Module 2, Lesson 2.3 VC Investments and the VC Method

The primary difficulty of VC investing is the substantial uncertainty about the company’s future prospects. Traditional valuation tools, such as discounted cash flow, earnings multiples, and the LBO model, are not usually practical in the VC context. Moreover, because of the uncertainty, VC financing is done in stages—financing rounds referred to as Series A, Series B, and so on—and it is essential to understand the effects of ownership dilution. So, we turn to the VC method.

Exercise: ABC Company and the VC Method

People in discussion during a meeting; a woman with pink hair who we assume is leading the meeting smiles. Imagine a start-up company is worth USD16 million, and its founding shareholders own 100% of the equity. The company decides to raise USD4 million in additional equity capital from a VC firm. The value of the start-up company after the financing is USD20 million (= USD16 million + USD4 million).

According to the VC method, USD16 million is known as the pre-money The agreed value of a company before a financing or investing round. (i.e., pre-financing) valuation, USD4 million is the amount of new equity, Series A investment, and USD20 million is known as the post-money The value of a company after a financing or investing round. (i.e., post-financing) valuation. That is,

Question: What is the total equity stake owned by the VC firm if it were to make the USD million investment?

Show Solution

After the transaction, the VC firm will own of the equity stake or, in VC terms, will have 20% fractional ownership The proportionate ownership of a company by the venture capital investor after a financing round (i.e., Investment / Post-Money Valuation). of the start-up. The original shareholder equity stake gets diluted down to 80%.

This basic example is central to understanding the VC Method.

The central challenge of the VC method is determining the pre-money valuation. The closer you are to the inception (or founding) date of the company, the harder it is to assess its pre-money valuation. Indeed, in early stage VC, the investor might be backing an idea with no tangible proof of commercial viability. At the heart of a successful VC investment is a fundamentally novel and uncertain idea; otherwise, existing firms would easily replicate it. It is hard to envision a comparable company in the public domain or even comparable VC investments when you are early in the process. So the VC method works backward to come up with the pre-money valuation, taking as inputs the expected exit valuation and the required return on investment.

Expected Exit Valuation

VC investments are typically financed through a closed-end fund with a finite life horizon; 10 years is very common in PE. The average holding period for individual investments within the fund is typically between five and eight years. Performance metrics for the portfolio firm, measuring its progress toward commercial success, are identified at the end of the expected investment period. The performance metric could be, for example, revenues or number of users. For early stage VC investments, it might be ambitious to expect that the company becomes profitable, but if that is the expectation, one could also use earnings per share or EBITDA. Choosing the right multiple to apply to performance metrics depends on the specifics of the industry, and the general idea is that, whatever the performance metrics, the value of the VC investment at exit can be estimated based on projected performance metrics at anticipated exit and an appropriate industry multiple.

Required Rate of Return

VC firms target a high expected hurdle return. The failure rate of VC investments, especially early stage VC investments, is much higher than that of growth equity or buyouts. Thus, the target return on investment (ROI) tends to be 10× to 30×, compared with 2.0× to 2.5× in the buyout space.

Armed with the hurdle return and the value of the portfolio company’s equity at exit, we can compute the post-money valuation:

so,

Given the capital needs of the company, we know that the pre-money valuation is as follows:

Exercise: XYZ Company and the VC Method

A young entrepreneur smiles confidently in an open plan office. Take an entrepreneur who is looking to raise USD500,000. Given the size of its market and the industry, the entrepreneur’s company expects to reach sales of USD80 million over the investment horizon. A typical revenue multiple for a revenue-generating business in its industry is 2x.

Question: If the VC firm’s ROI is 20x and the entrepreneur’s company has no debt, then what is the pre-money valuation? And what is the VC firm’s fractional ownership for the USD500,000 investment?

Show Solution

These numbers are sensitive to the revenue performance metric. The required ROI will be dictated by the competition and the cost of capital. Although ROI is not sensitive to the length of the holding period, an expected holding period of five to eight years is generally the assumption in the VC fund structure. The previous example could also be reframed in terms of required IRR on equity. Over a five-year period, 20× ROI is equivalent to an 82% IRR. In general,

or in this case,

Option Pools

Returning to the first example, assuming the start-up is owned by the founders, they held a total of 10 million shares, and there is no option pool, what is number of new shares that the company needs to issue? And at what price?

We know that:

This means that 2.5 million new shares [= (0.2 × 10 million)/0.8] must be issued. Based on the USD4 million of new equity raised, the shares would be issued at USD4 million/2.5 million = USD1.60 per share.

Scenarios without an outstanding option pool, however, are unrealistic. To attract and incentivize employees, start-ups grant their employees the option to purchase shares. When these options are exercised, they will naturally have a dilutive effect, so VC firms tend to calculate the per-share price on a fully diluted basis.

The basis of the dilution is contractually defined. The central question is about who bears the effect of future dilution: original shareholders or new investors? This is important because of the tension that exists between what benefits the VC investors and what benefits the founders. By calculating the share price on a fully diluted basis, VC investors are effectively left untouched by the dilution effect. Instead, the original shareholders, our founders, absorb the effects of dilution. We will return to this concept when we examine follow-up financing series.

Exercise: ABC Company and Option Pools

A businesswoman with pink hair gives a presentation. Returning to our start-up example, let’s say that in addition to the founders holding 10 million shares, there is an outstanding option pool of 2 million shares.

Question: How many shares need to be issued? And at what price per share? (Recall that the default is to make calculations on a fully diluted basis.) What is the starting equity stake of the VC firm? What is the VC firm’s equity stake after dilution?

Show Solution

The number of existing or original shares on a fully diluted basis now is 12 million. This means that 3 million new shares [= (0.2 × 12 million)/0.8] will have to be issued.
The new price per share is USD4 million/USD3 million = USD1.33.
The VC firm’s starting ownership is 3 million/13 million = 23.08%, but as options are exercised, this ownership will be diluted to 20%.
The VC fractional ownership on a postdilution basis is not affected and is equal to 20% = USD4 million/USD20 million. The ownership structure should not affect the value of the assets—the key insight of the Modigliani–Miller theorem. If the pre-money valuation of the VC’s stake is USD4 million, it should remain at USD4 million regardless of how many options the firm issues.

Concept in Action: Stage Financing in Facebook (Meta)

People looking at their smartphones huddle in a circle. We’ve established that VC financing is usually executed in stages, largely because of the uncertainty that surrounds VC investments. As an example, let’s take Meta (formerly, Facebook) and its initial financing rounds.

The first external investment in the company took place in 2004, shortly after the platform launched, in the amount of USD500,000. Just a year later, Meta raised USD12.7 million. In 2006, it raised USD27.5 million, followed by USD300 million in 2007. Behind this astonishing growth in fundraising sits an even more impressive rise in company valuation. So what changed for Meta in the three years between 2004 and 2007? Why were the initial rounds so small by comparison? The answer is uncertainty about the company’s future, which illustrates that even one year out, company valuation can fluctuate dramatically. This is despite the fact that Meta was a sought-after company with multiple veteran VC investors pursuing it. As the Meta user base grew, so did its investment and investors’ visibility into the company’s future commercial success. Stage financing, thus, is a key mitigator of the risk that is fundamental to VC: significant uncertainty about growth and profitability prospects.

Exercise: XYZ Company and Stage Financing

A young entrepreneur speaks to his colleagues in an open plan office. How do the different series of financing relate to each other? Because the earlier-stage investors take on higher risk, the return for those investors must be higher. Valuations, specifically pre-money valuations, at which later rounds of financing are raised, provide insight into the performance of an otherwise illiquid asset class.

Let’s assume that our earlier example—a VC firm raising USD500,000 for a start-up company in exchange for a 6.25% stake—describes a Series A financing. Imagine that one year later the firm raises USD2 million in a Series B financing at 10× ROI. The exit of all investors is expected to occur simultaneously, and Series B investors were projecting an exit valuation of USD300 million.

Question: Compute the ownership structure in each of the financing rounds along with the implied ROI for the Series A and B financings.

Show Solution

For Series B Investors,

$VC fractional ownership equals 2 million USD divided by (28 million USD plus 2 million USD) equals 6.67 percent$

These figures are summarized in Exhibit 4.

**Exhibit 4: Stage Financing Example**
(in USD thousands)	Series A	Series B
Required ROI	20.0%	10.0%
Investment	500	2000
Exit valuation	160,000	300,000
Post-money valuation	8,000	30,000
Pre-money valuation	7,500	28,000
Fractional ownership required	6.25%	6.67%
Ownership:	-	-
Entrepreneurs	93.75%	87.50%
Series A investors	6.25%	5.83%
Series B investors	-	6.67%
Total	100.00%	100.00%
Implied ROI	-	-
Series A investors	20.0%	35.0%
Series B investors	-

This example illustrates that the pre-money valuation implied by Series B indicates a substantial appreciation of the Series A investment. Instead of 20× ROI, Series A now has an implied ROI of 35×, although no exits occurred, and despite dilution of the Series A stake from 6.25% to 5.83%.

For Series A investors, the implied ROI, which was originally 20x, or

increases to 35× at the time of the Series B financing one year later, or

The entry of new investors with Series B dilutes ownership for both Series A investors and the entrepreneurs on a proportionate basis.

That is,

Entrepreneurs’ ownership = [(1 – 6.67%) × 93.75%] = 87.50%.

Series A investors’ ownership = [(1 – 6.67%) × 6.25%] = 5.83%.

VC investments tend to be minority stake investments. This is partly because the founders might not be willing to give up control but also because entrepreneurs are essential in the initial stages of business development. So, the dilution of initial investors through the subsequent financing rounds is common. In the previous example, the dilution from Series B was absorbed pro rata by the entrepreneurs and the Series A investors. Because control is not essential, this arrangement is typical. If an alternative economic arrangement is sought, however—as in the other example of employees’ stock options—designing an arrangement whereby the dilution is absorbed disproportionately by entrepreneurs is possible.

Whereas our example treated Series A and Series B shares as common stock, it is typical to use convertible preferred equity in late-stage financing. The capital that comes in later stages is less subject to less risk than early stage financing. In addition, to mitigate risk further, late-stage capital tends to have a preferred dividend. Series B shares could entitle shareholders to a preferred dividend of 5%, for example. On an investment of USD2 million over three years, the cumulative dividend is USD315,250. If the portfolio company performance is as expected and the returns are high, the preference shares will be irrelevant. However, if things do not go as planned, the accumulated dividend is treated as junior debt, diminishing the value held by earlier equity investors while preserving the value for Series B. Clearly, this makes Series B more valuable than if it had been just common equity. Importantly, the value comes at the expense of earlier investors. These adjustments are rarely accounted for in practice, however.

Knowledge Check

Check your knowledge by answering the following question. This is not graded.

Which one of the following statements about VC and LBO investing is false?

VC investments are primarily funded by equity, while LBO investments use extensive amounts of debt.

This is because it is False. Venture capital returns typically are very high (not moderate) across a limited number of (not many) highly successful investments, with a significant number of (not few) write-offs, while buyout returns typically have lower (not higher) variance from underlying investments, where bankruptcies are rare (not common).

VC returns typically are moderate across many highly successful investments, with few write-offs, while LBO returns typically have higher variance from underlying investments, where bankruptcies are common.

This is true. Venture capital investments are primarily funded by equity, while buyout investments use extensive amounts of debt.

Risk assessment of VC investments is typically more difficult due to new technologies and lack of operating history, while risk assessment of LBO investments is typically less difficult due to mature companies and long operating history.

This is true. Risk assessment of venture capital investments is typically more difficult due to new technologies and lack of operating history, while risk assessment of buyout investments is typically less difficult due to mature companies and long operating history.

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