3 Strategies to Value Seed and Series A Startups
VC Firms target returns of 3x net of fees. They invest in startups at valuations that they believe will help them achieve that.
There are three primary ways of valuing a startup:
Strategy 1: Ownership Targets
VC firms have increasingly been told by their LP’s that they should be targeting large ownership positions in their companies — especially at the onset. The reason is: if they own between 10–12% of their winners, they’ll be able to maintain their pro-rata and return a good sized percent of their fund upon a successful exit.
LP’s are tired of seeing the best companies in their VC’s portfolio return little money to the fund, because they VC only owned .5% of the business. VC’s have gotten smarter, and realizing buying a small part of a competitive round is much easier than leading the round.
Most VC firms have ownership targets they try to hit. The seed firms I’ve invested with target between 8–15%, and the series A firms we’ve invested with traditionally target 15–20% ownership.
That means that often, a VC firm’s logic will be: “do I want to invest in this company? How much are they asking for? What does the pre-money valuation need to be, for me to invest their target check size, and for me to get the ownership I want.”
For example: New Company is doing $2M in ARR, has 70% gross margins and is raising $5M. A Series A firm may say: “I want to invest in this business. If I invest, I’ll need to own 20% of the company, so I will offer them $5M at a $25M ‘post-money.’ That way I know I will get 20% of the business if I invest.”
- Most term sheets used to be offered on a “pre-money” basis, but as ownership targets have become more common, more VC firms are offering term sheets on a post-money basis. The logic is: if you offer a term sheet on a post-money basis, you automatically know how much of the company you’ll get at the closing. If you offer a term sheet at a “pre-money” valuation, you may not know.
- Example: If I invest in that company at a $20M pre-money and offer $5M, I may get 20% of the company if that’s all the money they raise. But if their other VC’s all want to invest $2M more, it’s suddenly a $27M post-money valuation, and I only own 18.5% of the company. And if some big shot wants to tack on another 3M, the round is suddenly $10M, and I own 16.67% of the business because the post-money at close was $30M.
- The problem: the problem is that if a VC firm offers a term sheet on a post-money valuation, the entrepreneur may not want her existing investors to keep investing, because all of that dilution is coming from the founder. And if the founder asks her investors not to take their pro-rata, those investors will be pissed off. So it puts the founder in an awkward position of getting diluted, or being a jerk.
I think that valuing a startup based on ownership targets makes some sense. The most convincing argument in my opinion, is that having enough ownership allows a VC firm to have influence on the decisions of the business, and therefore ensure the businesses’ decisions align with the VC’s specific interests (if some equity owners want to sell the business, but you want to hold on till a greater value, having more ownership helps).
I am less convinced that you need to have a larger ownership position to receive good returns. In the third strategy I’ll explain that writing checks that are a large enough % of the fund, and achieve a reasonable multiple are more important than ownership targets.
Strategy 2: The Best Companies Are So Awesome, Valuations Don’t Matter
Many firms believe that being a good VC firm requires getting into the best companies at any price. They believe that the upside of the best companies is unpredictable, it could be 30, 50, or 1000x. And all that matters is being in them and joining for the ride. The way they value the companies they invest in is by deciding “what is the lowest valuation I could offer, and still be certain I’ll win this investment?”
And that’s it.
Strategy 3: Cost of Capital & Expected Value
At CoVenture, we don’t think as much about ownership, because we believe the methodology, while directionally correct, is a bit overly simplistic and leads to false assumptions.
For example, if we invest $100,000 out of a $20M fund, for 10% ownership in a business, and the company sells for $50M (a 30x return) after ~40% dilution, we still only receive $3M back. So despite having the right “ownership,” the check size wasn’t large enough to warrant a strong return even on a great multiple.
And if we own too much of a company, that can never achieve a venture-scale multiple, we won’t have much success either.
Rather, we think more about
(1) Our cost of capital (we need to return 3x net of fees to investors)
(2) The percent of our fund we are investing (if we own a lot of the company, but the check size is only 1% of the NAV (Net Asset Value) of our fund, it won’t be worth our time to diligence the investment or monitor it)
(3) The potential multiple if things go well (if we can’t receive a high multiple, it won’t move the needle for our fund returns)
(4) The likelihood things will go well (we can take a lower potential multiple, if the chances the multiple is reached, is higher)
To come out to our expected value.
Every firm makes different assumptions. Some assume only 2% of their investments will be huge, outsized wins. Some assume 10% will be, and series A funds often assume (1/3 will be 0’s, 1/3 will be 1x, and 1/3 will be 5–20x).
To date, we’ve seen ~8% of our investments become 20x or greater, and so we use that as our benchmark. So bottom line, we are looking for companies that have a ~10% chance of working, and that we can invest at least 5% of our fund into (overt time). And we have to ascribe them a valuation such that if they achieve the result we hope they will, we will receive a 20x return upon realization, and after some dilution.