Based on my experience as both an entrepreneur and investor, there are six primary components that impact the venture capital valuation of an early stage technology company: market dynamics, company metrics, future funding needs, team, comparable transactions, and VC ownership targets. I will provide some detail on each in this article, though the relative importance of each category will vary by deal.
Market dynamics: Factors that impact valuation include the size of the total addressable market (TAM) and a company’s potential to become the market leader. Industry focused solutions should be pursuing at least a $300 million market size, while horizontal solutions that solve pain points across industries, need a $1 billion market size. Investors also want to think that if the company executes well that the upside scenario in each company has the potential to return 50-100% of the entire fund. Companies get a valuation bump for market leadership: the #1 player tends to get at least a 1.5 multiple premium over the #2 player in the space.
Company Metrics: VCs like to invest in companies that have a chance to go public. Today the minimum bar for a business cloud company to go public is $50 million in revenue growing at 50% a year. In the early stages (Series A & Series B), a company should demonstrate an ability to achieve 2-3x annual growth consistently. Valuations are most generous when enterprise companies can keep churn under 10% a year, otherwise growth can be constrained by just trying to replace lost customers. In addition, VCs look for unique leverage in the sales model allowing for capital efficient customer acquisition. This will impact the need to raise more capital in the future, often leading to a higher valuation today.
Future Funding Needs: Virtually every company will need to raise another round. A key aspect of the valuation is whether it is reasonable to believe the valuation of the next round will be at least 1.5-2X the current value. Founders never want to tell their teams that all the hard work they’ve done between rounds isn’t worth a higher valuation. Thus, does the executive team have the money it needs to meet key milestones before the next round of funding? If the answer is no, then the VC will likely discount the current valuation. Although most investors allocate 50%+ of their funds for follow-on, investors need to believe the company will be relatively capital efficient so their ownership stakes aren’t diluted significantly by the time of an exit.
Team: Investors tend to pay a premium for repeat entrepreneurs or super-star entrepreneurs who are motivated for a big outcome. Most VCs expect to find holes on the executive team – the question is whether the initial team can recruit the best people in the world for this opportunity.
Comparable Transactions: In order to settle on a valuation, investors look at comparable public companies as well as the revenue multiples of recent acquisitions. Most venture investors focus on comparable transactions above $100 million as those transactions are more likely based on business fundamentals than those below $50 million. Other key data points include the revenue multiples the potential acquirers are trading at and the revenue multiples paid on prior acquisitions.
VC Ownership Targets: Series A and B investors often have a desired ownership target of 20-25% after the funding round, which can impact valuations. For example, if a Series A company wants to raise $7 million, and the VC wants to own 25%, it would be difficult to settle on a post-money valuation of more than $28 million without raising more money or reducing the percent ownership for the VC.
These six categories are meant to be a guide, but in reality there are often other factors that come into play. For example, in competitive situations, a venture firm might stretch on valuation to “win” a strategic deal. In addition, venture valuations are cyclical, and they often track behind public market valuations. Two companies with similar metrics might end up with very different valuations based on market timing.
Finally, valuation isn’t everything when selecting a venture firm. Entrepreneurs and investors are building a long term relationship, and entrepreneurs who are fortunate to have multiple term sheets may opt for a lower valuation if it means having a certain partner on board. The key is starting the relationship with a valuation that feels fair to both parties, and sets the company up for long term success.
When I meet with entrepreneurs, I am often asked about the VC “pipeline.”
How many deals do we see? How many meetings? How often do we conduct due diligence? How many of those companies do we invest in?
I thought it would be helpful to provide visibility about the VC pipeline, while also outlining what helps a company move from an intro meeting into a closed investment.
In order to make 10 investments, the average venture capital firm reviews approximately 1,200 companies.
Leads: These 1,200 come from network introductions, conferences, in-bound inquiries, proactive efforts, portfolio company referrals, and seed investors. Of the 1,200, we find that approximately 500 lead to face-to-face meetings with someone on the investment team.
The most important factor in securing a meeting is the background of the founders. Do they have the skills and experience for the opportunity they are pursuing?
Of course, the pitch also matters: Is it concise and compelling?
In addition, most venture firms like to make sure that a company is not competitive with a current portfolio company.
Personally, the primary reason I don’t meet in person with in-bound requests is that the entrepreneur was not vetted by someone I trust.
Meetings: The average venture firm has approximately 500 face-to-face meetings each year, yet only 10 percent progress from that stage. What makes a venture firm want to dig in and spend the time required to do proper due diligence?
First, most early stage VC firms look for demonstrated product/market fit. At Emergence, we also want to confirm that the company is solving a problem that is relevant outside of Silicon Valley. Too often only customers are in the Bay Area, and they are friends of the founders, which means no proof of a real market.
One of the reasons that a meeting doesn’t go well is that the founding team will say they expect $50 million in revenue in 5 years, but they have difficulty articulating how they’ll get to their first $1million.
Due Diligence: Of these 500 meetings, a mid-sized venture firm may perform due diligence on approximately 50 companies in a year.
Due diligence consists of a product review, customer references, executive team references, financial modeling, market analysis and competitive analysis. Passionate customers who are very engaged with the product can really make a difference during due diligence.
Venture firms also look for at least 100 percent annual revenue growth in the first few years. However, often companies don’t meet short-term projections set in earlier meetings, and firms can lose confidence in their future projections.
Venture firms are also wary of high rates of churn and customer concentration.
Investments: In a typical mid-size venture firm, the 50 companies may generate 10 investments. Why do these companies stand out? A couple items are critical, such as efficient customer acquisition and a magnetic CEO that people follow. It’s a huge red flag if former employees don’t want to work with the CEO again.
With respect to market size, at Emergence, we like to see a reasonable path to $100 million in annualized revenue. For an industry focused solution, a $300 million market size is sufficient since if they become an industry standard they can get 30 to 50 percent of the market. For a horizontal solution that solves pain points across industries, a company needs $1 billion market size, since the market leader may only get 5 to 10 percent of the market.
While it may seem that one percent represents depressing odds for a founder to secure VC funding, in reality, the process tends to help entrepreneurs refine their strategy. If the first meeting didn’t result in moving to the next phase, a good venture firm will provide specific feedback and guidance. Most venture firms stay in touch with founders they have met in the past, and it is exciting when future meetings highlight changes that have led to more traction.
Sean Jacobsohn is a venture partner at Emergence Capital Partners. He joined Emergence Capital after being an executive and advisor at portfolio companies Hightail and Doximity, respectively. In addition to being a sales and alliances executive in the technology enabled services space for 13 years, he is cofounder and co-president of the Harvard Business School Alumni Angels, the largest university-affiliated angel group in the world.