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[Guest article by Pavan Krishnamurthy, Partner at Ojas Venture Partners.]
Early stage venture valuation is often misunderstood and viewed with suspicion by many people. This post makes an attempt to provide an overview of early stage venture valuation process within a VC fund.
Early stage investments are often based on incomplete or inadequate information/data and as a result lot of qualitative and subjective factors related to the investment opportunity become critical. In absence of either historical data or predictability of earnings, valuation techniques such as DCF and other sophisticated valuation models are not typically used for valuing early stage start-ups. In almost all cases, valuation of early stage deals is primarily determined with respect to the threshold return expectation of the VC fund from such an investment.
Generally speaking, there are 4 important variables that drive early stage venture valuation. These are
- Minimal threshold stake % required at the fund level
- Target return from the investment at the time of exit
- Expected dilution from follow-on financing rounds &
- Management incentive alignment
Minimal threshold stake required at the fund level
Most early stage funds have a pre-defined investment quantum per deal and a minimum required stake (in terms of a range) at the time of investment. This depends on the fund size, nature of opportunity at hand and the profile of the start-up team. Most early stage funds normally invest between US $ 750 K to US $ 2 million in the first round for a minimal stake ranging from 20% to 40%. This minimal threshold stake requirement by default pegs the start-up valuation range to US $ 1 million to US $ 3 million. Minimal thresh hold stake requirement rationale is based on factors such as likely exit valuation, stake required at exit for target returns as well as the impact of follow-on financing rounds on the % stake held by the investor. At this stage it is important to note that minimal stake requirement is only from an expected returns perspective and is nothing do with the control of the company.
Target return from the investment at the time of exit
All VC investments are based on the premise that an exit event will happen for the company either through an IPO or M&A and such an exit will enable them to realize money on their investments. At the time of investment itself, VC’s consider various exit scenarios, likely exit valuation and the estimated returns from an exit event. Based on the required return from the investment, required stake at the time of an exit event (for assumed exit valuation) is determined. Once the required end stake is estimated, VC’s work backwards to arrive at the required minimum stake at the time of the investment (after considering the impact of follow on financing rounds)
Expected dilution from follow-on financing rounds
Typically, a start-up would require multiple rounds of investments before it reaches an inflexion point from an exit perspective. Each such round dilutes the stake held by VC’s and impacts the return calculations (unless the decreased stake is offset by proportionately higher next round valuation). Therefore it becomes critical for VC’s to determine the likely capital required by the start-up over its life-cycle and plan for their pro-rata investments in the subsequent rounds (within the limits of their maximum investment per deal). Depending on the specifics of each deal, typical follow-on dilution ranges from 20% to 33%.
Management incentive alignment
Ownership % of founders and key employees is an important and critical element for the success of a start-up. After all, all early risks related to the venture are borne by the founders and early key hires. Therefore it becomes important for the success of the venture that these founders/key hires have a meaningful stake in the venture. Without a meaningful stake for the founders/key employees in the venture, it is almost impossible to align the interests of all stakeholders towards a common goal.
Let us take an example to illustrate how the above factors play out (This is a very simplistic example given only for illustration)
As can be seen from the above illustration, returns realized by VC’s depend on the exit valuation, dilution from subsequent rounds and the initial stake.
For example, let us assume that a start-up seeks a valuation of US 5 Million. From the above table, at this valuation, VC’s are realizing a return multiple ranging from 1.21 to 2.14 on their investments (1.21 at round 3, 1.61 at round 2 and 2.14 at round 1 assuming exit event happens at these rounds itself) over a 5 years’ time-frame. Assuming that VC’s have a minimum return expectation of 3X on this investment, valuation at the time of investment needs to be US $ 3 million (assuming that the company can reach exit without any follow on rounds) Similarly, different scenarios can be modelled from the above table to understand the impact of initial stake and therefore initial valuation on returns.
To summarize, it is important to highlight the fact that the valuation on its own is a not a significant factor and what is important to understand is the return at that valuation. If for example, if the first round valuation is US $ 15 million and investors can still make 3X on their investment, they would go ahead and invest at that valuation. On the other hand if the valuation is US $ 1 million and investors end up realizing a 1.5X on their investment, they would not invest in that deal.