Understanding how the venture capital investment model works can help entrepreneurs develop their business strategy and negotiate the price and terms of an investment.
Venture Capital (VC) investing is a portfolio game – you don’t just make one good deal. Rather, VC firms invest in several companies to spread out the risk. They know that eight or nine out of 10 investments will fail or bump along and return no real gain, while one or two might be a success.
Let’s say we launch a small, $100 million venture fund, as an example. To cover overheads and some profit, and to meet the investment targets of our fund’s investors, we need a 20% compounded return. Let’s say we have a five-year time horizon on the fund.
To meet the required 20% compounded return, our fund needs to return cash of approximately $250 million in five years. If the horizon is seven years, the return would need to be approximately $360 million.
What does this mean for our fund’s portfolio? Let’s say our fund invests its $100 million by making 10 equal investments of $10 million. Because we know that only two investments are going to generate our returns, and eight will not, we therefore need to generate $125 million of cash from each of the two successful investments.
That’s 12.5 times our money in five years. In seven years, we need 18 times our money.
VCs typically need to target 10 to 30 times their money on an investment for their model to work and they choose their portfolio companies with this outcome in mind.
For the entrepreneur looking for funding, this knowledge will impact your business strategy. Your business plan needs to speak to these returns and it must incorporate how and when you are going to exit, what valuation metrics are used in your industry and what multiples are reasonable.
How does this VC knowledge apply to the valuation discussion with a VC? How much company ownership will the entrepreneur give up for a $10 million investment?
Let’s assume that your business plan projects $125 million in revenue in 5 years and your industry standard exit multiple is 2x revenue. These figures amount to a $250 million valuation in five years. Remember that our VC fund is looking at a 12.5x return on its invested cash.
Here’s an easy formula:
Post money valuation = Exit Value / Return on Investment (expressed as a multiple)
So, in our example: ($125 million in revenue x 2) / 12.5 = $20 million post money valuation
Meaning, before the $10 million investment, your business is worth $10 million. And since the entrepreneur and VC are contributing $10.0 million each, the VC will require a 50% stake in the business.
Note that this analysis entirely skips further capital requirements, further dilution and capital structure engineering. We’ll write about and discuss those another day.