I have bad news for most of you. The answer is: Probably not much!
You might think your startup is worth a lot of money because you have put in months of sweat equity, raised thousands of dollars from friends and family, increasing monthly revenues, rapidly climbing Alexa ratings, growing customers at a rate of 20% per month, mounting account receivables, or even plain old cash in your company’s bank account. But, it does not matter! I am very happy for you, but your startup might still not be worth much.
Why is that? Your startup is probably not worth much because an efficient marketplace for small businesses does not exist. This is not due to the underdeveloped state of the Turkish startup ecosystem; the market for small businesses is very small all over the world. In other words, many small businesses cannot be valued because the ratio of buyers to sellers is very small.
If you have found a potential buyer, I feel for you but the value of your startup simply is what your buyer says it is. If you do not want to accept the buyer’s valuation and your startup generates $100 thousand per month in profits, then your startup is worth $100 thousand per month only for you. No more and no less. Still, you have achieved a very difficult task and very happy for you!
Then how come venture capital firms invest millions of dollars in minority stakes even before startups are launched? To answer this question, let’s put ourselves in the shoes of venture capitalists.
How do the venture capitalists value startups?
They actually don’t. As explained above, effective startup valuation is a mission impossible, thus very challenging.
We, the investment professionals at Buran Venture Capital, do not perform financial valuations for our target companies. We occasionally take a look at revenue and EBITDA multiples of comparable companies; however, we only do it to assess the implied market value, to balance the offer price and the exit potential, and then to create an optimal investment structure aligning our interests. Neither entrepreneurs nor investors are the types of people who listen to their hearts. They are engineers, financial experts or scientists. Not many artists follow this career path. And because we are coded in a certain way, the academic valuation methodologies offer us a way to make some sense of this madness.
In short, if you think that we, the venture capitalists, rely on valuation methodologies such as detailed DCF calculations, EBITDA comps, or option pricing models, you are greatly mistaken.
How are the investment amount and the share allocation calculated?
Very easy. The investment amount is the capital needed until the next major round of fund raising or sustainability with desired growth rates. As to the shares purchased, it should be enough to give investors significant minority interest with negative control rights and other protective provisions at the company board. Consequently, the shares purchased by investors typically represent 20% to 30% of the outstanding shares.
How is the investment decision made?
When we look at the expected target returns of early stage venture capital firms all around the globe, we see that the return multiples are in the range of 10X (times) of invested capital within 5 to 7 years. Though, it should be noted that this target multiple is much higher for seed and angel investors. As an example, if the invested capital is $1 million, the share value of the invested capital should be minimum $10 million after 5 years. If we assume that the share percentage allocated to the investor is 20%, then the investment decision is based on the belief that the startup has the potential to find a buyer for $50 million after 5 years.
At Buran Venture Capital, as a later stage (Series A) venture capital firm, we prefer investing in a growing but predictable company with a reasonable valuation rather than gambling on a hot niche trying to catch a unicorn. Given our lower risk profile, we try to make sure to return 5X to our investors on their invested capital.
Here is a list of risk profiles that venture capitalists must consider:
If we naively assume that every risk can be eliminated with 80% probability (in reality, the probability of total elimination for each risk is much lower than 80%), the potential value of the startup is discounted by approximately 87%. (Binominal tree calculation: 1 – 0.89 = ~ 13%) Based on this binominal tree probability calculation, a startup with $1 million investment should have the potential to reach $384 million of value in 5 years.
So, what do you think? Do you think you startup can find a buyer for $50 million in 5 years after taking into account the market risk, the execution risk, the risks associated with competitive dynamics, and all the other risks mentioned above? Can you really be honest to yourself and objectively measure these risks? If so, from a venture capitalist perspective, you can now estimate how much your startup is worth.
I know how much capital I need but what percentage of company shares should I offer to the investor? 20% or 30%? How should I decide?
If you have only one potential investor, then you are not the one who is deciding. The investor has got all the leverage. And, the shares allocated to the investor could go up to 40%. However, there are certain mechanisms that you may consider to minimize shares sold for the capital amount you need. Assuming you have exhausted all the options within your power and limited resources to reduce risk while moving your business forward by carrying out pre-sales, contracts with potential business partners, product testing, etc., you could make use of complex investment structures such as preferred stocks and liquidation preference explained in the table below.
Final words of advice
Keep in mind that your ultimate goal should be to mitigate the risks that your investor is taking. Lower risk will result in greater risk adjusted returns, higher valuation, thus fewer shares offered to the investor for the same investment amount.
We, as investors, do not mean to pretentiously value your life’s work, immense commitment and invaluable sacrifice to make the world a better place. On the contrary, we strive to help entrepreneurs thrive in many aspects of their business from strategy formation to team building even if we don’t invest in their companies during the process. In return, we ask founders to be reasonable and realistic when raising capital as venture capital investments are about mutual trust toward a brighter future.
May the force (of capital markets) be with you!