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Venture Capital Deal Algebra

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Venture Capital Deal Algebra

Fred Wilson wrote a useful post on valuation today. It reminded me of a document I had Dave Jilk write when he was doing some work for me. I decided to write this “bladon” (Blog Add-on) post – inspired by Fred. Please read Fred’s post first – it lays the groundwork for why VCs do things this way.

I’ve found that even sophisticated entrepreneurs didn’t necessary grasp how valuation math (or “deal algebra”) worked. VCs talk about pre-money, post-money, and share price as though these were universally defined terms that the average American voter would understand. To insure everyone is talking about the same thing, I started passing out this document. Recognize that this is about the math behind the calculations, not the philosophy of valuation (which Fred’s blog addresses).

In a venture capital investment, the terminology and mathematics can seem confusing at first, particularly given that the investors are able to calculate the relevant numbers in their heads. The concepts are actually not complicated, and with a few simple algebraic tips you will be able to do the math in your head as well, leading to more effective negotiation.

The essence of a venture capital transaction is that the investor puts cash in the company in return for newly-issued shares in the company. The state of affairs immediately prior to the transaction is referred to as “pre-money,” and immediately after the transaction “post-money.”

The value of the whole company before the transaction, called the “pre-money valuation” (and similar to a market capitalization) is just the share price times the number of shares outstanding before the transaction:

Pre-money Valuation = Share Price * Pre-money Shares

The total amount invested is just the share price times the number of shares purchased:

Investment = Share Price * Shares Issued

Unlike when you buy publicly traded shares, however, the shares purchased in a venture capital investment are new shares, leading to a change in the number of shares outstanding:

Post-money Shares = Pre-money Shares + Shares Issued

And because the only immediate effect of the transaction on the value of the company is to increase the amount of cash it has, the valuation after the transaction is just increased by the amount of that cash:

Post-money Valuation = Pre-money Valuation + Investment

The portion of the company owned by the investors after the deal will just be the number of shares they purchased divided by the total shares outstanding:

Fraction Owned = Shares Issued /Post-money Shares

Using some simple algebra (substitute from the earlier equations), we find out that there is another way to view this:

Fraction Owned = Investment / Post-money Valuation = Investment / (Pre-money Valuation + Investment)

So when an investor proposes an investment of $2 million at $3 million “pre” (short for premoney valuation), this means that the investors will own 40% of the company after the transaction:

$2m / ($3m + $2m) = 2/5 = 40%

And if you have 1.5 million shares outstanding prior to the investment, you can calculate the price per share:

Share Price = Pre-money Valuation / Pre-money Shares = $3m / 1.5m = $2.00

As well as the number of shares issued:

Shares Issued = Investment /Share Price = $2m / $2.00 = 1m

The key trick to remember is that share price is easier to calculate with pre-money numbers, and fraction of ownership is easier to calculate with post-money numbers; you switch back and forth by adding or subtracting the amount of the investment. It is also important to note that the share price is the same before and after the deal, which can also be shown with some simple algebraic manipulations.

A few other points to note:

  • Investors will almost always require that the company set aside additional shares for a stock option plan for employees. Investors will assume and require that these shares are set aside prior to the investment, thus diluting the founders.
  • If there are multiple investors, they must be treated as one in the calculations above.
  • To determine an individual ownership fraction, divide the individual investment by the post-money valuation for the entire deal.
  • For a subsequent financing, to keep the share price flat the pre-money valuation of the new investment must be the same as the post-money valuation of the prior investment.
  • For early-stage companies, venture investors are normally interested in owning a particular fraction of the company for an appropriate investment. The valuation is actually a derived number and does not really mean anything about what the business is “worth.”
Categories: Venture Capital    

Comments (1)

juric

juric Nov 11, 2010

Thank you Dorian

Venture Capital Funds - How the Math Works

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Venture Capital Funds - How the Math Works

Why the Size of Venture Capital Funds Matters to Angels and Entrepreneurs

My previous post was titled Venture Capital Firms Are Too Big. That post provides one important piece of data necessary to answer the really important question of why the size of venture capital funds matters to angel investors and entrepreneurs. This post describes the second key element.

Venture Capital Fund Math

Peter Rip of Leapfrog Ventures describes some of the math behind venture capital funds in a fascinating post titled ‘Traditional Venture Capital Sure Seems Broken – It's About Time.’ It provides some outstanding insight into how the math behind venture capital funds affects the way venture capital fund managers make investments and how they behave after they invest.

This post is a high level summary of how the math works for a typical venture capital fund.

In a Typical Fund the Returns are From 20% of the Investments

In a typical VC portfolio, most of the returns are from 20% of the investments. This is just a statistical fact - a law of nature. Statistically, if a VC makes ten investments, two will be winners and create most of the gains in the fund.

The Minimum Respectable Return on a VC Fund is 20% per year

A minimum 'respectable' return for a VC fund is 20% per year. This is set by the expectations of the investors in VC funds, the relative risk levels compared to other investment classes and the performance achieved by other venture capital fund managers.

Another way to look at this is that a ten-year venture capital fund needs to repay investors six times (6x) their investment.

This means that those two winner investments have to make a 30x return (on average) to provide the venture capital fund a 20% compound return – and that’s just to generate a minimum respectable return.

This math is simplified but it’s more than accurate enough to illustrate this important point. If you are not familiar with the math behind an investment portfolio, I hope you will spend a few minutes with a spreadsheet so you are comfortable with these numbers.

And Most VCs Only Get to Invest the Capital Once

Even more interesting is that a traditional venture capital funds are usually limited partnerships. This means that the fund managers only get to invest the money once. If they make an investment and exit for a 3 to 4x return, they have to give the principle and gains back to the venture capital fund's investors. They don’t get a chance to invest it again. From the VC partner’s perspective, this effectively guarantees they have failed.

One 10x and One 100x is More Likely

Of course, a successful venture capital fund is not likely to have exactly two 30x exits. It’s much more probable that a fund will have one 10x exit and one 100x exit.

What is important here is how the VC fund managers think, and act.

A VC Won't Let You Sell for Less Than a 10x to 30x Return to Them

This minimum acceptable return has profound implications for entrepreneurs and angel investors. It means that if company has venture capital fund investors, they will almost certainly block an opportunity to sell the company unless the price gives the VCs a 10 to 30x return.

Future posts will explain how venture capital funds block good exit opportunities and what this means for the exit timelines in VC backed companies.

This is also a main theme in my upcoming book "Early Exits - Exit Strategies for Entrepreneurs and Angel Investors - But Maybe Not VCs."

 

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