Valuation Techniques ◾ 265
whose stock is illiquid (private) and whose share value is theoretical until
the company goes public or is acquired.
VC rms must be very selective in their investments. Statistics show that
of every 100 business plans evaluated by VCs, only 1 or 2 end up getting
funded. Sadly, most VC-backed rms fail. Therefore, VC investments are very
risky. To stay in business, VCs must ensure that their rare successes generate
enough prot to compensate for their frequent failures. In an effort to lower
risks, VCs utilize the investment criteria shown in Figure13.8.
What rms are most likely to meet the VC investment criteria? VCs typi-
cally invest in companies starting at the early stage of development as
shown in Figure13.9.
4
5
6
7
8
5x 6x 7x 8x 9x
50% 57% 64% 68%73%
38% 43% 48% 52%55%
31% 35% 38% 41%44%
26% 29% 32% 35%37%
22% 25% 28% 30%32%
IRR between 25 –75%
Target Returns for VCs
Years to exit
Figure 13.8 Target returns for VCs—VCs set internal rates of return as the measuring
stick for investments.
Startup
First stage
Second stage
Bridge
Restart; reorganization
50–70%
40–60%
30–50%
20–35%
Negotiated
IRR Required at Stages
Figure 13.9 IRR required at stages—IRR rates decrease as the perceived risks are
lowered.
266 ◾ The Guide to Entrepreneurship: How to Create Wealth for Your Company
As the gure indicates, VC nancing rounds start at the “early” stage. The
early stage is after a company has expended initial capital in development
and market testing and is now ready to begin full-scale operations and sales.
The company is producing and shipping and has growing inventories and
accounts receivable. In the later stage, the company is breaking even or prof-
itable and requires funds for plant expansion, full-scale marketing, and work-
ing capital. The mezzanine is funding provided within 6 months to 1 year of
going public. Funds are to be repaid out of IPO proceeds. An IPO is when
the company is ready to be listed in one of the major exchanges. The public
market (MBO/acquisition) stage occurs if executives wish to purchase an inde-
pendent company or a division or product line of their investor, thus creating a
new independent rm, or the rm sells the business to another company.
13.8.1 Staged Capital Infusions
“Pick battles big enough to matter, small enough to win.”
Rather than providing the entrepreneur all the necessary capital up front, VCs
typically provide funding at discrete stages (milestones driven) over time. At
the end of each stage, prospects of the rm are reevaluated. If the VC discov-
ers some negative information, it keeps the option to abandon the project.
Staged capital infusion keeps the entrepreneur on a “short leash” and
reduces his or her incentives to use the rm’s capital for his or her personal
benet and at the expense of the VCs. As the potential conict of interest
between the entrepreneur and the VC increases, the duration of funding
decreases and the frequency of reevaluations increases.
Staged capital infusions attempt to lower the investment risks associated
with unproven companies or technologies, as discussed next:
◾ Run out of money
◾ Non-performing founders
◾ Key management team member leaves
◾ Product/technology doesn’t work
◾ Market/competitive landscape changes
◾ Major changes in regulations
It should be noted that VC rms tend to concentrate their investments in
specic industries. According to PricewaterhouseCoopers/Money Tree™, the
following investments were made in 2012:
Valuation Techniques ◾ 267
Industry 2012 Investment Total Rank
Software $ 1,797,910,800 1
Media and entertainment $ 468,632,100 2
Biotechnology $ 455,715,600 3
IT services $ 298,444,700 4
Industrial/energy $ 252,263,700 5
Medical devices & equipment $ 224,805,300 6
Consumer products & services $ 221,649,000 7
Telecommunications $ 143,281,700 8
Semiconductors $ 83,385,800 9
Healthcare services $ 70,584,900 10
Examples of companies that received staged VC infusions in their early
development include Apple, Federal Express, Microsoft, Genentech, and
Google.
13.8.2 Venture Capital Metrics
“If it’s stupid but works, it isn’t stupid.”
At the time of rst investment, company valuation (pre-money) is the basic
metric for calculating the theoretical ROI. Entrepreneurs need to under-
stand that ROI is based on the potential increase in the valuation of shares
received by VCs in exchange for their capital investment. Reaching agree-
ment between entrepreneurs and VCs depends on successful agreement
regarding pre-investment valuation.
Many VCs target 5x to 10x ROI (cash-on-cash ROI on the investment) in
four to ve years, which yields an IRR of between 25 and 75%. The IRR
is a tool useful in corporate and personal nance for comparing invest-
ment opportunities. The goal of IRR nance is to optimize your investment
funds within a dened time period to obtain the best return among com-
peting investment opportunities.
268 ◾ The Guide to Entrepreneurship: How to Create Wealth for Your Company
13.8.3 The Investment “Hurdle Rate”
“I hate to lose more than I love to win.”
In business and investment, the minimum acceptable rate of return
(MARR) or hurdle rate is the minimum IRR on a project a manager or
company is willing to accept before starting a project, given its risk and
the opportunity cost of forgoing other projects.
8
A synonym seen in many
contexts is minimum attractive rate of return.
9
When an investment is
being evaluated, it must rst go through a preliminary analysis in order to
determine whether it has the desired net present value using the hurdle
rate as the discount rate.
10
The hurdle rate (measured as IRR) varies sub-
stantially depending on the stage of the rm at the time of investment, as
shown in Figure13.10.
Figure13.10 presents a calculated example of the necessary future value
of an investment of $1 million at the end of 5 years, assuming an IRR of
40%. Under this scenario, the investors will expect a return of $5.8 million in
exchange for their initial investment. The “hurdle rate” is therefore 40%.
13.8.4 Top Ten Lies VCs Tell
“Don’t pee on my leg and tell me it is raining.” —Judge Judith
Scheindlin
Among the most frustrating “games” that VCs play with applicants is their
tendency to keep you in limbo regarding your proposal. Even after a fund-
ing presentation, this waiting game may go on for weeks, or months, if you
do not push them for a denitive answer.
Venture Capital Metrics
Given a $ 1.0 m VC investment, the target
IRR (40%) and the investment time horizon
(5 years), calculate the future value of the
VC investment
FV = PV(1+i)
n
i = target IRR (40%)
n = time horizon to exit (5 years)
FV = $ 1.0m(1+0.4)
5
= $ 5.38 m
Figure 13.10 Venture capital metrics—A model calculation.
Valuation Techniques ◾ 269
You feel like saying, “I can take a yes, and I can take a no, but what I
cannot take is a maybe.” The warning signs of a VC kiss-off are the follow-
ing answers:
1. We are in the middle of several major closings.
2. It was a good presentation; I will talk with my other partners.
3. We have some major concerns about your technology.
4. Fix these issues and come back to us when they are solved.
5. The environment for funding this technology is poor at the moment.
6. Your intellectual property portfolio looks weak.
7. We need to syndicate this offering.
8. Have you been shopping this offering? For how long?
9. We are concerned about your barriers to entry.
10. You have several weaknesses in your team. You need to agree to re-
structure your team.
13.9 Vulture Capitalist
“A rm is known by the company it keeps.”
Vulture capitalist is a derogatory term used by critics of the VC establish-
ment. Ofcially, it means an investor who used deceptive clauses and terms
to gain ownership of a company. A vulture capitalist focuses on investments
to show an early prot and then exit quickly, trigger a takeover clause, or
gain control of the company and then sell valuable parts for their prot, but
in the process they may destroy the company.
True “vulture” capitalists exert their inuence through onerous terms and
restrictive covenants such as:
◾ Board seats and majority stock ownership (minimum of 51%)
◾ Drag-along and tag-along rights (force sale of company)
◾ Liquidation and dividend preferences
◾ Non-competition clauses
◾ Weighted and full ratchets (use down-round share price)
◾ Reserved matters (veto or approval):
− Any sale, acquisition, merger, liquidation
− Budget approvals
− Executive removal/appointment
− Strategic or business plan changes
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