The 5 Steps a VC Takes to Value Your Business – And the 3 Things You Can Do About It

Today, we’ll discuss how VCs think about valuing your round, and how you should think about it. We’ll admit that everyone thinks venture valuations are black magic and arbitrary.  But there’s actually some science behind it.  The methodology below is a grounded way that VCs arrive at valuations – for example, in this blog post, Fred Wilson is using the methodology we discuss below.

In practice, the later-stage the investment, the more grounded the valuation becomes.  So while this may not always be used at the seed stage, by Series B and later the below almost always drives the starting point for setting your company’s valuation.

The Five Steps a VC takes to value your business:

1.Estimate exit valuation range

VCs start with the end.  They’ll triangulate your business model, your addressable market, and your buyer universe to identify a range of likely exit values for your business.  For example, if you’re a vertically-oriented SaaS business, that might be two hundred million US.  If you’re a next-gen ad tech company (with a larger market and more potential buyers), it might be a five hundred million.

Note that likely is the key word here – VCs know that the typical exit is in the low $100s of millions so it takes a pretty strong case to convince them a unicorn valuation is in the exit range

2. Build target ROI with safety margin

They work backward by an expected ROI.  The average multiple for a “home run” VC exit (which drives a portfolio) is 16x.  This is driven by the pareto rule in venture investing – because of the high failure rate of startups, the successes need to be home runs to drive portfolio returns.

But of course, VCs will actually need more than the 16x at the outset.  This is for two reasons:

  • First, the math here doesn’t account for dilution from future rounds.  So earlier investors will demand a higher “expected ROI” than growth stage investors – probably at least double the ROI
  • Second, VCs are wrong often and they know it, so they’ll build in a safety margin into their ROI to compensate for mistakes. They don’t know how many of their portfolio companies will be home runs, so they’ll actually shoot for a little higher than 16x to compensate for this.

So the big question is what ROI do VCs look for?  There’s a lot of chest-thumping around “we need 100x!” but we feel it’s not actually that high. We think a good estimate is anywhere from 20x-40x (that’s exit cash divided by invested cash).  This is actually a great question to talk about with your VCs, so you can tune this even more specifically with each potential investor.  Some VCs might consider this controversial, but if you can’t have this discussion openly, you probably don’t want them as your investors.

3. Divide Exit Valuation by target ROI

If we take our exit ranges of $100m-$1bn, and divide by target ROIs of 20-40x, we end up with a rough startup valuation range of $2.5m to $50m.

That’s a pretty common range of valuations you see for venture stage startups.  The range feels large, but bear in mind this is for startups from Seed to Series B.  For brevity, we won’t do the math for each individual series here, but the calculations for Seed, Series A, etc individually all fall within their more specific ranges.

4. Sense-check strongly against rule-of-thumb values

After all of this precise, results-driven math, the dirty secret of venture capital is that everyone still triangulates against market values.

The good news is those ranges are wide – Christoph Janz ballparks US SaaS businesses at $2-6m for seed, $10-40m for Series A, and $30-$200m for Series B in 2017.  So all of the work we’ve done so far isn’t a write-off, but the market will definitely encourage a VC to nudge the valuation in either direction.

One example to determine that nudge is revenues – a seed/A/B startup should be in the $500k/$2m/$10m revenue range, respectively.  And if you fall above/below that for your stage, expect to be on the high/low side of your above range, respectively.

5. Check if this is too much/too little money for the business plan

VCs generally look for about 20% per round, so divide your valuation by four to figure out how much is the ticket size (glossary: ticket size = how much their investment amount is).

This again gets a nudge and is a big driver of what pushes valuations around within their market ranges.  The key here is that (honestly, for reasons unknown) the 20% is fairly constant.  So if there’s a strong case for you to raise a larger round, then you’ll get both more cash AND a high valuation.  Great!

For example: if you’re a Series A company, the valuation ranges start to widen – in Christoph’s chart, from $10-$40m.  What’s the difference between $10m and $40m valuation?  The $40m business here would have strong proof that they’re ready to productively scale up their sales force (such as proven CAC:CLTV at scale, numerous large enterprise customers, etc).  This will drive a larger ticket size (roughly $10m).  So they would ideally show that they can invest $10m in scaling the business NOW and achieve solid ROI.

What you can do about it

So this is all thrilling, but what does it mean for someone who’s negotiating their next round?  Learn which parts of this you can influence and which you can’t.

1. Show you can spend it: Bring data

Checking the ticket size is the last step for a reason – it has the highest power to swing both valuation and ticket size.

How can you show that you’re ready for the big ticket?  Bring data.  Bring historical performance against conventional metrics that shows a strong growth ROI.

And most importantly (this is the part everyone misses) – bring data that shows scalability!  There are many pitches where the entrepreneurs played with Facebook ads for a few hours and failed to account for the fact that their 300,000th user will be much more expensive than their 3000th.

2. Don’t sell your company, sell your exit

Likewise, the exit size is the first step for a reason.  This will anchor your entire valuation discussion, which is why showing exit potential is the best way to demonstrate value.

Too many entrepreneurs go in and pitch how cool their product is instead of painting a rich narrative ending in the exit.  Who will buy you?  For how much?  Why?  Why won’t they build it themselves?

3. Understand your investor’s ROI expectations

This is a good idea for aligning interests generally.  But make sure to ask your own questions in the pitch sessions – especially around the investor’s return appetites for various investments.  If you know an investor is used to making higher-risk investments, you might get a premium for the round (and vice versa).

This legwork expands to more than just the meetings – do some desk work and figure out if an investor has already had a big hit in their current fund this could influence their risk appetites (and your ROI safety margin).

Next Steps

Hopefully this provides some context for your improving your next fundraise – but ultimately, don’t fall into the high valuation trap.

It happens often: a founder sees round sizes increasing, and their friend at that hot AI business just raised at $45m pre and they don’t even have any revenues!  Don’t let those outliers fool you – you can see from this process that there’s a huge variety of situations that lead to different valuations.

And remember that pushing for a higher valuation takes work.  You might achieve it, and you might not – but be prepared to spend months chasing it down when you could be building your business.   Furthermore, overvaluing your company makes it hard to raise the next round or exit – it’s called the Valuation Trap and it’s really, really real.  So weigh the cost of pushing hard for a better valuation against the value you’ll gain by growing the pie instead.  This is true not only for late stage companies, that can box themselves into an “IPO or bust” situation, but even getting from Seed to A to B.  If you are over-valued and can’t hit your milestones, you can face a easily face a serious downround, especially if the market turns and all the rules change, which can have a major negative impact on founder and employee holdings in the company.

For more information contact us at Disclaimer: These general perspectives are not legal advice.  If you’re negotiating a round, get a lawyer.