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How Do VC’s Determine Company Valuations?

Question: Valuation is often one of the first questions VC’s ask of companies seeking capital.  It seems that VC firms have their own way of doing a down and dirty estimate of the companies value.  Will you share some of the common “quick ways” they arrive at the companies value?

The short answer is “no – we won’t share common quick ways VCs arrive at companies value – that’s part of the secret VC voodoo magic that we keep secret from entrepreneurs, especially if they are on double secret probation.”  Oops – that was mean for the blog www.dontaskthevc.com – I forgot which one I was posting to.

Valuation – especially for early stage companies – falls in the category of “more art than science.”  While buyout investors who are acquiring companies with meaningful cash flow streams love their multi-sheet Excel models with 37 pivot tables, most early stage VCs can do valuations on a napkin (or – if they are good at simple math (e.g. addition and subtraction) – in their head.)  In the early stages three things drive valuation: (a) ownership dynamics, (b) market terms, and (c) competitive deal dynamics. 

Ownership dynamics are the most vague – many VC firms have a view of their “target ownership” of a company (e.g. “we like to own 20% of the companies we invest in”) and use this to back into a valuation.  However, the specific amount varies by firm.  In addition, most firms – especially larger ones – can simply write bigger checks to get the ownership they want, which results in larger post money (but not always premoney) valuations.

Market terms are a little easier to understand.  If you are an early stage company, you’ll start hearing things like “1 on 2” or “3 on 3” or “5 on 4”.  “1 on 2” is VC shorthand for “$1m buys 33% of the company.”  While market terms move around over time, most seed deals get done between $1m and $3m premoney and most first round investments typically get done where the capital in buys 50% of the company (e.g. “4 on 4” or “5 on 5.”)  Again – this is art – there is no scientific way to really value three guys and a powerpoint slide or a web service with 10,000 subscribers of which 250 are active (although no one can prove that only 250 are active.)  When you are in this position and your prospective VC starts talking about discounted cash flow in year 10, run screaming from the building – he is not the droid you are looking for.

Competitive deal dynamics are where all of this goes out the window.  If you only have one VC interested in your deal, you have relatively little negotiating leverage.  However, if you are the hottest company of the week, have a dozen different firms that want to get into your deal, and you have three great angel investors ready to write $500k checks each to fund your first round, you probably can negotiate a meaningfully higher price. 

January 25th, 2007 by     Categories: Valuation    
  • http://www.vimac.com Doug Redding

    Thought you’d be interested in this data from VC Experts Buzz of the week. You may need to paste it into a table or Excel worksheet.
    (11) What valuation method(s) does your firm use when evaluating initial investment (frequency distribution):
    Seed Early Expansion Later Bridge Mezzanine – debt Buyout PIPES Turnaround Distressed
    Comparable Transactions 36 59 45 29 3 8 24 6 3 1
    Comparable Multiples (P/E, EV/EBITDA) 10 26 39 34 4 7 34 5 5 1
    Discounted Cash Flows 5 17 18 23 1 3 23 4 3 0
    Net Assets of Investment Company 6 8 5 5 1 2 8 1 2 2
    Industry Valuation Benchmarks (e.g. price per subscriber) 16 30 24 22 3 4 12 5 2 1
    Adjusted Present Value 6 7 11 10 1 3 6 0 0 0
    Option Valuation Approach 2 1 5 7 1 2 0 0 0 0
    Other 13 14 3 4 1 0 1 1 3 0