Early stage venture capital valuations

Since this is my first post as a former venture capitalist I thought it might be interesting to answer a one of the more… opaque issues in venture financing. Two of the most frequent questions I got as a VC from entrepreneurs were “how much is my company worth” and “how do venture capitalists value my company?” The truth is that the answer has nothing to do with DCF’s or other business school theories, but instead is based around what the VC thinks/needs to return to their fund from that particular investment. The following is a bit of an over simplification, but is as close to a “rule” as I could gleam from my time in venture capital.

Series A valuations 

Series A* valuations are usually based on percentages – as in, how much of the company does the venture capital fund want to own. Most established venture funds have an established strategy of owning a particular percentage of a company after a Series A investment. A typical, good fund will look to own 20% to 33% of a company after the initial investment. I’ll ignore the rational behind this for a moment and cut to the chase: this means that during a normal two-VC, syndicated Series A investment your startup sells around half the company to the VCs. Raising $4 million? Pre-money of $4 million. Raising $6 million? Pre-money of $6 million. 

Getting a higher valuation

Strange as it sounds, this does imply that the more you raise the higher the valuation. I’ll get into the rational behind this “math” later in the post, but first I’ll mention a few things that you can do to try to command a higher valuation.

  • Have a name-brand management team. CEOs/CTOs and founders who have been previously successful and previously venture backed command higher valuations for their companies. Recruiting the right one of these executives to your team will increase your valuation. It may very-well be worth the percent ownership in the company that you will have to give them to get them on-board. (Who knows, they may actually be able to help grow the business too…)
  • Get multiple firms interested in your startup. VCs can get competitive. If they fear losing the deal to another venture firm they can become more aggressive around the valuation.
  • Have real customer traction. It is honestly impossible to do real financial analysis on companies without historical financial statements, particularly income statements. This is why early stage valuations are so nebulous. However, if your startup is experiencing paying customer growth then you may be able to justify using real metrics to concoct a valuation. (As an aside, I find it really funny how much time business schools spend going over valuations in venture capital courses. This is a minor part of how VCs create value and a very small part of how VCs spend their time.)

The rational

So why are valuations dependant mainly on percentage of the startup owned? When making an investment, venture capitalists are already thinking of the exit. They want to know how much they will return to the fund if the company is sold for $50 million, $100 million, half a billion or more. (Don’t try to present the results of this calculation to them; they can do the math on their own. You can do this calculation for your own edification, but you’ll come across as a naive management team if you try to tell the VC how much money they are going to make.) This return is very much dependent on how much of the company they own at the exit. Keep in mind that an early stage investor is likely to experience some dilution if the company will need to raise more funding later down the road, and that the first round VCs will also have to invest some money in these rounds to defend their ownership as new investors come into the company.  

The VCs are also thinking about how much of the company is owned by the management team. A good management team has many, many employment opportunities. The VC wants to make sure that the team is properly motivated to help grow the startup. Basically, an important founding team member need to own enough of the startup at an exit to make more (hopefully a lot more) then they would have if they were getting a good salary for five+ years at a big company. The VC can’t let the management team get so diluted that they lose motivation. A venture capital firm needs to think ahead to the likely future financing needs of the business and estimate how much of the business the management team will own at the exit. In truth, the VC will probably only run this exercise for the CEO and the most important technical founder (if they are not the same person.)  

There are logical limits to the “raise more money/get a higher valuation” theory I’m proposing. There is likely a narrow band of capital that most VCs will be willing to invest in certain type of companies at the Series A round. For most software and online businesses, this is likely $2 to $6 million, perhaps a bit more on the high end if you have a great team and some traction. So, venture capitalists are unlikely to let you raise $20 million of venture funding at a $20 million pre-money valuation for your online dog food distribution company. They are usually smart enough to not want to over-capitalize a business unless the plan justifies it and the risk/return ratio is correct. If multiple VCs are telling you that they don’t think you can/should raise more than $4 million for your particular startup then you’ve probably found the market clearing round size, and by extension, narrowed the band of the likely pre-money valuation.

Does this make sense? Probably not. But it is the best theory I can fit to the evidence that I’ve seen during my brief time as a venture capitalist. I’d love to hear your theories and experiences.

*I am speaking to the usual “Series A” startup, which usually does not have much in the way of revenues and is often pre-product.

Author: Healy Jones

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  1. Very interesting article. Series A do tend to be vague, and percentage based; I have, however, seen some VC's go a very stringent, scientific route and use valuation books (the firm I was at used this); yet–I've also seen the most informal valuations ever–especially when negotiation the valuation of my startup ;-)

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  2. Thanks for the good article.

    Valuation is also a function of the size of the VC, and the size of the fund. Ie; in the late 90's we watched company valuations skyrocket, not because there was more substance in the businesses, but rather because the funds were raising larger amounts of money with the same staff.

    VC A raises 100M dollars with a team of 5 guys, goes out and makes 5M dollar investments in 10 companies leaving 5M for follow-on capital. That makes the companies they are investing in worth about 10-15M post money. Now they go out and raise 1B dollars with a team of 5 guys. That means they have to put more money to work, they after all have the same sized team. So now they are putting 50M to work. They either have to change their model, ie shift to series B or PE type deals, or they have to figure out how to value their investments higher… This is a gross simplification, but I think you get the idea.

    First round investments are gut instinct backed up with market insights, and knowledge of other deals that are going on, along with close connections to those who might be buying in 3-5 years down the road.

    Umm, magic? Not really. But it sure buffaloes the startup guys, and the investors.

    Wake up and Smell the Coffee…

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    • From what I remember from the late 90's valuations skyrocketed because there was a bubble in internet companies. Everything just got out of line.
      Re: fund sizes and valuations, the more successful venture firms that I've seen increase in size have adopted a barbell strategy, still doing some smaller early stage deals but using the bulk of their capital in later stage investments (I am thinking of Battery, Highland, etc.) . These later stage investments are valued using traditional buyout type valuation analyses, based off of financial metrics. These larger later stage companies can support larger valuations because they have the financial scale and metrics to calculate valuations. However, for earlier stage valuations they seem to continue to use the typical analysis-light early stage valuation "math."

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      • Yup. And if you look at it… Perhaps I just have too much scar tissue. But when you look at the late 90's you got hype on a couple of deals that spilled over into greed from everyone. That included folks dumping large amounts into the VC niche. That had an impact. When deals were done over napkins for things that weren't even companies, but just features, at millions pre money there is too much money chasing too few deals.

        That doesn't mean the analysis of more money into a fund raises the size of the deals they are willing to do and in some ways pushes those values is wrong. In fact that's what happened in the late 90's. Yes it was a bubble, but what caused the bubble? A wide variety of factors, but it certainly did nothing to calm down the greed when VC's were PRing 20M seed rounds… Stupid follows smart and smart becomes dumb in a greedy environment.

        The resulting fallout was and could have been predicted. I recall an event at which I called a partner and said, Ok 6B IPO with nothing but air in the company, it's time to sell everything you own, then go sit on a beach for 3-5 years.

        I think that axiom of sell when everyone is buying and buy when everyone is selling is a good one for the investors. For the startup guys, when everyone is buying sell what you can, and hold on for the ride down the otherside. Don't get caught up in your own KoolAid.

        Wake up and Smell the Coffee.

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  3. I think valuation this early in the game is largely market driven. Rounds get done where they need to get done in order to win the deal. I think it's largely on the entrepreneur's shoulders to gauge interest from VCs. If you meet with 3 vcs and they all want to introduce you to their partners, pick the 5 hottest A rounds in the last 6 months, find out what the pre was, and then say you're looking for term sheets in that range. If you've been passed on 5 times, and 1 firm wants you to present to the partnership, take whatever they are offering, because that is @ or likely above market. They are basically benchmarking your deal to everything else they've seen get done in the last year, so be brutally honest when power ranking yourself relative to what you know has gotten done, and you should arrive in the same place as them.

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    • This is good advice, Jordan. However, I think it is very hard for entrepreneurs to honestly rank themselves. 1) An entrepreneur is likely very optimistic around his/her company – otherwise why would you give up a good job at a big company to try to start something? So they typically think they are in the top quartile of all deals, when in fact only a certain % can actually be top quartile! 2) It is very hard for an entrepreneur to get statistics on other deals in the marketplace. Check out Foley Hoag's Knowledge Center to get some ideas on recent valuations – the "EEC Perspectives" downloads have some data on recent New England Series A deals. http://www.emergingenterprisecenter.com/knowledge

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  4. Good job in putting the 'unspoken rule' of valuation into words. As manager of a VC firm, I understand what you are trying to say. I did want to put some more emphasis on the whole 'ProForma' and projection arena. To me, this is where early stage companies do not do enough 'specific' research. Entrepreneurs need to realize that general market education and research put into the business plan is great, but need to take a clearer, more specific look at the competition. Ive noticed that alot of Entrepreneurs mention competitors in their plans and quickly move into how much better they are …. blah blah blah… (continued on next post)

    Your best days are ahead,

    Blake Robbins

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  5. (continued from previous post) Entrepreneurs must embrace competitors and know them well. They need to know how all their competitors work. Not merely to out perform them, but to find out what systems are working efficiently, and what can be improved. An investment firm wants to see a proven model. If you can give your competition necessary recognition as a threat in the marketplace to your business, then you can also use them as a model of success in your planning. This is crucial. Know your competition— to understand the industry better, to know how to out perform them, and most importantly, to know what systems are working the best.

    Your best days are ahead,

    Blake Robbins
    Does your Business need:

    Venture Capital?
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    A great High Yield Investment?

    Click on the above links and ‘Request More Information.’ Learn more about how you and Empower can work together to effectively implement your vision. Success is a choice. It is up to you.

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    • Your thought that they should look to big examples of success in their competitive set is very excellent. It not only shows a proven path to success, it allows a VC to dream of creating something equally successful. Of course, very few companies can truly follow the development of a company like Google – It is pretty funny when some startups in totally different industries try to suggest they will be just like Google.Maybe I just don\'t have good enough of an imagination. Some startups spend too much time worrying about tiny competitors. I wouldn\'t recommend obsessing over a couple of tiny look alikes if you are in a really big market.

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  6. Your thought that they should look to big examples of success in their competitive set is very excellent. It not only shows a proven path to success, it allows a VC to dream of creating something equally successful. Of course, very few companies can truly follow the development of a company like Google – It is pretty funny when some startups in totally different industries try to suggest they will be just like Google.Maybe I just don't have good enough of an imagination.
    Some startups spend too much time worrying about tiny competitors. I wouldn't recommend obsessing over a couple of tiny look alikes if you are in a really big market.

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  7. In surviving the dot com downstroke, and subsequently obtaining a more tempered view on Series A valuations, I do think that most VCs are still taking the same approach, however they are just being realistic now, compared to a decade ago. Here is the recipe in my mind: Start with industry sector tragectory, combine with equal parts Company value propositions (new technology, disintermediation of old, unstable business model, mgmt. profile, etc), throw in an assessment of company stage (pre / post revenue, etc) and then take a step back and determine two things. Assuming this is going to be a hit and not a miss in the portfolio, what is our minimum required discounted ROI, taking into consideration potential dilution of follow-on rounds pre exit. In many cases this “ingredient” approach will determine ultimate Series A valuation put on the table.

    These are certainly new times, and my hat goes off to people like Josh Kopelan (see http://www.businessweek.com/magazine/content/09_22/b4133044585602.htm) who are keeping their fund levels at reasonable levels relative to portfolio ROI requirements, and are diversifying their overall portfolio risk by investing less early stage money in more deals (while also not necessarily having to take 40#s of the entrepreneur’s flesh off the table on the first go-around).

    I think history will indeed repeat itself and not just good, but great companies will be started in these turbulent times, and when we look back in the rear-view mirror we will say wow, they trued up the figure, and venture backed companies are now providing north of 25% of GDP!

    Wish us luck with LawyerHD.com (launch forthcoming in early summer ’09)….here we go again…

    Frank Greces

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