Like most people I thought that there was a lot of arcane math behind venture capital and private equity. High finance is an arcane field, and in the movies the characters who play in this sector are all math wizzes who wield arcane formulae to predict the future.
The reality is that VC math isn’t all that complicated. Sure – other parts of private and public equity like high frequency trading (HFT) are pretty black magic. And yes, some venture firms like Correllation Ventures embrace such dark arts in their investments. But most of venture capital remains a qualitative and not quantitative “science”; as such, most of the math we use to investigate and model companies remains fairly basic.
Most of the math in VC revolves around the valuation of company and the possible returns on an investment. Valuation is a critical factor for investment; when investing into a new portfolio company, valuation is effectively the price of the investment.
Given that venture firms must have a high rate of return due to the inherent risk of their industry (VC funds are much higher risk than other asset classes like mutual funds), a high valuation prior to investing means that the return on the investment after a liquidity event (when the company is either bought in M&A, IPOs on the public market, or similarly “exits” such that the venture firm can convert their ownership into cash) must similarly be high.
Let’s take a look an extremely basic example for investment to see what VC math looks like (and if there’s anything interesting that we learn from it). Say I’m a partner at Tenderloin Ventures and I want to lead an investment in Coolness.io, a high profile SaaS API provider that gets more Tech Crunch coverage than Kim Dot Com after an extradition hearing. Coolness’ CEO is a huge fan of the Lean Startup movement, has successfully bootstrapped her company this far without angel or institutional investment, and plans on raising only one round of funding – a Series A investment. We thus don’t need to worry about dilution through other rounds of funding.
Before I start thinking about anything, I need to remember a few things about my firm. First, I have a minimum IRR (internal rate of return) that I need to generate over the life of my fund. IRR is effectively the “growth rate” of my investments, and is important for the limited partners (or LPs) that invest in my fund because it’s one of the primary ways they decide to invest in me versus other venture firms and other types of asset classes.
Let’s say that Coolness is probably going to be the only investment I make in my fund (I’m lazy), and I need to have a minimum IRR of 50% and return the investment through a liquidity event in 5 years. I keep this in mind as I meet with the Coolness.io management team. After several rounds of diligence and “building rapport” over bottles of wine at District in SoMA, Coolness decides that I’m the outside investor they’d like to be on their board – and vice versa. They agree to let me invest $10 million for their Series A, and they predict that in 5 years their annual revenue will be approximately $300 million.
Given all of this information, I can calculate just how much Coolness needs to be valued at to exit at my minimum IRR. I do this through the following formula:
Required Future Value = [ (1 + IRR)^years ] * investment
So let’s plug in what I know to see what this looks like:
rFV = [(1 + .5)^5] * 10
rFV = $75,937,500
So Coolness.io needs to be worth at least $76mm for me to make my minimal IRR. But is this realistic? To understand whether or not it makes sense, I need to do some comparative valuation (or “comps“) analysis. I need to look for liquidity events similar to what I think might go down with Coolness’ exit.
There’s a lot of consolidation going on in Coolness’ industry, so I think it’s probably going to be an acquisition. Oracle, Microsoft, and SAP all seem like likely acquirers in this case. To understand how these companies acquired firms similar to Coolness over the last few years, I’ll start going through historical acquisitions and try to determine the revenue multiplier that corresponds to each purchase. This multiplier is used to represent the value of the business – factoring for its potential for growth and also the current status of the business. For our purposes, we’ll use the multipler of total enterprise value to (sales) revenue, or:
RevMult = TEV / Rev
After reviewing the history of these titans’ acquisitions – and doing a little digging by getting to know the disposition and appetite of each’s corporate development team – I’ve discovered that the Coolness.io story sounds a lot like the story behind Oracle’s Eloqua acquisition in 2012. In this case, the TEV/Rev was 7.9X. I can use this multiplier to calculate what I think Oracle would pay for Coolness.io in a similar situation. Ceteris paribus, Oracle’s 5yr later acquisition of Coolness.io should be something like
Terminal Value = RevMult * Terminal Net Revenue
TV = 7.9 * $300mm (remember that 5 year revenue from up top?)
TV = $2.375 Billion
B’damn. Coolness has the potential – assuming everything goes swimmingly – to be a $2.375 Billion dollar company. That’s awesome, and if I get in now I could probably make a lot of money off of the deal. But just because I throw in $10mm doesn’t mean that I own the entire company. In order to ensure that I get at least my minimum IRR on the investment, I need to figure out what my the final ownership of the company would be (e.g.: how much I own when Oracle might buy them). I can do this using the following:
Final Ownership Required = Required Future Value / Terminal Value.
Luckily I already calculated this before. Plugging some numbers in:
Final Ownership Required = $75,937,500 / $2,375,000,000
Final Ownership Required = 3%
Wow. I only need to own %3 to pull off my minimum IRR? What a steal! At this point one would think I’d be signing that check lickity-split. And maybe I should be, but we’re forgetting one thing: what’s the valuation of the company right now?
People in tech aren’t dumb. If Coolness.io wants to get to becoming a billion dollar company, a feat in and of itself nearly impossible for most companies, they’re going to be have to be led by some very strong industry veterans. These veterans know that I want to buy up as much of their company as possible, and they’ve also done the same comps analysis that I have to determine that they could turn out to be another Eloqua.
Because of this, Coolness.io may demand a very high valuation for the company. They could become a billion dollar company right? So why not swing for the fences and say we’re worth over a hundred million right now. Lots of cool kids like New Relic and AppDynamics are getting these valuations, so Coolness.io should be too right? In fact, Coolness.io comes back to me and says that they think they’d like to be valued at $150mm pre-money (the value of the company prior to me throwing in another $10mm).
Well, okay. That might be reasonable; remember I only need to get 3% ownership to get my minimum IRR. I can use the following formula to calculate my ownership of the company post money (value after we finish the investment).
Ownership = Investment / (Pre Money Valuation + Investment from Round)
There’s no other investors in this round, so I’m basically the round. That means that if I accept this valuation and buy into the company I’m effectively going to own…
Ownership = $10mm / ($150mm + $10mm)
Ownership = 6.25%
Well, alright. I’m getting twice the ownership necessary for my minimum IRR and having a good time. Provided that they turn out to be Eloqua, this $150mm valuation seems pretty fair right?
Hold up. Let’s look into that pre-money valuation. Given that we’re calculating the value of the company now as opposed to at terminal exit, we need to use their existing revenue. Coolness has been in developer acquisition mode for the past few months, and hasn’t made a ton of revenue. Their forward revenue for this year is expected to be only $2mm. Given this, we can determine the implicit revenue multiplier that Coolness.io thinks they’re worth:
Multiplier for Round = Pre-Money Valuation / Revenue
Multiplier = $150mm / $2mm
Multiplier = 75x
Holy crap!?!? 75x multiplier!? At this point I’m floored – this means that Coolness believes that their business’ potential value is more than an order of magnitude better than Oracle’s, Facebook’s, Salesforce.com’s, and basically every other major tech company out there right now. SaaS multipliers are pretty high, but 75X is absolutely ridiculous.
I’d spend some time working with them to try and dial it back to a reasonable valuation – something more in line with what their exit multiplier might actually be. But in the end things break down, and Coolness.io wants to be a $100mm+ pre-money valued company. I walk away, dejected, and their round disappears.
So, what did we learn?
This is a pretty unusual case and by no means reflects the full complexity of investing. For example, you’re rarely going to have only one investor (angel investors and seed funds will exist on your capitalization table prior to my institutional investment and I’ll need to deal with that aspect of ownership) and more likely than not syndicates of investors will band together to invest in a company’s round.
Also, maintaining that minimum ownership might be difficult as the company takes on more and more venture capital. With subsequent rounds of investing the shares of existing shareholders will be diluted, and unless I have pro rata rights that allow me to spend more money to maintain my ownership I’ll lose my position within the company.
But while it’s slightly unrealistic it highlights a few critical points in analysis that tend to make or break deals for venture capitalists:
- Respect the multiplier: Without the revenue to back up a high pre-money valuation ($100mm+ for example), your company is going to look absolutely insane on paper to your average associate or partner.A common mistake that many new entrepreneurs make is to just choose a valuation that’s high and similar to a name-brand startup in their sector; this leads to situations like Coolness.io’s ridiculous 75x multiplier. Instead, select a pre-money valuation that makes sense given the multiplier for your sector (which you can get from both acquisitions and the performance of public companies in your sector).If you want to be truly amenable to a VC, it’s important to select a valuation that also takes into account subsequent rounds of investing. Let’s take this back to Coolness.io: if I start at $150mm pre-money for this round, I’m probably going to want to raise my next round at a valuation higher than the $160 post that came out of my last investment to reflect the fact that business has improved. That’s fine, but if my revenue hasn’t caught up to make my multiplier sane I’m going to run into a similar situation like the above.
- Not everyone is a billion dollar company: Keeping your eyes on the prize is important, and the upside of possibly being a stunning example of success like your comps is great. But the reality is that fewer than %0.1 of startups actually survive long enough to go public, and only a small handful of startups will ever be acquired for over a hundred million dollars (much less a billion+ dollars). It’s important to take this reality into account when building your company and pitching VCs, as they most certainly will be doing it on their end.
- It’s a long way from here to there: Being an early stage investor means that you can put money into high growth companies at a low valuation and potentially walk away with a massive return. But there’s an incredible amount of risk to both yourself and the firm at this point, and few startups survive long enough to make necessary venture returns.A lot can change in high tech over 5 years, and it’s critical that as an entrepreneur you take that into account with your preferred valuation. A high valuation on a very exciting but temporal product is less attractive than a moderate valuation on a less exciting but sustainable and important product.