How does a VC value a business?

Thirteenth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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‘What is my business worth?’ is a question every entrepreneur and investor asks themselves all the time.  Then when it comes to selling the company or raising money the question shifts subtly to ‘what value will the investor/acquirer place on my business?’.  The answer to the second question is often lower than the answer to the first one.

If you are trying to answer the question ‘what value will an investor place on my business?’ I think there are three things you need to understand.  The first is what I would describe as the right way for a VC to value a company, the second are the rules of thumb that we use to sense check and short cut the proper analysis, and the third is the impact of market forces on the numbers thrown out by the first two.

The right way for a VC to value a company

The right way for a VC to value a business is to estimate what it would fetch on a successful sale and then divide that figure by the return appropriate for the risk involved.  So if the planned exit is for $100m but the business is still early stage and the level of risk implies the target return should be 10x then the post-money value today would be $10m.  If the investment was for $3m then the pre-money would be $7m ($10m-$3m) and the investor would get a 30% stake.

In practice it is slightly more complicated than this because adjustments need to be made for liquidation preference and dilution from further rounds.  Usually there are both.

A number of data points will be taken into consideration to forecast the exit value:

• likely turnover and profits (losses) of the target company at the point of exit
• revenue and profit multiples that likely acquirers trade at
• multiples that other similar businesses have been acquired at
• track record of potential acquirers in making high value acquisitions
• strategic importance of the target company to potential acquirers

After projected exit value the next driver of the target valuation is the target return.  There is very little science here and most VCs think of the risk inherent in a startup, and hence the required target return, in three bands – low risk = 3x return, medium risk = 5x return, and high risk = 10x return.

In nearly every case that I have seen the investor sees more risk in the deal than the entrepreneur.  I’m sure that in part that is because one is selling and the other is buying, but at a more fundamental level any experienced VC will have seen many deals that looked low risk end up as failures, whilst the entrepreneur’s greater intimacy with the business always gives them greater confidence.

The rules of thumb

One enduring rule of thumb is that an investment round should get around a third of the company.  When we hear how much a company is planning to raise our first reaction is to multiply that by three and see if that feels like an appropriate post money valuation for the business.  If it does then the deal immediately feels like it is more likely to happen.  This rule is most applicable to businesses at the seed and Series A stages. After that it starts to lose its power.

Other rules of thumb come and go over time depending on sector trends and market characteristics.  Three times current year revenues is one for a software business, another that has been operating until recently in the Valley is $3m for an angel round in an internet company.

Market forces

In practice valuations are arrived at by VCs figuring out what they think is a fair valuation using the methodology and rules of thumb described above and then stretching them up or down depending on the prevailing market conditions and the competition for an individual deal.

If competition for a deal is intense, or the market is hot, then VCs will often look again at their analysis and see if they can justify a higher valuation.  The most common route to justify a higher valuation is to look again at the exit valuation and work to build a stronger case for a larger exit.

The reality of venture capital is that there are a small number of companies that go on to have truly huge valuations (Facebook and Google stand out from recent years) and drive most of the returns for the industry.  Competition for deals that have the potential to be one of the 10-15 breakout companies created each year is always intense, and estimating how high they could go is pure guess work, which creates the perfect conditions for a bidding frenzy between potential investors resulting in valuations losing touch with any of the analysis described above.