PS#022: How to Value a Startup (4/4) – Returns
Over the past two weeks, we’ve covered the concepts of dilution and exit analysis.
This week we’re going to bring it all together.
By leveraging our dilution and exit analysis, we can create a range of possible scenarios and better understand the likelihood of meeting our return threshold at a given valuation.
In this issue of Preferred Shares, we are going to build out a scenario analysis for an investment by running the returns analysis in different situations. This will include the final two pieces of analysis highlighted in part 1 of this series…
Returns analysis – what is required from a returns perspective?
Scenario analysis – how do we think about the different future scenarios for this startup?
Alright, let’s get started…
Calculate the return.
We’ve got all the pieces. Now it’s time to put it all together.
Through our previous analysis, we’ve gathered…
Required capital investments
Final ownership percentage (after dilution)
Potential exit valuation based on financial profile
With this information, we can now calculate the investment’s return by doing the following…
Chart the investments (cash outflows) over time
Identify your fund’s final ownership percentage (at the time of exit)
Determine the exit valuation of the company (based on the financial profile)
Add the distributed capital from the exit in your charted timeline (from step 1)
Calculate the cash on cash multiple (CoC) and internal rate of return (IRR)
Cash on cash multiple is the multiple of cash distributed divided by the cash invested (i.e., CoC = cash outflows / cash inflows).
The IRR is a methodology used to calculate the profitability of an investment.
Based on your fund’s return expectations, this analysis will help determine if the contemplated valuation for a startup actually works within the fund’s portfolio construction. From here, you can adjust the entry valuation to meet the returns your fund requires.
Before we move to the scenario analysis, a bit of a warning…
This analysis can get a lot more complicated than what I have outlined here. Calculating your ownership and dilution can be pretty complex, depending on the structure of the investment (and previous investments), the number of financing rounds over the life of an investment, and the approach to follow-on investments.
It takes time and reps to really understand the implications behind structuring an investment.
If this isn’t quite clicking for you, don’t sweat it. I provide a template for all of this analysis as well as walk through a detailed example in my course How to be a VC Associate.
Build the scenarios.
Top tier investors won’t just look at one set of calculations for their returns. Instead, they will calculate a range of potential outcomes and weigh the different scenarios accordingly.
This is called a scenario analysis. It brings all of the previous 5 types of analysis (i.e., comparable investments, comparable transactions, dilution analysis, exit analysis, and returns analysis) all together into one comprehensive analysis.
And, as I mentioned in part 1 of this series, startup valuation is more of an art than a science.
Well, in this analysis, we are leaning into the art and creative side of investing. We are building a narrative for how this investment unfolds. We are telling a story about how this business grows (or fails) over time.
What will happen to this startup? How will it perform? What will it look like in two years? In five? In ten? Will it succeed? Will it fail? If so, what happens in each of those situations?
To answer these questions, we could build out the following scenarios for the startup…
Startup fails to execute
Acquired for team/technology
Startup builds a competitive business
Wins core market & builds sizable business
Dominates core market & expands, creating massive business
Each of these scenarios will require us changing the items we outlined in the returns analysis section above to fit the narrative (i.e., required capital investment, ownership at exit, and potential exit valuation).
For the earlier scenarios, when the startup is less successful, we will lower the exit valuation, reduce the capital invested, and shorten the overall timeline of the investment.
For the later, more successful scenarios, we may increase the valuation (based on financial performance), increase our capital invested in future rounds, and lengthen the overall timeline.
It all depends on the narrative you decide to create in each of the scenarios.
Review the probabilities.
As I mentioned, we can combine all of this into one comprehensive analysis.
Once we’ve calculated the returns in each scenario, we can apply probabilities to better understand the weighted average outcome.
Here’s an example of a completed scenario analysis…
This table is a summary of all the analysis we’ve done in this series. You’ll notice, along the right hand side, we’ve assigned probabilities to each scenario.
This isn’t about predicting the right scenario, but instead, it’s about understanding the range of potential outcomes. This chart makes it easier for investment teams and committees to discuss the potential outcomes for an investment and whether they agree.
Ultimately, what the team thinks about the company’s potential will determine the valuation that they are willing to pay.
But, remember, none of this is certain. We’re playing with a lot of variables and predicting an outcome well into the future. We’re simply trying to calculate different ranges to create our best guess on the future outcome of the investment.
This analysis helps guide that decision-making process.
As I mentioned earlier, this is something that top tier investors do in their process. If you’d like to see some more examples, check out Bessemer’s investment memos. For example, their Shopify investment memo gives a good depiction of this process.
There it is. How to value a startup.
