The Black Art of Deal Pricing

Summary:
— pricing is driven off of multiples not IRR
— VC’s target 10x due to high failure rates
— start at the expected final valuation and work backwards.

What area of venture capital is more opaque and mysterious than how VC’s price deals? Professors have tried to quantify and analyze what we do. Ironically, it is quite simple, though subjective.

Many entrepreneurs try to approach valuation from a classical discounted cash flow model. They show what the next 5 years are going to look like and then discount it back to the present using various discount factors. If you are going to pitch a VC, please don’t use this methodology as you will start your relationship there with a mark against you (also, don’t claim a) your numbers are conservative…trust me, they are optimistic at best and b) you have no competitors…you need to do more homework).

The core issue is that the venture business is unpredictable. Numbers going out more than a quarter are unruly. Those going out 5 years are pure fantasy. Market adoption rates, pricing models, product mix and such are all up in the air. Therefore, the numbers are useless and the DCF from them are even more so. Furthermore, good luck trying to nail down what the right discount rate is…lot of beta in this business.

The venture business is driven off of multiples. Early stage VC’s target 10x return of capital and expansion/late stage investors target 3-5x. Why 10x…seems a bit usurious? The classic venture portfolio looks like this. Of ten deals done:
— 4 crater
— 2 are breakeven +/- a little
— 3 are 2-5x capital
— 1 is 8-10x

So, as a VC, you hope that all 10 deals will be the next Microsoft, but reality sets in at the first board meeting. You need to target 10x for your winners in order to pay for the losses elsewhere.

VC’s will then try to estimate a) what they think the company might be worth if successful in 3-5 years and b) how much more capital will be needed. In a simple case, let’s assume that the company is worth $100m in 4 years and will not take additional capital. Using the 10x rule, the VC will price the deal so that post-$ valuation of the deal is $10m. If the company is raising $2M and adds $1M worth of options to its pool, the VC will pay $7M pre-$.

Clearly, the Achilles heel here is how to estimate the terminal value. I have seen several reports indicating the average IPO (only about 10% of exits these days) has had an $180m valuation and the average M&A valuation is around $120m (about 90% of exits). This puts the average overall around $125-130m. Assuming no new capital (big assumption) and an average raise of $3-5m, this would put your average pre-$ around $7-9m. Seed deals will usually price between $2-4m pre-$.

There is lot of variance in these numbers, so use them more as examples to help you understand the black, Voodoo art of VC pricing.

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