Simon Cook, founder and CEO of VC firm Draper Esprit plc, explains how company valuations are created.
In 1452 the first ‘internet 0.1’ VC round took place between Johannes Gutenberg and business angel Johann Fust from Mainz. The deal was 1,600 guilders (worth about €180,000 today), paid in two tranches, with profits to be split 50/50 after the repayment of the secured investment with 6% interest. Thus this was a €180,000 pre-money, 1x 6% pref deal in modern VC parlance.
After three years, Gutenberg ran out of money before finishing the creation of his printing press and Fust effected a cram down, taking over the printing press business. Fust went on to sell hundreds of books at 40-75 guilders each. Gutenberg lost everything.
The point of this story is that venture capital is, and has always been, about risk and reward, not valuation. An investor stands to lose all their money, so typically wants some downside protection, such as Fust above, but also wants a decent amount of the profits if it succeeds. The investor also wants the founder to feel it is the founder’s business, so typically would never take more than 50%.
So the question of valuation is more about how much can you raise for a stake less than 50%, and how strong are the downside protections the investor demands? An investor with only 5% of the upside will not feel he or she will participate sufficiently in the upside, and thus typically venture rounds require a sale of 10-40% equity in each funding round. Want to see this in practice? Watch an episode of Dragon’s Den.
Downside protections
The downside protections are more driven by the competition for the deal, the level of assets available for security, and other market conditions of the day, and range from straight equity, through a simple convertible or participating preference, to full asset security.
So how much can you raise for 10-40%? This will be dictated by the current stage of your business and the potential of your business to be very valuable in future, based on measurable evidence of momentum today.
Two factors guide this number. The first is longer-term potential. Ultimately, all businesses will be based on a multiple of profits. For example, a business growing at 20% and generating a profit margin of 20% earnings before interest, taxes, depreciation, and amortisation (EBITDA) will be valued at 4x revenues (1 sales x 0.20 EBITDA x 20 = 4 ), reduced to 3x after 20% tax.
A low-growth, low-margin business, for example 10% EBITDA and 10% growth is 1x revenues, or 0.7x after tax. Market leaders will often be given a superior price/growth (PEG) ratio up to 2x. As an example, Facebook makes over 50% EBITDA of $15bn on $28bn sales, and is growing at 20%, but on a PEG of 1.5, so is worth about $375bn (28*.55*20*.8*1.5), or about 13x revenues mathematically.
Understanding
At early stages, it is the understanding of potential profits and potential growth that matter. If your gross margin is 20% then it is highly unlikely your long-term EBITDA will be much above 10% and you will have little cash generated for growth, so a lower gross margin business is likely to be worth, at best, 1x revenues. On the other hand, a good SaaS business might have 90% gross margins, so longer term it might be possible to believe in potential EBITDA margins of 20%+ and growth of 20%, or 3-4x revenues mathematically. A really successful business that can generate longer term EBITDA of 30% and growth of 30% is worth 7-9x revenues.
So VCs need to understand why your business will be able to generate long-term profits and long-term growth, to buy into why it might be worth 3-9x revenues at a later date. If you can explain how you might get to $100m revenues in future years, on this basis an exit value of $300-900m becomes conceivable and double that for market leaders.
Most VCs (not longer-term patient capital evergreen funds like ours), are measured by internal rate of return (IRR), and have a target per company of 40%+ to cover for some business failures. A ~40% IRR over 3-5 years requires a 3-5x return as shown below. Hence assuming an exit of $300m-$900m, the value today might be $60m-$300m. At this level, a 25% equity raise would allow you to raise $15m-$75m.
So if you show your business can grow from its current stage to $100m revenues in 3-5 years, you are able to potentially raise $15m–$75m for 25% today. You might be able to convince someone you can reach that from zero today, but most VCs might not take that at face value. If you already have significant revenues, however, and strong gross margins, and are growing at 50% over recent years then it may be easier to convince a VC you are on track to reach $100m in a few years.
VCs will often look at current performance and try to form a solid view of what you can achieve with the next 12 months. Most deals we have seen end up being valued at about 3-6x forecast gross margin that can be supported by due diligence. So, for example, a business with strong evidence to support a forecast of $20 sales and $15m gross margin will be valued at $75-$90m, and could raise $25-$30m for 25%.
Most will use current year forecasts, but the hottest deals with real evidence of traction might be able to use a further year out forecast. Entrepreneurs will put out the most ambitious forecasts and VCs will test them, and from this dance will emerge a negotiated valuation. From here you can calculate how much you can raise from VCs for the 25% average stake they will want to have some meaningful upside. And from this number will emerge the pre-money valuation of your business magically. Art and science combined.
This article first appeared on edition 14 of Tech City News’ print magazine – The Virtual Reality Issue. Buy your copy here.