How do VC firms value a start-up?

Ultimately it is more art than science.  Ultimately a company that needs money receives a valuation that an investor is willing to pay and a entrepreneur is willing to accept.  Just like in more liquid public markets a company is worth per share what the last person paid for the last share of stock purchased.  In private equity VC markets pricing factors include:

  1. Timing – Valuation vary with circumstances and timing.  Valuations in 2003 across the board were higher than valuations in 2009. Like the real estate market the venture capital market has cycles.  Sometimes you’re in a sellers market and other times your in a buyers market (the investor being the buyer).  Lately there has been more people raising money than investors.  Which means lower valuations.
  2. Relative Value – Value compared to like companies.  Similar industry, cost structure, revenue growth, etc. Exact same size company in a related industry with similar numbers would be valued the same. Perhaps your company is 1/2 the size as the comparable company. Your valuation would be based on a multiple of revenue comparison.  Let’s say the comparable company had revenues of 3 million and was valued at 9 Million and you have revenues of 1.5 million.  You could justify a 3X revenue valuation of 4.5 million.
  3. Bidder Exuberance/Auction – Are multiple companies interested and willing to bid to get the deal. The more interested parties the more likely you are to raise the valuation.
  4. Sellers Desperation – What is the lowest walk-away price of the ownership group.  If you’re not desperate and you are willing to walk away that can raise the value.

Ultimately to get a VC deal you have to fit into a VCs model.  That is they have a minimum return they must be able to project on each investment to produce their Internal Rate of Return goal.  Factors that come into the value are, what they pay, how much they predict they can get in an exit, and how long until they can get an exit.

Other factors that effect valuation and can be just as important in terms of return to the founders and employees include:

  1. Participation – Do the investors get participating preferred shares.  In which case the investment is treated as a loan and in case of an exit, the loan gets paid back with interest from the gross of any exit.  Then the preferred shares are converted to common shares and get their pro-rata share of the net exit price (the gross minus the participation).
  2. The multiple of Participation – at times the participating preferred shares are treated as a multiple.  So it could be a 2X or 3X participating preferred.  In which case the preferred share holder receives the multiple back for their original investment off the gross proceeds which converts their preferred shares to common and then receives their pro-rata share of the net.  So for example if the investor invested $10 million at $10 million pre-money valuation.  The $10 million would represent 50% of the post money valuation and entitles the investor to 50% of the stock.  If the $10 million was 2X participating and the interest rate was 10% and the company was sold for $100 million one year later.  Then the investor would receive $1 million in interest, and 2X participation of 20 million for a total of $21 million taken off the gross $100 million.  This would convert their stock to common stock and entitle the investor to 50% of the remaining $79 million or $39.5 million.  The investor walks away with $60.5 million leaving the remaining $39.5 million for the founders and employees

Lastly the type of investor effects the valuation.

  1. VC’s usually give the lowest valuation.  They usually invest with a need to deliver an IRR and they invest by a committee or partnership vote.  The numbers including projected returns have to be agreed to by the partnership and emotion is usually not part of the investment process.
  2. Angel investors, usually don’t get preferred shares (unless investing alongside VCs) or participation.  They also might pay more and can invest more on emotion then relying on cold spreadsheet formulas
  3. Strategic Investors – Corporate investors who have a strategic need for your product or vested interest in your success.  They will usually pay a higher price then Angel’s or VCs as investment returns are important, yet strategic goals can be just as or more important as the investment return.

Ultimately the rules are written by the person in power.  A very hot company that isn’t seeking capital can dictate it’s own terms.  A weak company that is in desperate need of cash has terms dictated to it.

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