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Valuation and VCs
There’s this dance that entrepreneurs and venture capitalists do when it comes time to negotiate the economic terms of an investment. And it all revolves around valuation.
The question is what is the fair value of the business? This supposedly establishes how much of the company the venture capitalists will own for their investment.
But I think the concept of valuation is often misunderstood by the people engaged in this process. And it’s particularly true in early stage investing.
I do not believe that negotiating a valuation on an early stage venture investment has much to do with the current value of the business. If it did, why would a venture capitalist agree to a $10 million value for a business that will lose money for the next 2-4 years and has little, if any, revenue?
The fact is that almost all venture capital deals are done as convertible preferred stock investments. That means that the money VCs invest is more like a debt instrument in the event the business doesn’t work out very well. VCs get their money out before the entrepreneurs do if the deal goes sideways or down.
It’s only in the event that the deal works out that the percentage of the business (the thing that valuation is supposed to determine) matters in terms of how much money everyone makes.
Another important factor to consider is that only a relatively small portion of early stage venture investments really work out in the way they were supposed to when the investment was made. The following is from a friend of mine and I thought it was brilliant so, I thought I’d share his thoughts here with you – He calls it the 1/3 rule which goes as follows:
1/3 of the deals really work out the way you thought they would and produce great gains. These gains are often in the 5-10x range. The entrepreneurs generally do very well on these deals (the VCs do even better).
1/3 of the deals end up going mostly sideways. They turn into businesses, but not businesses that can produce significant gains. The gains on these deals are in the range of 1x-2x and the venture capitalists get most to all of the money generated in these deals.
1/3 of the deals turn out badly. They are shut down or sold for less than the money invested. In these deals the venture capitalists get all the money even though it isn’t much.
So if you take the 1/3 rule and add to it the typical structure of a venture capital deal, you’ll quickly see that the venture capitalist is not really negotiating a value at all. They are negotiating how much of the upside they are going to get in the 1/3 of the deals that actually produce real gains. A VC’s deal structure provides most of the downside protection that protects their capital.
I think it is much better to think of a venture capital deal as a loan plus an option. The loan will be repaid on 2/3 of their investments and partially repaid on some of the rest. The option comes into play in a big way on something like 1/3 of the investments and probably no more than half of all of a VC’s investments.
There is more to this whole issue of valuation because there are often follow-on rounds where the deal between the venture capitalists and entrepreneurs gets renegotiated. Let’s save that for another time.