million).

Using algebra, we look to find the exit value of the company necessary to reach the returns the VC needs to satisfy its LPs.

25%* (The Necessary Exit Value of the Company) = $1 billion

(The Necessary Exit Value of the Company) = $1 billion / 25%

(The Necessary Exit Value of the Company) = $4 billion = $500 million Revenue* 8X

*This is 1000% or 100X the value of what the company was worth when the VC invested!!!

VCs need to find, invest, and allocate the right amount of dollars into hypergrowth companies that address massive problems that will occur in the future. If today we are living the problem that a company is trying to solve, it’s most likely too late to generate venture returns. VCs are counting on your company to be worth over $1 billion in order to cover the losses of the other portfolio companies so that they can provide the returns they need to satisfy their LPs.

This is a lot of pressure. That’s why VCs work so hard with their portfolio companies, looking to take sizeable portions of equity and sit on their portfolio companies’ boards. VCs have to drive this return. Though VCs may ultimately face the harsh reality that the majority of their companies failed or underperformed, each investment needs to demonstrate its capability to generate a 10X return.

HOW MUCH STOCK SHOULD BE ISSUED IN THE ROUND?

Now that we know the end value of the company after the new raise, we need to know how much stock to give to the new money investor.

Let’s start off with what we know.

• We know the pre-money value of the company is $30 million.
• We will also establish the assumption that we know the amount of shares outstanding per the company’s cap table is 6 million shares (though the cap table was not mentioned previously, you should be keeping track of the company’s equity via cap table).

Now we want to find the price per share, since this is the cost for each share of the company that a new investor will have to pay. We find this number by simply dividing the value of the company before new investment (the pre-money valuation) by the amount of outstanding shares.

Price Per Share = (Pre-Money Valuation) / (Number of Outstanding Shares)

Price Per Share = ($30 million) / (6 million Shares)

Price Per Share = $5.00 / Share

New Outstanding Shares

At this point, we know that the cost of a share is $5.00 per share, so in order to find the amount of outstanding shares that a new-money investment will yield, all we need to do is divide the amount of new money investment by the cost of shares.

New Shares = (New Money) / (Price Per Share)

New Shares = ($10 million) / ($5.00/Share)

New Shares = 2 million Shares

Company Ownership

Now, you may be wondering how much of the company the new investors own at the end of this financing. There are a few ways to do this.

We can divide the new money by the post-money valuation.

Investor Ownership = (Investor New Money) / (Post-Money Valuation)

Investor Ownership = ($10 million) / ($40 million)

Investor Ownership = 25%

We can also divide the number of new shares to be outstanding by the company’s total capitalization. Keep in mind that the total capitalization will include the new shares.

Total Capitalization = (New Shares) + (Old Shares)

Total Capitalization = (2 million Shares) + (6 million Shares)

Total Capitalization = 8 million Shares

Investor Ownership = (New Shares) / (Total Capitalization)

Investor Ownership = (2 million Shares) / (8 million Shares)

Investor Ownership = 25%

Please note that this was a simplified explanation of venture math assuming only one round of funding. VCs generally invest in companies expecting multiple rounds of funding. For future fundraising rounds, the math is more complex than above, but the foundations are the same. In any case, the goal is still to obtain an amount of ownership that will achieve the necessary returns for LPs.

GETTING THE “RIGHT” VALUATION

Generally speaking, the right valuation manages exceptions, keeps investors of all stages happy, divvies equity as fairly as possible to prevent negative sentiment, and balances company ownership vis-à-vispreexisting investors and founders.

Valuing Too High

Overvaluing your company puts your company at risk of being in a subsequent down round which no company or investor wants to be in. A down round means that the value of your company has decreased from the value stated in the previous funding stage. In a down round, previous investors are already upset that the company did not meet expectations and the previous investors likely have a smaller portion of the equity than they would if the company had been valued properly. Additionally, the previous investors are likely more than perturbed that the new investors are able to purchase equity in the company at a lesser rate than what the previous investors paid. The addition of new investors to the company’s cap table will dilute the previous investors’ equity. Keep in mind that previous investors probably have seats on the board. So, you can imagine the discord that can occur between the management of the company and an unhappy board member.

Valuing Too Low

Undervaluing puts your company at risk of giving up too much of the company initially and, in a down round scenario, causes sentiments from new investors that they are overpaying for what the previous investors paid for. With less equity in the company, there is more negotiation to be had between the new and old investors. Unsurprisingly, you are left with less in the company than you would have been left with had you valued the company properly. This means less control and less reward for all of your hard work in building the company.

So, naturally, you are probably wondering how you find that magic valuation. Well, the truth is, the market dictates valuations and your service provider (i.e. advisor, legal team, business development team, market researcher, etc.) should be able to provide you with market data that gives you a range at which to value your company which would likely satisfy investors since they are paying what the market is paying—a fair deal. If your service provider is unable to provide such data, it is in your best interest to tap into your network to find someone who can.

VC PRESSURES

Before we conclude, let’s talk about VC pressures when working under valuations. Following our earlier discussion, a VC is beholden to provide returns to its LPs. This return amount varies, but generally is around 10X (or ~30% IRR) the amount of money that was given to the VC.

Typically, an investor will use a deductive analytical approach to determine a valuation for a company based on the perceived risk vs. reward. For a seed deal, it could be at least a 10-15X required return, with a Series A at 10X and a Series B at 7X, using the methodology of identifying the target ownership and projected exit value as in the previous example.

They will also look at market precedents that illustrate similar risk profiles, which for the past number of years show that for the seed’s A, B, and C rounds, a company will sell up to 30% (typically 20-30% on average) of the business in each financing.

CONCLUSION

As you can see, it is important to keep track of your records and understand the implications of picking the right valuation. Reach out to us for market data in order to ensure that you are on the right path and approach fundraising with a strong grasp.