Fundraising? Intrigued about valuations? Understand how VCs do their math!

j0398769-thumb If you are in the process of raising funds from VCs you need to understand how they will look at your company’s valuation. VCs are not evil (at least reputable ones…) and don’t want to take a large piece of your company just because. They have commitments and thresholds, and their LPs are watching…

I’m going to talk now about valuations for early stage technology companies, where the application of a DCF model will render useless. When VCs look at these companies they generally use three lenses and combine the results in different ways according to their gut feeling and the market conditions.

  1. Starting with the exit valuation and working backwards: the easiest way to get to a valuation is to start with the expected exit value. Let’s say the expected exit value is $80mm (which can be calculated using a weighted average of different scenarios). Now let’s assume that the cash-on-cash hurdle is 5x, then the post money valuation should be around $16mm (post money = expected exit value / cash-on-cash hurdle). Finally, if the investment is $5mm, then the pre-money valuation should be around $11mm (pre money = post money – investment). This method has many shortcomings, as it doesn’t take into account the time to exit which will definitely affect your IRR.
  2. Target ownership: if the initial target ownership is 25% and the amount invested $5mm, then the post money valuation should be around $20mm, making the  pre money valuation around $15mm.
  3. Comparables: this final method takes into consideration the temperature of the market, public and M&A transactions deals, and precedent transactions within the VC’s portfolio. These transactions will include a diverse basket measuring TTM revenues, EBITDA, subscribers and other metrics depending on your company’s industry. It is not easy to find private comparables as this information isn’t generally disclosed, but looking at public comps and M&A activity can give you a sense of where the market is. VC’s might even have pre defined ranges for their own Series A, Series B and Series C.

Even though these methods should be used as general frameworks, adjustments need to me made for different scenarios. For example, the cash-on-cash hurdle will be higher for seed and series A rounds than for series C and growth equity rounds. Target ownerships will also vary across stages and across funds.

Valuations have always been and will continue to be a topic for discussion as even though there is some math behind it, there are also many softer components. VC’s personal style and gut feeling will always play a critical role.