This is the second in a three-part series designed to educate business owners on sources of capital for fast-growth businesses.
One of the most emotional conversations a venture capital investor can have with an entrepreneur surrounds the issue of valuation, with the key question being, “How much of my company do I have to give up for the amount of capital I am raising?”
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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.
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 and the greater the return it requires to compensate for that risk.
• Business risk can be further 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 – i.e., 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, i.e. 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 must recognize that this represents a risk that the investor bears.
Having calculated stage and business risk, the two are then combined to build an overall target return expectation. VCs typically calculate return two ways – multiple of cash and internal rate of return (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 (e.g. more than 10 times invested capital) to compensate for this risk. Investors in later-stage deals, which carry a decreased risk of capital loss, might expect returns ranging from three to six times invested capital.
Once a VC determines a fair return for risk taken, he turns to the company’s financial projections over the expected investment period to calculate an estimated company value and then a risk-adjusted future return.
This is achieved by working backward from the investment “exit” to today – i.e. if the business will be sold for $50 million five years from now, and I need to make 10 times my $1 million investment, then I need to make $10 million – or own 20 percent of the company in year five.
The most common form of investment made is a new class of shares called convertible preferred stock. This class of stock acts like debt (accumulating non-current paying interest) until such time as the VC investor decides to convert to common stock, at a pre-agreed valuation basis (if the investor chooses to convert). Convertible preferred is the most management-friendly form of preferred stock in that it is a simple either/or proposition: either the investment remains as “debt” and is redeemed as such; or it converts to common stock on the same terms as founders/management.
When investors and the VC differ on valuation, a VC may propose a participating preferred stock issue. In this form of preferred stock the investor gets return of capital plus a pro-rata share of the residual value.
To illustrate: The VC invests $2 million at a $4 million pre-investment valuation (and thus a $6 million post-money valuation); the investor then owns 33 percent of the post-money value.
Assume the company is sold at exit for $20 million. In a convertible preferred issue, the investor changes the convertible preferred to common stock and takes 33 percent of the exit value, or $6.7 million (3.35 times invested capital).
In a participating preferred stock, the VC takes its $2 million “off the top,” leaving $18 million of residual exit value. The VC then takes 33 percent of that residual or $6 million. Total to investor: $8 million or four times cost. Participating preferred stock tends to “bite” owners most when the exit valuation is low (presumably due to disappointing performance by management). Considering that management disappointed itself and investors with a low exit, this is not unreasonable for the VC. However, it highlights the point that structure (participating preferred) can matter more than the percentage ownership that valuation suggests.
The better you understand the risk analysis process, the better chance you have to address and mitigate these risks, manage your expectations regarding valuation, and negotiate your best deal with prospective investors. •
Michael Gurau is managing general partner of Clear Venture Partners, a venture capital fund targeting Rhode Island growth companies across a range of sectors. He can be reached at mg@clearvcs.com.
