How Do VCs Valuate a Company?

One thing that I don’t generally like to admit to others is that I’m an extremely slow learner. Even after starting my own business five times, it wasn’t until I became a VC myself that I finally figured out what Venture Capitalists were looking for in my old proposals.

If you couldn’t already tell, I love to tell stories and build narratives that captivate audiences and inspire them to take action. For this reason, I always assumed that I could simply stroll into a boardroom, dazzle investors with a well-crafted presentation, and walk out with a term sheet.

As it turns out, getting funding from a VC is less about creating hype and more about presenting the cold, hard numbers. After all, investors don’t show up to hear business proposals because they want to be entertained—it’s because they want to make money.

If you’ve been invited to present your proposal to the VC firm’s partners, it’s because you’ve already told your story and have gotten your foot in the door. Now, it’s time to enter the gauntlet.

In this article, I’ll address the key facts and figures that every VC looks for in a proposal and break down step by step how VCs measure the valuation of a startup or small business. I’ll also teach you how to estimate the value of your company so you can show up to the big meeting prepared to negotiate.

Here are some of the top questions that an investor will ask themselves before they decide whether or not to invest in your company:

“What’s This Business Worth, in the Future?”

Predicting the future is a tricky thing. For this reason, statisticians, financial analysts, and investors have worked diligently to construct complex models that eliminate uncertainty and help them better determine the future value of a business. But, how can you predict the value of a startup or small business when it has only been in business for a few years?

In order to estimate ROI based on limited information, Venture Capitalists developed something called “the VC method.” The aptly-named VC method is most commonly used in valuations of pre-revenue companies in the seed stage. It can also be used to estimate the valuation of companies seeking Series A through C funding. For companies that have already made it past the seed stage, previous VC rounds will be used to determine the size of future investments.

Even if financial analysis and statistics aren’t your strong points, there are plenty of resources online for performing these equations, such as calculators and spreadsheets. With the use of these tools, you can get a ballpark number for the valuation of your company before ever entering negotiations. This will give you an advantage when dealing with VCs, as it helps you accurately assess your company’s worth—and know when you are getting lowballed.

Discounted Cash Flow

The discounted cash flow method is a common, quick technique for analyzing future value.

Using this method requires analyzing your business’s current cash flow statements and building a model of future cash flow. Investors will start by estimating the net cash flow for each year that the VC is involved with your business. As I mentioned in my article on how to get an audience with a VC, the average length of VC involvement is 5–7 years, depending if you exit by M&A or by IPO.

Investors will then calculate the net cash flow for the final year that the VC is involved. They’ll use historical growth rates of your company, your specific industry, and even the national and global economies to come up with this number.

However logical it may be, this method is extremely speculative and is not used as the sole determining factor by VCs. Younger businesses—in particular—are harder to measure, as they tend to grow much faster and more unpredictably than mature firms. Both the scarcity of historical data and instability add towards the perceived risk of investment.

Market Multiples

In addition to the discounted cash flow method, investors will also use the market multiples method to estimate their ROI.

The first step of this equation requires using your Price to Earnings Ratio(P/E) to calculate the terminal value of your business. (Terminal value is a fancy term that means, “how much your business is worth at the exit.”) Multiplying the P/E ratio by the annual net income in the year of exit will determine this number.

Once they’ve calculated how much your business will be worth at exit, investors will divide that number by a discount factor, or their expected or required ROI. For example, an investor may be looking for 10x, 20x, or even 30x their initial investment.

“Does This Meet My Required ROI?”

The majority of firms have a required ROI that needs to be demonstrated before they agree to work with a new business. And, depending on the perceived risk of the venture, the required ROI can change dramatically.

On average, VCs expect to see an ROI of at least 10x from new ventures.This is because 67% of companies in a VC’s portfolio will either lose money or be unprofitable, meaning that the few that do succeed need to carry their weight. An ROI lower than 10x will most likely result in a loss for the portfolio as a whole.

Keep in mind that VCs aren’t the same as angels. While many VCs—like angels—do invest their own money, they also manage the funds of others and are held accountable to said investors. Venture Capitalists are expected to generate a substantial Return on Investment for their own clients, meaning that if they’re going to invest their money in your business, you better excel.

“How Risky Is It?”

Perceived risk also factors into an investor’s expected ROI. The riskier your business plan seems, the higher the ROI will have to be.

Both the age of your company and the stability of the industry will affect perceived risk and the likelihood that a VC says “yes” to your pitch. As I mentioned earlier, younger firms lack sufficient historical data, making their future performance much harder to predict. This risk is compounded even further when the firm is involved in a relatively new industry that may or may not last.

Macroeconomic factors also play a large part in your ability to secure VC funding. The stock market, interest rates, and the state of the economy as a whole can all seriously hinder your plans to raise capital or go public. 2019 has been a great example of this, so far.

Uber, Lyft, Airbnb, Slack, and other promising startups have been slated to release IPOs this year, but have been holding off due to instability in the stock market and fears that the US economy could be a bubble waiting to burst. For the average person, the delayed release of Uber’s IPO may not be that big of a deal. But for the VCs that hold equity in the startup, nothing could be more nervewracking.

And if investors are already feeling the pressure to pawn off the companies in their portfolio, they’re very unlikely to take on more liabilities.

“Does This Fit into My Firm’s Portfolio?”

A VC firm will have an average of 10 companies in its portfolio at a time.And out of these 10 different companies, just one is expected to make a successful exit. When you realize just how low the chances of success are, it makes sense why investors ask for such high ROIs. They know that one venture will have to carry the team.

They also know that even the most appealing investments are still at risk of fizzling out. Due to the unpredictable nature of Venture Capital, businesses that once seemed promising could still end up failing completely.

VCs also like to diversify their portfolio with companies from a variety of different industries. It’s a strategy that both mitigates risk and allows VCs to build an interesting portfolio.

Although SaaS and tech startups have been the hot topic in recent years, other industries like Fintech, Medical, and Transportation & Logistics are rising through the ranks. As a founder, your challenge is to strike a balance between getting lost in an oversaturated market and confining yourself to a niche market that lacks a large consumer base.

“Will This Be an Easy Exit?”

VCs don’t get the big paycheck until they exit. For this reason, they’ll be searching high and low for ways to either sell your business to someone else via M&A or get you to go public via IPO.

This should raise another question for you as an entrepreneur: are you willing to be absorbed by another company or answer to public shareholders? If not, you might want to reconsider pursuing VC in the first place.

In recent years, however, it has become exceedingly common for startups to continue raising consecutive rounds while remaining private. Thanks to the rise of “mega-funds” and high competition among investors, startups are now able to raise billions of dollars without the need to go public. In other words, startups in today’s economy can have their cake and eat it too.

“Will Follow-On Investments Dilute my ROI?”

Dilution occurs when a business requires additional capital from VCs to achieve an exit. For a variety of reasons, a business may fall short of its goals and require more funds to keep growing until the point that it is ready to go public on the stock market or achieve an M&A.

These unforeseen investments negatively affect the ROI that was calculated at the beginning. If an investor were to put down $10 million in expectation of receiving $30 million upon exit, their estimated ROI would be 3x. However, if along the way they were required to inject an additional $5 million in the business, their ROI would be reduced to a mere 2x.

The same would happen if another investor were to give that $5 million to the same business in return for equity. Upon issuing new stocks in exchange for the capital, the equity stake of all current shareholders would be reduced. And that small percentage of the company you were holding on to would quickly become a fraction. Since VCs receive percentages and not fixed numbers in return for their investments, any further investment by themselves or by others will lower ROI.

Conclusion: Know Your Worth

Walking into a VC meeting without knowing the value of your company is a real recipe for disaster. Not only do you risk giving away too much equity in exchange for too little capital but you also risk looking foolish in negotiations. Placing an unrealistic valuation on your company or asking for too much capital in early rounds can make you look inexperienced and out of touch with the market.

By analyzing the valuation of your own company beforehand, you can avoid a number of unpleasant scenarios such as these and more.

Today, I have the privilege of seeing things from a different perspective and having the veil lifted away from my eyes. When I mentor new entrepreneurs and teach them about VC, it’s often like seeing a younger version of myself in the mirror. But this time, I have the opportunity to go back and correct my mistakes.

If you’re raising Series B or C funding your business leave a comment below and I’ll do my best to give you insider advice on what steps to take moving forward. You can also visit our page to discuss how we at VCengine can help.