Valuation

There’s this dance that entrepreneurs and venture capitalists do when it comes time to negotiate the economic terms of an investment. And it all revolves around valuation.

The question is what is the fair value of the business? This supposedly establishes how much of the company the venture capitalists will own for their investment.

But I think the concept of valuation is often misunderstood by the people engaged in this process. And it’s particularly true in early stage investing.

I do not believe that negotiating a valuation on an early stage venture investment has much to do with the current value of the business. If it did, why would a venture capitalist agree to a $10 million value for a business that will lose money for the next 2-4 years and has little, if any, revenue?

The fact is that almost all venture capital deals are done as convertible preferred stock investments. That means that the money we invest is more like a debt instrument in the event the business doesn’t work out very well. We get our money out before the entrepreneurs do if the deal goes sideways or down.

It’s only in the event that the deal works out that the percentage of the business (the thing that valuation is supposed to determine) matters in terms of how much money we make.

Another important factor to consider is that only a relatively small portion of early stage venture investments really work out in the way they were supposed to when the investment was made. In my experience, which is based on 17 years in the business and over 100 different early stage investments over that time period, there is a 1/3 rule.

The 1/3 rule goes as follows:

1/3 of the deals really work out the way you thought they would and produce great gains. These gains are often in the 5-10x range. The entrepreneurs generally do very well on these deals.

1/3 of the deals end up going mostly sideways. They turn into businesses, but not businesses that can produce significant gains. The gains on these deals are in the range of 1-2x and the venture capitalists get most to all of the money generated in these deals.

1/3 of the deals turn out badly. They are shut down or sold for less than the money invested. In these deals the venture capitalists get all the money even though it isn’t much.

So if you take the 1/3 rule and add to it the typical structure of a venture capital deal, you’ll quickly see that the venture capitalist is not really negotiating a value at all. We are negotiating how much of the upside we are going to in the 1/3 of our deals that actually produce real gains. Our deal structure provides most of the downside protection that protects our capital.

I think it is much better to think of a venture capital deal as a loan plus an option. The loan will be repaid on 2/3 of our investments and partially repaid on some of the rest. The option comes into play in a big way on something like 1/3 of our investments and probably no more than half of all of our investments.

There is more to this whole issue of valuation because there are often follow-on rounds where the deal between the venture capitalists and entrepreneurs gets renegotiated. I’ll save that for another post.

Comments

[Randy Charles Morin]

Nice to see these rough numbers. I would have said that the last part would comprise more than 1/3 and the first part would comprise less than 1/3. But maybe that's just my 2001-2 nightmares.

[Andreas Duess]

That's a really interesting post, thanks.

We're currently debating if we should approach VC firms for our own start-up. Part of me is being sick of being poor and underfunded, part of me wants to build the business slowly and keep total control.
We attended 'Show me the money' in London a couple of weeks back and got a lot of attention. Unfortunately all that did was to make me feel like a sheep surrounded by wolves.
I, and this is not a statement meant to cause offence, still have to meet a VC I trust to have my best interest in mind.

[Robb Hendrickson]

Hi Fred,

Just started trawling the VC/entrepreneur blogs as my co's in the midst of a raise...looking for useful info. and I've found much thanks to you, Brad Feld, Matt Blumberg and Ed Sim!

Anyway, I came across something interesting not too long ago that relates to this Valuation post you wrote last July.

An analysis of by a local (Chicago) F500 consumer products company of its most recent 26 strategic investments yielded the following metrics (these are multiples on investment):

* MAX = 7.4
* MIN = 1.3
* MEAN = 3.2
* STD DEV = 1.7

What seems noteworthy to me is that they never wound-up underwater. True, you don't see any Google-like gains, but -- at least over the time period / basket analyzed -- still seems like returns with which, were this a VC versus SI, the LPs would be happy.

So, my question is: Why aren't there any VCs pitching prospective LPs on a lower fallout model; i.e., why stick with 1/3, 1/3, 1/3 always going/hoping for the outsized gains?

I must be missing something, because I'm sure I haven't thought of anything that hasn't already been considered; e.g., are these stat's an aberation -- or do strategics have more influence to keep things from going sideways/down so as to make these numbers inapplicable to a VC model?

Sorry for the long response, but I sadly enjoy spending my Saturdays thinking about such questions :)

[Tyler Jones]

Do you know of any good public sites with average multiples for early-stage investments listed by sector? I'm a student and trying to value a tecnology company that in the early stages. Thanks.

[Anil Tandon]

We are in the midst of raising funds from a VC for our auto classifieds portal and this post has given us an insight into the valuation for an early stage startup like ours.

[James P.]

I was wondering if you could send me information or direct me where I could find some information with venture capitalism with the video/computer game industry. A couple main questions I choose to address is:

1. What entry/exit strategies are most common for VC's investing in game vendors?

2. How do VC's in the US invest in European/Swedish game vendors? (directly, via partners, not at all, ect.)

[IsaacGarcia]

I really like the idea of looking at VCs proffering a Debt Instrument or a Loan + Option. This is the most realistic approach to evaluating VC investment.

One difference, though, is that early stage companies rarely, if ever, qualify for debt or lines of credits (much less loans) so VC amounts are usually a few orders of magnitude higher than what a "conventional loan or debt instrument" could have ever been.

Debt and loans+options, are usually sub-$500k (more often in the sub $150k) for early stage companies. Series A and even Seed investments can easily be in the $500k - $1.5mm range. These are amounts that start-ups could never raise with debt with just an idea.

So, its not entirely an apples to apples comparison.

Not to mention that....with the exception of fraud, VCs don't normally ask their founders to personally guarantee their capital ("loan"). At least, not yet they don't.

[jk callum]

What do you do if the company was never really a VC company to begin with. The VC owners/capitalists never put a dime into it, yet you gave them 40%. There was a personal investor who invested the initial seed money and agreed to 40% shares and no salary for 2 years.

Later, the VC owner ousts the original investor "for cause" and 1M no interest over 60 months. Then, the founder dies and the VC owner attempts to exercise options to buy the founder's share 26%, while he, big-time VC guy has 66% and there is only one other remarkable shareholder of about 9%. VC$guy has a plan and wants to undervalue shares and buy out founder's 26--hiding the fact the company has become his one that laid the golden egg and is not effected by the market fluctuations. Additionally, there is no mention that company had formal buyout proposal 2+ years ago and widow/3 children of founder are not adverserial nor majority shareholders -- just desire to let their shares ride until M/A or IPO? Nodoubt you know this upstanding group of greedy grunts....?????