My first blog post back on Startable after I left the venture capital world was on early stage venture capital valuations. Basically, what an entrepreneur raising a Series A needed to know about how VC’s approached valuing their business.

Having raised money with OfficeDrop, I think that the answer is still pretty much the same – it has nothing to do with DCF’s or other business school theories, but instead is based around what the VC thinks/needs to return to their fund from that particular investment. The following is a bit of an over simplification, but is as close to a “rule” as I could gleam from my time in venture capital.

Series A valuations

Series A* valuations are usually based on percentages – as in, how much of the company does the venture capital fund want to own. Most established venture funds have an established strategy of owning a particular percentage of a company after a Series A investment. A typical, good fund will look to own 20% to 33% of a company after the initial investment. I’ll ignore the rational behind this for a moment and cut to the chase: this means that during a normal two-VC, syndicated Series A investment your startup sells around half the company to the VCs. Raising $4 million? Pre-money of $4 million. Raising $6 million? Pre-money of $6 million.

Getting a higher valuation

Strange as it sounds, this does imply that the more you raise the higher the valuation. I’ll get into the rational behind this “math” later in the post, but first I’ll mention a few things that you can do to try to command a higher valuation.

• Have a name-brand management team. CEOs/CTOs and founders who have been previously successful and previously venture backed command higher valuations for their companies. Recruiting the right one of these executives to your team will increase your valuation. It may very-well be worth the percent ownership in the company that you will have to give them to get them on-board. (Who knows, they may actually be able to help grow the business too…)
• Get multiple firms interested in your startup. VCs can get competitive. If they fear losing the deal to another venture firm they can become more aggressive around the valuation. This is more true than ever. The greater the interest, the better.
• Have real customer traction. It is honestly impossible to do real financial analysis on companies without historical financial statements, particularly income statements. This is why early stage valuations are so nebulous. However, if your startup is experiencing paying customer growth then you may be able to justify using real metrics to concoct a valuation. (As an aside, I find it really funny how much time business schools spend going over valuations in venture capital courses. This is a minor part of how VCs create value and a very small part of how VCs spend their time.)
• Get great seed investors – this is a new one that I’ve just added as I reposted this piece. Seed/angel investments have become really important in 2013 and 2014 – this is how most companies are getting going. And great seed investors can lead you to great VCs and can help you drive great valuations by virtue of their network, name brand and negotiating help.

The rational

So why are valuations dependent mainly on percentage of the startup owned? When making an investment, venture capitalists are already thinking of the exit. They want to know how much they will return to the fund if the company is sold for $50 million, $100 million, half a billion or more. (Don’t try to present the results of this calculation to them; they can do the math on their own. You can do this calculation for your own edification, but you’ll come across as a naive management team if you try to tell the VC how much money they are going to make.) This return is very much dependent on how much of the company they own at the exit. Keep in mind that an early stage investor is likely to experience some dilution if the company will need to raise more funding later down the road, and that the first round VCs will also have to invest some money in these rounds to defend their ownership as new investors come into the company.

The VCs are also thinking about how much of the company is owned by the management team. A good management team has many, many employment opportunities. The VC wants to make sure that the team is properly motivated to help grow the startup. Basically, an important founding team member need to own enough of the startup at an exit to make more (hopefully a lot more) then they would have if they were getting a good salary for five+ years at a big company. The VC can’t let the management team get so diluted that they lose motivation. A venture capital firm needs to think ahead to the likely future financing needs of the business and estimate how much of the business the management team will own at the exit. In truth, the VC will probably only run this exercise for the CEO and the most important technical founder (if they are not the same person.)

There are logical limits to the “raise more money/get a higher valuation” theory I’m proposing. There is likely a narrow band of capital that most VCs will be willing to invest in certain type of companies at the Series A round. For most software and online businesses, this is likely $2 to $6 million, perhaps a bit more on the high end if you have a great team and some traction. So, venture capitalists are unlikely to let you raise $20 million of venture funding at a $20 million pre-money valuation for your online dog food distribution company. They are usually smart enough to not want to over-capitalize a business unless the plan justifies it and the risk/return ratio is correct. If multiple VCs are telling you that they don’t think you can/should raise more than $4 million for your particular startup then you’ve probably found the market clearing round size, and by extension, narrowed the band of the likely pre-money valuation.

Does this make sense? Probably not. But it is the best theory I can fit to the evidence that I’ve seen during my brief time as a venture capitalist. I’d love to hear your theories and experiences.

*I am speaking to the usual “Series A” startup, which usually does not have much in the way of revenues and is often pre-product.

One of the top posts from my older blog was an outline of a generic venture capital investment memo. I’m reposting it here, with a few minor tweaks, because I still think it’s helpful for entrepreneurs looking to raise capital.

Prior to jumping to the other side of the table and helping lead startup marketing, I worked at several VC and PE funds. I feel like I have a pretty good idea of what is standard investment memo material.

This outline is does not contain any of the “secret sauce” or unique things I’ve seen in any particular venture firm’s deal memos, only the sections and themes that are recurring across all the funds I’ve spent time with.

Standard venture capital investment memo outline

A. Intro/executive summary – This part is usually only a page long; it needs to very concisely summarize the opportunity; depth and discussion of diligence findings will be found later in the document in the respective sub-sections

1. Business Summary – Couple of paragraphs to set the stage on the opportunity
2. Proposed Financing – $ invested; size of round/sources of capital; (go into more dept in the Deal Description/Details section)
3. Pros of the Investment/Reasons to Invest – Bullets on why the investment is exciting. Usually mention management, market and technology differentiation. (If you don’t have these, why are you investing?)
4. Cons/Key risks – Highlight the key issues that could derail/destroy the company/the investment’s return potential. Holes in mgmt team, competition with deep pockets/stated interest in the space, etc.
5. Deal goals – Use of proceeds; milestones to be hit with the funds from this funding; alignment with management and other investors on goals and direction of company (if a complicated investment or many other investors may require its own section later.)

B. Market opportunity – After the introduction comes the meat of the investment memo.

Each section is as long or short as required for the particular investment opportunity. The market section tried to explain how big the potential market is and how/where the startup fits into that market.

1. Market – Size of market; discussion of analysts’ opinion on market; summaries of customer and ecosystem reference calls
2. Problem to be addressed – Does management’s description of the problem match up with the VC’s diligence findings?
3. Pain point/value proposition – Not a description of the product, but a description of the “relief” that is felt by customers; what customers/potential customers has the VC talked to and what have they said?
4. Competition – Very important section. Articulate what the competitive landscape is NOW and in the FUTURE. How does the company fit into the ecosystem.

C. Product – What does the product look like; who is buying it; why are they buying it and does this match up with the market opportunity/stated pain point addressed; is the product defensible; can you actually make it and how much R&D is required

1. Product description – include who the buyer is at the customer
2. IP – if an important part of the investment thesis; did a lawyer conduct an IP review?
3. Product development timeline/roadmap
4. Price points/margins/economies of scale – who is actually “making” it and what is required to get “production” to scale; if a web based business what are the key costs of delivering the product
5. Highlight issues on the product/features to be developed from the reference calls with potential customers/existing customers

D. Sales/marketing strategy

1. Re-define ideal customer – how reach them/where are they
2. How much cost to acquire/what is the sales process timeline – are there different costs by different channels
3. How does this fit with the reference discussions/market analysis conducted
4. If company has current customer then case studies and list of major customers/revenue concentration
5. Are partnerships/business development tactics to be important in the startups marketing/customer acquisition plans

E. Team/advisory board – This is perhaps the most important section. Sometimes it should be put right after the Intro/Summary. There needs to be real detail on each team member and the people to be hired/needs analysis. VCs usually have an honest write up of which team members are scale-able and which will need to augmented

F. Operational plan – The more “grown up” the company is the more detail will be spent on historical financial statements.

1. Quarterly or monthly burn rate
2. Historical financials – only important/included if the company has real historicals; if of a certain size, say over $5 million in revenues, then an accounting review may be required; not usually included in detail if the company is still developmental stage
3. Use of funds – make sure the metrics highlighted in the “Deal Goals” section match the metrics you will be funding towards…
4. Revenue plan/revenue model and build up
5. Margin discussion
6. Staffing plan – looking at the staffing needs from a “how much it will cost” perspective

G. Deal Description/Structure/Details

1. $ invested; size of round/sources of capital; ownership;
2. Type of security
3. Any other interesting facts such as what management is putting in or is a convert note rolling in at a discount/etc.

H. Long-term financing plans

1. Reserves set aside for the investment in the fund
2. Total amount of capital needed to get the business to self-sustainability
3. Going forward financing plan – milestones that will be hit with the current fund raise & explanition of how those are valid value creation metrics for the industry

J. Deal history – Source of deal; who has met; what diligence has been done;

Appendix

1. Capitalization Table
2. Other supporting documents
3. Some funds put the references and due diligence findings in the investment memo, others reference them and make them available to the partnership on a server or in a database

It’s also important to realize that the purpose of these memos really vary by firm. Some firms use the memo to educate the investment committee on the startup and the memo is an important part of the deal approval process. Other firms circulate memos as more of a heads up to the other partners, alerting them to the deal and seeking advice and introductions that can help with due diligence. Regardless, someone at the VC is consolidating this kind of information if they are thinking of investing in your company, and doing it in a way that helps the investors make a decision on investing or not in your business.

This is for tech and startup stuff that isn’t marketing oriented.