9. Return Analysis

VC Math 101

The two most fundamental terms in a venture capital term sheet are the pre-money valuation and the investment size. Adding those two gives you the post-money valuation:

For example, VCs have offered to invest $4M on a $6M pre-money, sometimes called a “4 on 6” deal, though it is becoming more common to hear this as a “4 on 10 post,” as the post-money would then be $10M.

The next level of this algebra is used to determine the ownership structure, and needs to become second nature to a VC. Pre-money divided by post gives you founders’ percent ownership. The investment divided by post gives you the VCs’ stake.

       

In our 4 on 6 example, we end up with:

       

 

Another quick example, let’s say a VC firm is investing $2M in a startup with a pre-money valuation of $3M (or 2 on 3). The post-money valuation is $5M and the VC owns 40%, the founders 60%.

 

$2M Investment + $3M Pre-Money = $5M Post-Money
 

 

VC Ownership =

$2M Investment
______________

$5M Post-Money

= 40%

 

VCs quickly learn to do this algebra in their head. Knowing the key deal terms, like “1 on 2″ or “5 on 5,” VCs will immediately know that their ownership would be 33% or 50%, respectively. See the table for a cheat sheet of percent ownership for various deal terms.

Shark Math

I want to take a quick aside to address what I call Shark Math. Due to the popularity of ABC’s show Shark Tank, many people think that equity deals should be offered as “_% of the company for $__.”

As we’ve already discussed, this is not how VCs offer deals because it implies that a percentage of a pre-existing company is being sold (p. 57). With VC investing, a new class of preferred stock is being created and new shares are being sold. Nonetheless, the algebra is the same. Money comes into the startup, and the investors now own a percentage of the company.

If a deal is offered as _% of the company for sale for $__, we can solve for the valuation:

VC Ownership =

Investment
____________

Post-Money

Post-Money = Investment
_______________VC Ownership

 

For example, let’s look at a deal where 25% of the company is being offered for a $100,000 investment. Plug that into our deal algebra:

 

25% VC Ownership

 

= $100,000 Investment
________________Post-Money

 

Post-Money

 

 

=

$100,000
___________25%
Post-Money = $400,000

 

If you are a regular viewer of Shark Tank, you have heard sharks say something like, “Do you realize you are valuing your company at $400,000.” This is actually a manipulation (or a mistake). Take a moment and see if you can catch what the Sharks are trying to do in the above example by claiming the founders are pricing their startup at $400,000.

What is the mistake? (answer below)

Also covered in this chapter in the book:

  • Breaking it Down
  • Seed Round
  • Series A
  • Series B
  • Series C
  • Fund Fit Alert!
  • To the Exit
  • Back to the Forest: Rules of Thumb
  • Adding the Option Pool

 

The founders are actually pricing their startup at $300,000 prior to receiving the investment. The $400,000 valuation derived in the formula above is post-money. That valuation includes the investment, which the startup has not yet received. The current valuation should be pre-money, and should be $300,000. The valuation will increase to $400,000 after the cash is received.

In manipulating the math, the Sharks are employing a negotiation technique to make the valuation seem higher. Coming up with a valuation, also known as “pricing the deal,” is often the stickiest part of the negotiation. I believe that is why I’m hearing more VCs talk about 4 on 10 post deals, when they used to all say 4 on 6 ($4M investment on a $6M pre-money).

The use of post-money vs. pre-money as the valuation can make a big difference in perception if the investment is for a large percentage of the company. If you take a traditional 2 on 2 deal: a $2M investment on a $2M pre-money valuation, and reframe it as a 2 on 4 post—wow, we just doubled the value of the company!

More VC Math – Breaking Down a Deal

Posted in Fund Fit.