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Venture Capital Deal Pricing

Posted on April 18, 2006

Throughout my high school and college days I learned many valuation methods. In fact, I have a book sitting on a shelf in my apartment called “Valuation” (convenient title, I know…) that is seriously two inches thick! With that said, these valuation methods make sense and can yield fairly good results when used in conjunction with each other to value a company and, in my case, it’s common stock. However, I always wondered how often I would use these models outside of the classroom.

Turns out, a lot of money managers that play in the public markets use these tools regularly and even modify them to yield better information. This is not the case in the VC game (nor should it be). I learned this fairly quickly after taking a job at Cambridge Associates right after school. Meeting VCs and hearing about how they do things was fascinating. I thought that they must have some pretty interetsting (read: hard to understand and complicated) valuation methods in order to value such brand new technologies and companies. Looks like I was off base. The valuation methods of VCs are actually, as Matt McCall put it in his post today, quite simple though subjective.

Before you can really understand why VCs value companies the way they do you first need to understand that the VC business is one of multiples. To quote Matt:

Early stage VC’s target 10x return of capital and expansion/late stage investors target 3-5x. Why 10x…seems a bit usurious? The classic venture portfolio looks like this. Of ten deals done:
– 4 crater
– 2 are breakeven +/- a little
– 3 are 2-5x capital
– 1 is 8-10x

The reason VCs need to target 10x is that they will have many losers and semi-losers in their portfolios. It’s just part of the game. Therefore, the winners not only need to provide a large gain, they also need to pay back the losses from the other investments in order to raise the overall portfolio return.

Matt goes on to describe how VCs price deals based on their target of 10x:

VC’s will then try to estimate a) what they think the company might be worth if successful in 3-5 years and b) how much more capital will be needed. In a simple case, let’s assume that the company is worth $100m in 4 years and will not take additional capital. Using the 10x rule, the VC will price the deal so that post-$ valuation of the deal is $10m. If the company is raising $2M and adds $1M worth of options to its pool, the VC will pay $7M pre-$.

Pretty straightforward, no? Determining the terminal value of the company and subsequently what the funding round in question should be valued at (in order for the 10x return) is really the wild card in all of this. Matt cranks out some simple math though which leads us right to some average pre moneys that look a lot like the 2005 VC investment statistics I mentioned yesterday on VentureWeek. The median pre moneys for 2005 were:

Matt suggests between 7 and 9 for series A and between 2 and 4 for seed stage deals from his quick math. These numbers are pretty much right on with what happened in 2005. (It should be noted that Matt’s numbers are averages and the VC stats are medians so all in all they are pretty much the same. Also, Matt says these numbers have a lot variance in them so be sure to use them more as examples to understand VC deal pricing than hard facts.) By combining the 2005 stats with Matt’s quick math we can come to the conclusion that most VCs are in fact valuing companies the way Matt suggests.

There you have it. VC company valuation in a nutshell. A big thank you to Matt McCall for putting a post out there explaining this! It really clears up a lot of misconceptions and I am sure a lot of entrepreneurs now see why VCs aren’t really interested in discounted cash flow model valuations.

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1 Comment so far
  1. Jay Gokani October 5, 2006 8:54 am

    how do VC’s value in case there is an impending finance (say 12 months later)?
    example:
    If the company is worth $100mn after four years the VC will pay $10mn assuming 10x returns.
    But if there will be additional funding of $2 mn after one year, then how will th VC value the firm.