How venture investors evaluate startups

Arthur Welf (translation), IdeaBlog.ru

This article is intended more for venture investors, but it is also useful for startups to find out how venture investors evaluate startups when investing in them at an early stage. This is especially true for startups that are at the seed stage. Many startups, claiming that the idea also costs money, cite the example of venture capitalists who invest millions in startups at this stage, while sometimes taking not even a controlling stake. And this serves as an argument to such people that the idea, they say, was valued by these venture capitalists at such and such an amount. In fact, this is not the case at all, and when investing in startups at the seed stage, venture investors estimate not the cost of a startup, but the complex probability that this startup with this team will be able to "shoot". This is what the most experienced venture capitalist Fred Wilson writes in his article, the translation of which I thought it necessary to present to you.

Startup EvaluationWhen it comes time to discuss the economic conditions of investments, entrepreneurs and venture capitalists begin to perform obscure "marriage dances" from the outside.

And everything revolves around evaluating a startup.

The main question is: what is the fair value of the business? By all accounts, this denotes the part of the company that venture capitalists receive for their investments. That is, if an investor invests $4 million and receives 40% for it, then this means that the startup is worth $10 million entirely.

This is true in the traditional economy, but it is not applicable to the evaluation of startups. In my opinion, the people involved in this process often misunderstand the idea of evaluating startups. And this is especially evident at the early stage of investing.

I do not believe that determining value at an early stage of venture investments has anything to do with the current value of the business. If this would be true, then why would a venture capitalist agree to pay $10 million for a company that will lose money over the next 2-4 years and generate very low income, if at all?

In fact, all venture capital transactions are executed as investments in convertible preferred shares (this term here means that in case of liquidation of the enterprise, money is first given to the investor, and the remaining amount after this payment is divided between the entrepreneur and the investor – IdeaBlog.ru ). This means that the investment of funds is more like the execution of a debt obligation, which can be used if things do not go very well. We get a refund first of all if the project goes sideways or fails.

Our share in the business (and this is what the assessment should determine) affects the amount of money we receive only if the project is successful.

In addition, it is important to remember that only a relatively small part of venture investments at an early stage actually brings such a profit as is expected at the time of investment. Based on my experience (17 years in business, more than 100 investments in various projects at an early stage) I know there is a 1/3 rule.

Rule 1/3 states:
• 1/3 of the projects are really implemented as you expected, and bring huge income. The amount of such income is usually 5-10 times higher than the costs. Entrepreneurs and venture capitalists thrive on such projects.
• 1/3 of the projects "go away" from what was planned. They are transformed into a business, but this is not a business that can bring substantial income. The income from such projects amounts to 1-2 sums of costs, and venture capitalists receive most of the money earned by the project.
• 1/3 of projects end badly. They are closed or sold for less than the amount invested. Venture capitalists take all the money from the sale of such projects, although the amount received is not enough to cover their expenses.

So, take rule 1/3, add to it the typical structure of a venture transaction, and you will see that the venture capitalist does not really discuss the cost of the project at all. He discusses what is the probability that our project will fall into the first group, which brings a good profit. The structure of the transaction (the very "privileges" of its shares – IdeaBlog.ru ) protects us (venture capitalists – IdeaBlog.ru ) from the failure of the project, thus protecting our capital.

I believe that it is best for venture capitalists to perceive a venture transaction as a loan plus an option. The loan will be paid in 2/3 of the investment cases and partially paid in some other cases. The option becomes active in about 1/3 of the investment cases and, perhaps, in no more than half of all other cases.

The assessment includes many more nuances, since when renegotiating a deal between venture capitalists and entrepreneurs, the terms of the agreement may change. But this is a topic for another conversation...

Portal "Eternal youth" www.vechnayamolodost.ru13.02.2008