How Venture Capitalists Calculate Valuation
The elephant in the room
When you’re working with a venture capitalist, the topic of valuation is always looming in the back of everyone’s minds. Sometimes entrepreneurs and investors align on the subject, but most of the time they are not. This can cause a bit of a rift between the parties, in fact, I’ve seen it topple potential investment rounds. Don’t fret! Having a clear line of communication can ease the tension and it especially helps when both the investors and entrepreneurs can clearly explain their methods and rationale.
From the investment side, here are three ways that I’ve seen VC’s calculate valuations at the seed-stage:
1. Dilution-based
The dilution method is a relatively simple but quite sensible way of calculating valuation. It is especially effective for the pre-revenue and seed-stage investment rounds.
It involves taking the current market rates for dilution (how much of the total ownership the investment round will consume) and deriving a valuation based on that number. The current dilution rates in the market are between 20–30% total dilution of the company when the investment round has closed.
Let’s try an example: say that you’re a pre-revenue start-up, raising a seed round of $1M. If we assume that a hypothetical investor chooses a dilution rate of 25%, your post-money (after you get the money) valuation is $4M.
This is because the round is going to dilute your company’s ownership by 25%, meaning that the investor has paid $1M to own a quarter of your company. The way we get to $4M is by dividing the investment size by the desired dilution: $1M/0.25 = $4M.
This isn’t a ‘one-size fits all’ situation though. The investors may fluctuate the levels of dilution based on different factors that are specific to your company.
This is where managing risk comes in. If they believe that you mitigating certain risks by having an experienced team, great product, and business model, the investors may be willing to lower the dilution level which would, in turn, raise your valuation. If they believe that there is more risk involved with this investment, the investors may want to increase the dilution which lowers your valuation.
A quick way to remember this is that valuation and dilution are inversely related.
2. Financial Projection-based
This method is a bit more complex. When start-ups and investors have a strong reason to have confidence in the financial projections (rarely happens) then they may value the company based on the cash-flow and exit scenarios.
This is done by forecasting the revenue projections out a certain amount of years, applying an exit multiple to the start-up (this is what we can assume the acquisition price to be, it can be around 10X of revenue or EBITDA for SaaS start-ups). Based on how much of a return they are looking for, they can figure out how much of the company they need to own.
Here’s an example. Let’s say that a start-up has somehow created an incredibly accurate set of projections that span the next seven years. If they assume that they can reach $100M in revenue in seven years and applying a hypothetical revenue multiple of 10X, we can estimate that the company could be bought for $1B.
If the investors are putting in $1M dollars and want to generate an ROI of 100X, they would need to own 10% of the company when it’s sold. To do this, they would have to model out the subsequent investment rounds, their participation in those rounds, and then the valuation that will get them as close to the mark on this seed round.
If they are confident owning the 10% for the first round, the valuation would be $1M/10%=$10M valuation (post-money).
This is why seed investing is the riskiest but also has the highest return potential. You can make an investment at an early stage and try to ensure you maintain enough ownership to make adequate returns.
3. Fund Return-based
Every VC as a fund which they can invest from and other investors have invested in that fund. In order for the VC to be profitable, it must generate returns that are larger than the fund itself.
When VC’s are looking to invest in a company, they are doing so because they are confident that the company can provide them with a high return on their money which will make their overall fund profitable.
If a VC has a total fund size of $100M, they’re aiming for returns they would get from the investments would be greater than $100M. To do this, they assess each potential investment for its ability to be able to return the total fund size.
Here’s an example:
If I have a fund size of $100M, and I’ve found a start-up that will be wildly successful and I want to invest, I have to ensure that I retain enough ownership in this company so that when it does exit, I’ll get at least $100M in return.
If we think the company will sell for $1B, then I should try and re-invest on the later rounds to keep my position as close as I can to 10%. Sometimes VC’s will try to have more than that amount of ownership on the first round so they can be as close to that 10% ownership on exit.
So, knowing that I need the $100M return and I want to make a $1M investment, I may value the company at a $5M post-money valuation because this means I’ll own 20% of the company after the round ($1M/$5M). This, along with re-investing on later rounds, will give me breathing room for my desired ownership when other investors come in later.
There are other methods out there as well (409A, etc.) which are essentially official appraisals of your company’s stock, but these methods are particularly used when it comes to figuring out the strike price of options.
