Round comparables (aka comps) are useful when determining a pre-money valuation for a company that has revenue.  A source like Triple Tree provides some nice public comps based on trailing twelve months (TTM) of revenue, however they may be out of date.  Even then, it will give point you in the correct direction for similar companies by industry.

There are many ways to use multiples to value a company’s current valuation (e.g. revenue, EBITDA, etc), including the run-rate that has two popular methods:

1. Annualize the latest quarter of revenue. Take the last quarter/3-months and multiple by 4 to give a yearly amount assuming things stay consistent with the latest quarter.
2. Annualize the monthly average of the last quarter/3-months. Take the average of the last 3-months and multiple by 12 to give the yearly amount.

Each of these valuation techniques provide additional clarity into the range of values for an early stage startup. However, another critical factor is the potential exit amount for their investment.

Exit Comparables

Early stage investors focus intensely on potential exits for their investments (mergers and acquisitions or with an Initial Public Offering, IPO) as that is the typical method for them to gain liquidity. Let’s look at the three components for an ideal M&A exit comparable (as IPOs have been rare these days):

1. Totally public information on the exit event. All round level comparables (revenue, EBITDA, etc) along with the details of the acquisition (amount of the exit and for cash, or cash and stock, etc).
2. The exit comparable is in the same industry and has a similar product with a similar business model.
3. The stage of the exit comparable is roughly the same as when you expect the company you are valuing to exit.

The ideal M&A exit comparble is rare, but one that matches a few of the criteria listed above is a good start. One complicating factor is that most M&A activity is not public. Large companies may acquire many businesses where it is not required for them to disclose all of the details as they are relatively small in size. As an example, Microsoft has acquired numerous companies as listed here. For the larger acquisitions they have a press release sometimes with the terms of the deal. Smaller ones are never discussed.

It is possible to use some metrics from Round Comparables to estimate an exit amount. For example, using the revenue multiples of a similar company with the financial projections for the company being valued is possible. It is normal for the investor to give a “haircut” to the financial projections, meaning a discount.

Definitions

Venture Capital: Investment into early stage companies by full-time professionals.  The majority of the money invested is not their own (99% typically comes from Limited Partners).

Limited Partners:  LPs are the money.  Limited Partners are typically corporations (private pension plans), endowments, foundations, or state pension plans.  Wealthy families also invest as LPs into, typically, smaller venture capital funds.

General Partners:  These are the actual Venture Capitalists.  In VC firms (management companies), you hear about the “partner track”.  General Partners often put in 1% of the overall VC fund, with LPs accounting for 99% of the fund.

Venture Capital Fund:  This is the separate legal entity where the money is placed (either from the beginning, or is available through capital calls as needed during the lifetime of the fund which is typically 10 years).  These are typically Private Partnerships, which is the why you have “Partners” as they are the basis of the entity.

Details

Venture capitalists raise money from Limited Partners and invest that money into early stage companies.  LPs are only passive investors and agree to pay a management fee (typically 2-2.5% per year for the duration of the fund) to the GPs to manage their investments.  As Limited Partners include state pension plans and private pension plans, you may actually be a limited partner in a VC fund without even knowing it.

A VC firm may have multiple funds that have been raised and invested over a long period of time.  When money is invested into early stage companies, they become portfolio companies.

External Links

National Venture Capital Association – NVCA – describes the basics very well if you want a more detailed description.

High pre-money valuation

Example: a pre-money valuation of $10M for a pre-revenue software company.  Although this would appear to favor the company and the founders, what may result is an inability to raise money in the future from angel investors or venture capitalists.  Professional investors sometimes avoid companies where an unjustified high valuation would require a “down round” to correct to market valuations.

Low pre-money valuation

Normally this dilutes the founders, which can be fixed with stock options.  However, it may be a flag of inexperience to investors in future rounds.

As part of due diligence, investors will ask about an entrepreneur’s previous startup experience.  Especially important is when they ask about the returns for investors in these earlier companies.

External Links

Collection of articles on angel investing
Do VCs like Angel backed companies by Brad Feld
Another VC takes on the same topic by Fred Wilson

• Founder’s Stock (owned outright from formation, no vesting)
• Restricted Stock (same as founder’s, but with vesting)
• Option Pool (usually for incentive plans)

Types of Preferred Stock

• Convertible Preferred
• Participating Preferred

Types of Stock Options

• Incentive Stock Options (ISO)
• Non-qualified Stock Options (NSO)

NOTE on Preferred Stock

Preferred Stock is different than stock market, as it includes:

• Conversion Rights (go from Preferred to Common)
• Liquidation Preferences
• Dividends
• Antidilution Rights
• Redemption Rights
• Protection Provisions
• and many more

External Link

Comparison of ISO and NSO

Let’s start with stock options.  Stock options are created from the Option Pool, which was described in an earlier post.  Warrants are not created from the Option Pool.  They are unique in that they can be used with Preferred Stock.  Both have to be exercised to get voting rights.

Another major difference is that warrants are not tied to an employee’s (or outside Board Member’s) employment time frame. Instead, warrants are typically valid for a longer term (3-7 years) and are transferable during that period.  Stock Options are instead tied to the employee and employment period.

Warrants are often used as an “equity kicker” for investors, meaning that they give upside potential for risk taken by the investor’s.  An example would be a bridge loan utilizing convertible debt.  In the External Links section below there are two good resources provided that go into more detail on how warrants are used in financings.

External Links

Terms of Bridge Loans
Pre-VC investment structures

Let’s look at the example shown on the right. First, let’s take the initial exit amount at $15M. In this example, everyone walks away with some money. Now, change the exit amount from $15M to $5M (just enter and hit return). First off, you may notice is that the Convertible Preferred stock is no longer converting to common. Instead, it is staying as preferred during the exit. Also the liquidation stack takes over, and you see that the last investor (VC2) walks away with all $2M of their initial investment as this was a 1x liquidation preference. The first investor (VC1) only receives $3M of their original $4M investment. Last, you’ll notice that the founders receive $0.

In this example, the seniority of the liquidation stack was on the last money-in. You can edit the exit amount and see various scenarios for what happens with the liquidation stack.

Hurdle rate chart

If you click on the chart, you can download an Excel file with both the image and the formulas used to create it.  For a startup, the most important aspect to the Hurdle Rate is not the 40% IRR number, but the fact that most VCs use the multiple (shown on the verticle axis) when discussing an investment’s potential.  A venture capitalist might say a deal is a “10 bagger”, which means the deal could return 10 times their money.  Rarely, if ever, will a VC say that a deal shows the potential for an IRR of 63.3%.  However, as VCs report to their limited partners using IRRs the hurdle rate is still something on their mind when evaluating investments.

Illustrated on the right is the difference for methods used to create an option pool. In both pie charts, you’ll notice that the option pool size is 10%, as this is computed on a post-money basis (after the investment). On the top is the option pool created from the pre-money side. As the Investor bought 40% the company ($2M investment on a $3M pre-money valuation), that leaves 60% for the founder and option pool. Since the option pool accounts for 10%, logically the founder own’s 50% of the company. In the bottom the option pool is created from the post-money side, which dilutes both the founder and investor. Before the option pool, the founder owned 60% while the investor owned 40%. Dilution to both sides is based on the 60/40 ratio. Therefore, the founder goes from 60% ownership to 54%. The investor goes from 40% to 36%.

The equations are shown for these two situations. Please note that you can update the values and watch the equations solve for other values as you desire.

The example to the right illustrates how each type of preferred stock behaves given the same exit event. Participating will always give a higher return to the investor than convertible. Try some different exit values to see how each type of stock behaves.