Agenda for Growth: The role of valuations in venture capital financing

One of the most animated and emotional conversations a venture capital investor can have with an entrepreneur surrounds the issue of valuation: “How much of my company do I have to give up for the amount of capital I am raising?”

For many company owners, this part of the venture capital valuation process seems like a somewhat arbitrary method to maximize VC ownership at the expense of founders and managers. However, much of the process reflects as much objective science as it does subjective judgment. Companies that better understand this process can both manage their expectations and improve the chances of reaching consensus.

Importantly, VCs do not only provide capital. An “ideal” VC also is a business builder and partner. As such, VCs use their experience and networks to help management teams execute their strategic and operational aims through an active role on a company’s board of directors.

To become partners, VCs must first be willing to invest in a company. VCs get their money from other investors (i.e., pension funds, banks, endowments), and in order to create a return for these investors, VCs must make sure they properly assess and price risk for their prospective investments.

Determining risk

VCs break down risk into two broad categories: stage and business. Stage risk relates to a company’s stage of development — early-stage companies (pre-revenue, early revenue with losses) have very high failure rates; later-stage companies (material revenue, at or near profitability) carry lower risks. The earlier the stage of investment, the greater risk the VC bears. Correspondingly, the VC requires a greater return to compensate for the risk.

Business risk can be broken into six sub-categories: management; market; product; technology/barrier to entry; financial/financing; and business model/plan. Importantly, these categories carry unequal weighting. Management experience often trumps other categories – for example, many investors would sooner back an “A” team with a “C” product than a “C” team with an “A” product.

Each business risk area has an ideal definition. For instance, the ideal, lowest-risk management team is one that: is complete in all functional roles; has deep domain experience in its target market; and has successfully built businesses and made money for investors in the past.

Companies that fall short of these ideals — and most companies do — must recognize that this represents a risk that the investor bears.

Pricing risk

Having calculated stage and business risk, the two are then combined to build an overall target return expectation.

VCs typically calculate return in two ways — multiple of cash and internal rate of return, or IRR. Multiple of cash is indifferent to time (i.e., how long the investment is held) while IRR is calculated according to the time the investment is held.

Investors care about both but are most interested in multiple of cash for their fund as a whole. As many early-stage companies fail, these investors must price for a relatively higher return (more than 10 times cost) to compensate for this risk. Investors in later-stage deals, which carry a decreased risk of capital loss, might expect returns of three-to-six times cost.

Once a VC determines a fair return for risk taken, he or she turns to the company’s financial projections over the expected investment period to calculate — using public company data, where possible — an estimated company value. From there, a VC will determine the ownership required today to achieve a risk-adjusted future return.

This is achieved by working backwards from the investment “exit” to today – for instance, if the business will be sold for $50 million five years from now and I need to make 10X my $1 million investment, then I need to make $10 million, or own 20 percent of the company in year five.

Valuation vs. structure

The maxim most often used by VCs to help founder/owner’s cope with a value they feel is less than what they’d like is “it’s better to own a small piece of a big pie than a big piece of a small pie.”

In other words, with the VC’s capital and business support, a company can significantly improve its overall market value compared to trying to grow organically with internally generated funds.

The other maxim — which VCs tend to tell company owners less frequently — is that investment structure matters more than valuation/pricing. Structure relates to the form, terms and conditions of the stock (most often a new class of preferred stock) being traded for capital.

A greater understanding of the venture capital process can mitigate the inherent tension between parties during valuation negotiations.

Michael Gurau is president of CEI Community Ventures Inc., a $10 million venture capital fund targeting New Hampshire, Maine and Vermont and co-sponsor of the Dec. 7 Agenda for Growth conference. Gurau, with 11 years in the venture capital industry and four years of startup experience, was a presenter for two sessions at the conference: “Spectrum of Financing, from Grants to Venture Capital” and “What’s my company worth? An introduction to valuing your business for growth and capital.” For more information, visit ceicommunityventures.com or call 207-772-5356.