How VCs Value Technology Companies

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How VCs Value Technology Companies

• Bob Stearns
• Sternhill Partners
• February 20, 2004
• Rice Alliance for Technology and Entrepreneurship

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What We Look for

• Management, management, management
• Hard-to-do technologies
• Sound business models/path to profitability We
  invest in businesses, not products
• Large (and growing) potential markets
• Intellectual property and other barriers to
  competitive entry
• Liquidity opportunities

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Venture Capital in Perspective

• Equity Financing
• 72 of start-up funding comes from informal
  sources (founders, family, friends, and foolhardy
  strangers) about 104B in 2002
• Fewer than 2 of the fastest growing private
  companies (per Inc. magazine) are started with
  venture capital
• Debt Financing
• SBA loan guarantees only help 2-3 of all
  start-ups obtain debt

Sources of Equity Capital for Start-ups
Classical Venture Capital (28)
Classical Venture Capital is defined to consist
of seed, early, and expansion-stage financing.
Informal Sources (72)
Source Kauffman Center for Entrepreneurial
Leadership, Babson College, 2002.
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Types of Funds by Stages
Source Venture Economics, July 2003
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Valuation is More Art, Than Science
Valuations differ largely according to
investment stage
Early Stage
Late Stage
Determined mostly by subjective factors
Objective/quantitative factors more relevant
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First, Some Definitions

• Pre-money valuation is the dollar value of the
  idea (or company) at the time new money is
  invested
• There is a new pre-money valuation at each new
  round of financing higher or lower than the
  post-money valuation of the last round

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Example
Series A
3,000,000 pre-money valuation
2,000,000 equity invested 5,000,000 post-money
valuation
Therefore
Entrepreneurs own 60 (3M / 5M) Investors own
40 (2M / 5M)
This process repeats itself on each subsequent
round of financing
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Early-stage Valuations

• Traditional techniques cant be used because
  theres no
• revenue or cash flow, so VCs must use subjective
  factors to
• gauge value
• Management Is leadership experienced and
  entrepreneurial?
• Technology How unique is it? Are there IP
  (intellectual property) and other barriers to
  competitive entry?
• Market What is the potential growth, size of
  the market?
• Financial What is the total expected capital
  required?

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Valuation Rule of Thumb for High Tech

• In todays market, first-round valuations will
  start well below 10M, pre-money
• Novice entrepreneurs are unlikely to get more
  than 5M in valuation
• However and as always, for start-up/IPO veterans
  the skys the limit

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Case StudyEarly-stage Deal I

• Market large but unproven,
• sales/marketing is a weakness
• Financial greatest concern
• is cash requirement

• Management entrepreneurial,
• engineering-oriented, will
• require change in CEO to scale
• Technology untested but
• potentially disruptive

Solution Offer relatively low valuation, given
effort required to enhance management, prove
technology, and develop sales operation.
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Case StudyEarly-stage Deal II

• Management inexperienced
• incubator
• Technology solves real customer problems

• Market emergent, but high potential
• Financial has received large
• offer from non-VC investor

Solution Because of inexperienced management,
this company receives a lower valuation than
previous case example even though its technology
and market appear stronger.
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Case StudyEarly-stage Deal III

• Financial company had
• rejected earlier, cheaper offer
• by VC, and had instead con-
• ducted small insider round

• Management just recruited
• exceptional new team
• Technology not breakthrough
• technology but meets a need
• Market attractive market

Solution This company receives significantly
higher valuation than either of the previous
cases because the management team enhances
attractiveness. Deal is considerably
over-subscribed.
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Later-stage Valuations

• Objective factors like discounted cash flows and
  comparables
• are more relevant. VCs must also weigh progress
  of
• company in achieving milestones
• Management Is leadership able to scale
  business? Is complete team in place?
• Technology Is technology being translated into a
  strong and extensible product?
• Market Is there customer validation? What level
  of market penetration has been achieved?
• Financial Is revenue being generated? When will
  it reach breakeven/become cash-flow
  neutral/positive?

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Case StudyLater-stage Deal

• Management experienced
• in the industry, complete team
• Technology fills real niche has just
  completed beta testing

• Market just received initial order from a
  large lightship customer
• Financial later-stage,
• needs funds to take it to
• IPO

Solution Strong market validation leads to
higher valuation and significant
over-subscription.
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Other Factors

• The basics of a company provide valuation
  guidance. Other factors help the VC determine a
  final number
• Terms of the deal
• Expected return
• Value VC brings to the table
• Industry expertise, contacts
• Recruitment ability
• Fundraising ability

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Case StudyOther Factors

• -- VC wants to ensure adequate return multiple
  for both upside downside

• -- Early-stage company
• -- Very large potential upside
• -- Technology has some risk
• -- Management wants as high a valuation as
  possible

Solution Modify terms of the deal incorporating
a 3x liquidation preference to protect the
downside while offering management a fair
valuation that could result in a 10x multiple.
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Impact of VCs Required Returns
After assessing a companys current valuation and
expected liquidation value, the VC determines if
the potential return meets his funds
requirements

• For the entire fund
• 25-35 IRR over five years that means 3.5-4.0 x
  invested capital
• That can produce triple-digit returns to limited
  partners (because of staggered timing of capital
  calls)

• For each investment
• For a 100M fund, need to make 10-15 (7-10M)
  investments (over multiple rounds)
• 2-3 home runs (10x)
• 2-3 triples (3-5x)
• 2-3 doubles (1-2x)

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Suggestions to the Entrepreneur

• Find the best management you can!
• Identify your competitive differentiation and
  value proposition (e.g., IP, management)
• Know how much money youll need and why you need
  it
• Know the VCs strengths and weaknesses, and what
  return the VC requires
• Know the tricks of the trade (participation,
  anti-dilution, liquidation preferences, etc.) and
  be prepared to negotiate yourself (not through a
  third-party)
• Dont price the deal Thats the VCs job!

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The Bottom Line

• What matters most is ensuring the
• companys ultimate success Building
• a strong company.
• Valuation will
• then take care of
• itself.