PS#020: How to Value a Startup – Dilution (2/4)
Today, we are going to continue answering the question of how to value a startup.
As I mentioned in the previous issue of Preferred Shares, this can be a confusing and complicated topic. It’s an art, not an exact science.
Even more so, at its core, it is all about aligning incentives.
In this issue of Preferred Shares, we are going to discuss one component of the valuation process – dilution. This will include two of the six pieces of analysis we discussed last time…
Comparable investments – how are similar VC investments pricing in the market?
Dilution analysis – what type of dilution should we expect today & in the future?
OK, let’s dive in…
Dilution is about ownership over time.
When we think about dilution, we are really thinking about our ownership (or someone else’s ownership) over a certain period of time.
This is one of the main differences between venture capital and traditional private equity. In traditional private equity, you are acquiring a company outright (i.e., taking a majority position) and don’t need to worry about your ownership percentage decreasing or being diluted over time.
On the other hand, in venture capital, there are often many rounds of financing that take on a minority stake, decreasing (diluting) the ownership percentage of previous investors or owners of the business.
With this in mind, an important part of any investment analysis is understanding your ownership percentage at the time of investment and the eventual ownership percentage at the time of exit or liquidation.
While where you start is very important, it’s all about where you finish.
If you’ve been diluted to a very small ownership percentage by the time the company exits, this may lower your overall returns. There are mechanisms to “defend” your ownership percentage, namely investing your pro rata or super pro rata, but we’ll discuss this a bit more later.
What’s market?
The market dictates the price (or valuation) for a particular type of asset.
In other words, the market (i.e., investors) will set a price (i.e., valuation) to invest a certain amount (i.e, which will determine ownership percentage) in a certain startup profile (i.e., an enterprise SaaS startup growing 3x YoY).
To figure out what market actually is in practice, venture capitalists will leverage large data sets and historical information on the price or valuations of certain startups. This is where our comparable investments analysis comes into play.
VCs will use data sets (such as pitchbook, crunchbase, cb insights, law firm data, etc.) to see where valuations for a particular type of startup have priced historically and where they are currently pricing in the market.
Here’s an example of one of those data sets…
In this situation, I’ve used pitchbook to understand how B2B products & services startups have priced historically, assuming that they are raising $2-6M in capital at a pre-money valuation somewhere between $10-30M.
As you can see, from 2017-2023, most financing rounds of this profile were acquiring about 20% of the company (in terms of the median). This is a good starting point for us to think about the overall valuation, but we will need to combine this information with the rest of the analysis I outlined before we can commit to a valuation, more to come here.
As a general rule of thumb, most financing rounds are acquiring between 10-30% ownership in a venture startup. This depends on the results of the analysis I’ve outlined, the profile of the business, and the overall performance & potential of the startup in question.
How will our ownership change over time?
As I mentioned earlier, dilution is about understanding our ownership percentage over time.
This brings us to dilution analysis.
With most startups, we expect that they will be raising multiple rounds of capital before reaching a profitable scale or exiting. That means we’ll need to perform the analysis above (i.e., comparable investments) for those future rounds. This will allow us to understand how much dilution we can expect over time with this investment. It will also help us think through how other stakeholders’ (i.e., founders, management team, employees, existing investors, future investors, etc.) ownership will change over time.
For this dilution analysis, we should understand or at least have a view on two points…
How much capital will the company require in the future?
How do we expect this to manifest in terms of future financing rounds?
This will require a strong understanding of the startup’s business to predict how much capital will be required to eventually meet scale. I discuss this in much more detail in the Financial Modeling section of the How to be a VC Associate course.
We’ll use that information to create assumptions around future financing rounds, including capital raised, pre-money valuation, post-money valuation, our participation, etc.
Now, earlier, I mentioned pro rata and super pro rata. Depending on your fund’s strategy, you may have the opportunity to invest in these future rounds and protect your ownership percentage from dilution. This will depend on the round dynamics and your rights as an investor, but it can be a helpful tool to maintain or increase your ownership percentage. I go into detail about this in the legal & structuring section of the How to be a VC Associate course.
Ultimately, the combination of comparable investment and dilution analysis will give you an idea of the current ownership percentages being acquired and future dilution expectations.
Remember, this is just one part of the process. We’ll need all the pieces to make the right decision in regards to a startup’s valuation.
Next week, we’ll dive into more of the analysis outlined in part 1 of this series.
