How VCs Stress-Test your Valuation
Early-stage VC valuations involve some art and some science. This can make it difficult for founders to know what to suggest or expect when coming up with a valuation number. To simplify things, founders often benchmark themselves against other recent financings and propose the same number. For example, many companies coming out of an accelerator program like Y Combinator suggest the same valuation regardless of differences in addressable market size, team, business model, traction, etc.
Some VCs are fine with this as their business model assumes that every deal can be a unicorn exit ($1 billion+) and therefore they are relatively insensitive to early-stage valuation. However, in reality, the vast majority of M&A deals are not unicorns and that is OK. Exits well under a billion dollars can be great venture investments but it means that valuation is important at every stage.
The key point is that an investor’s assumptions about your future exit path shape how they view your valuation today. If you are a first-time Founder embarking on an equity round of financing, it may be helpful to think through exit scenarios for your business and get ahead of questions like:
- Who are the possible future acquirers of your company?
- What might they be willing to pay and why?
- Would a venture investor be satisfied with this return profile?
Investors are not going to take your exit assumptions as any kind of guarantee but they do want to see that you understand the implications of valuation on future returns and have a long-term view for the business.
Exit Analysis Exercise
Context. Let’s pretend that I am the CEO of SkillCo., a company operating in the online skills training market. I am currently raising a $10mm Series A round of financing with a proposed post-money valuation of $50mm. I am speaking with SkillsVC, a potential $10mm investor that would own 20% of the company after the transaction. SkillsVC has asked about the likely exit path for my company but I am not sure where to start or what type of information is salient…
Step 1. Who are the likely acquirers?
Skillco. is anticipated to be a high-growth company that will exit through strategic acquisition or by going public. Let’s focus on some of the ways to think about what a strategic buyer may be willing to pay for Skillco. In this market segment, there are some good publicly available data points about recent acquisitions:
- LinkedIn acquired Lynda.com in 2015 for $1.5 billion. At that time, Lynda had approx $150mm in revenue and was acquired for ~10X revenue. This is our first data point on the potential acquirer set.
- In 2018, another skills training business, General Assembly was acquired by staffing giant, Adecco for $413mm. TechCrunch reported that revenue was $100mm in 2017 so the company was acquired in the ballpark of 4X revenue.
- In 2019, Thinkful was acquired by Chegg for $80mm. According to Chegg, Thinkful had 2018 revenue of $14mm and was growing 30% YoY so we can assume that they were acquired for a multiple of ~4.5X 2019 revenue.
Based on this small sample size of three transactions, we have a revenue multiple range of 4–10X. When doing this in real life, you can use data from Crunchbase, Pitchbook, Axios, Dealbook, or M&A reports from investment banking firms to build out a larger set of data points.
Note: For the sake of simplicity I am focusing this exercise on an exit to a strategic buyer. Private equity firms are also active acquirers and they generally evaluate companies based on a multiple of EBITDA rather than topline revenue. They also tend to be more price-sensitive than strategics. To figure out what an IPO exit scenario could look like for your company, identify some comparable public companies (in terms of business model, end market), and review coverage of the company’s metrics at the time they went public to find benchmarks that can support your IPO plans.
Step 2. What would a strategic acquirer pay for SkillCo.?
There are a lot of factors that determine the actual multiple of revenue applied to a company — the biggest factor is what the strategic acquirer is willing to pay at a moment in time given their needs, the output of their build/buy/partner analysis, and available acquisition options.
More generally speaking, there are two drivers that influence the revenue multiple: the company’s revenue growth rate and the quality of revenue (i.e. high degree recurring versus one-off revenue, high margins (80%+), and strong metrics generally).
Pure software companies like Lynda.com tend to command higher multiples than businesses like General Assembly that have significant services and fixed costs for classroom training etc. If a company is growing very aggressively (ex. following something like the T2D3 model) and has majority recurring revenue and high gross margins, it should be well-positioned to command a revenue multiple at the upper end of the scale (not guaranteed but a plausible assumption).
Taking all of these inputs into account, I have created some possible exit scenarios for SkillCo. As you can see below, I have come up with some basic assumptions for a low, base, and high case exit scenario.
Let’s say that I have the highest conviction around the base case; I believe that SkillCo. will reach $100mm in revenue within 5 years. That would mean that by year 5, I would have a moderate annual revenue growth rate of 30%. Let’s also assume that there is a significant services component to the revenue model and this is likely to always be the case. Applying what we know about past transactions, my assumption is that unless the growth rate or quality of revenue changes materially, SkillCo. could likely command a multiple of ~5X revenue, generating an exit price of $500mm.
Step 3. How will an investor view that return?
The answer is that it depends. The investor’s return will be determined by their ownership stake at the time of exit (after dilution from future capital raises) and the number of years to exit. Let’s look at these in more detail.
Ownership & Dilution. Capital efficiency hasn’t been sexy in past years as venture poster children like WeWork and Uber have pursued growth at all costs. Things have changed a lot with the economic uncertainty of the pandemic but even aside from that, the reality is that capital efficiency really matters; the more money a company raises, the more dilution assumed by the Founders and existing shareholders. There’s nothing wrong with raising large amounts of capital and it’s often needed to scale quickly but the key question is how efficiently the company can put that money to work to create more value and growth.
As a general rule of thumb, each additional equity round of financing will involve somewhere in the range of ~20% dilution to the existing shareholders. Therefore, if SkillsVC moves ahead with the $10mm investment for 20% ownership and the company goes on to raise three additional rounds of financing, the investor’s stake will be diluted by almost half to~10.24% (i.e. (0.2*0.8*0.8*0.8)). If SkillCo. sells for $500mm, SkillsVC would receive ~$51.2mm.
Time to Exit. A VC investor will measure this return in two ways: Cash-on-cash multiple and IRR. When an investor is evaluating an investment, they want to believe that there is a very plausible upside scenario where the investment could return the entire fund. At the same time, they likely recognize that that doesn’t happen every time and so they are testing to see how hard it would be for the investment to pass a minimum hurdle rate. Often investors are looking to see whether the investment can plausibly be a 5X cash on cash return (i.e. if they invest $10mm, they want to know if the investment could return $50mm). SkillCo. has delivered a 5.1X return on the capital invested so SkillsVC should be happy. However, whether SkillsVC is simply content with this return or absolutely over the moon depends on the time value of money.
Very simply, if SkillsVC gets ~$50mm back on the $10mm investment after 3 years, it generates an IRR of 71%. If the investor gets the same $50mm back but after 7 years, it is an IRR of 25.8%. Generally, a 30%+ IRR is what investors have in mind in terms of the hurdle rate for the risk profile of venture investing.
Bringing It All Together
The screenshot below shows the SkillCo. exit scenario assumptions that we have walked through and explores what the return profile would look like in each of the high, base, and low cases. The main levers that you can play with are the time to exit, ownership at exit, revenue at exit, and enterprise value (shown here as a multiple of revenue). Hopefully, this gives you food for thought and a framework to think through your company’s possible exit scenarios and what they would mean for you and your other investors.
This is clearly not rigorous science. Essentially, what you are looking to do is build a strong narrative around an exit scenario that seems plausible today. Ideally, this should be based on some M&A datapoints and the revenue characteristics of your company. VCs definitely do not take this type of exit analysis as gospel — we expect businesses to change over time but we do see this as a helpful tool to stress test the chances of a company delivering a venture-style return given today’s valuation.
Finally, it is worth noting that the investor is also going to care a lot about how well-positioned the company will be to raise at a higher valuation at the time of the next capital raise. If a company cannot command a higher valuation at the next financing, it is a down round where the company is ‘out over its skis’ having raised at an aspirationally high price that it cannot match with traction. To get ahead of investor questions about this, it’s useful to think through the big milestones that your company will need to hit in the coming 18–24 months (likely timeline to next financing) and how plausible this plan is based on the team’s capabilities and signals from the market.
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