A typical venture deal:
You sell 250 new shares (20%) to a VC. In 5-7 years the VC sells these shares either to another investor or an industry buyer. The buyer pays the VC $2M. The VC pays you $200K.
At first glance this appears to be a very good deal for the VC.
If everything goes as planned, he will make a money multiple (MM) = exit / investment = $2M / $200K = 10.0 or a 10x return.
Why is 10x a reasonable return for VCs?
Money multiples are used as shorthand in venture deals.
VCs actually think in annual returns (IRR).
Years till exit
Assume a MM of 10.0.
Assume an exit in 5-7 years.
Then the VC’s IRR = MM ^ (1 / years till exit) = 10.0 ^ (1 / 5) = 58%.
That still seems a really high return.
But what about dilution?
Your cash-flow planning shows that you will need to raise more money in the future.
Assume another $3M Series A at $5M post-money valuation.
Then the Series Seed VC will dilute = investment / post-money valuation = $3M / $5M = 60%.
So the VC’s MM = (1 – dilution) * “old” MM = (1 – 60%) * 10.0 = 4.0.
That implies an IRR = MM ^ (1 / years till exit) = 4.0 ^ (1 / 5) = 32%.
That still seems really high.
But what about the probability of success?
Probability of success
Your startup is no sure thing. Did you hear about that startup where everything went exactly according to plan? Me neither.
Assume you still have 3 milestones to go. Say, product, market and team.
Assume you have an 80% probability of achieving each milestone.
Then the probability of success (POS) for your startup = probability of success per milestone ^ # milestones = 80% ^ 3 = 50%.
So the VC’s MM = POS * “old” MM * = 50% * 4.0 = 2.0.
That implies an IRR = MM ^ (1 / years till exit) = 2.0 ^ (1 / 5) = 15%.
10x = 2x
So you have to sell your shares at a money multiple of 10.0 – or a 10x return to the VC, so that he can have an actual annual return of 15%? That seems far more reasonable. Though still quite attractive compared to other risk-adjusted returns like almost 0% on Government bonds.
By the way, you can flip this logic around if you want to value price your shares.
Assume you think a 15% IRR is reasonable. And that 5 years till exit, 60% dilution and 50% probability of success are all reasonable too. Then by definition pricing your shares at a 10.0 MM is reasonable.
Thanks to Hans Westerhof and Chretien Herben.
Venture Value does startup valuations for founders who want to raise money with an investor.