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?

**IRR**

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?

**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%.

Huh.

**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.

*Joachim Blazer is author of The #1 Guide to Startup Valuation. How to value a startup in 6 easy steps. For founders and investors. For seed rounds and Series A.*