How VCs Evaluate & Make High-Quality Investment Decisions?
Case Studies from Leading Investment VC Firms | VC Remote Jobs
Understanding how leading investment firms like Tiger Global, Sequoia Capital, and Antler make investment decisions is a subject of great interest to many. This knowledge holds significant importance for aspiring investors and founders, as it enables them to comprehend the underlying thought process of investors and gain invaluable insights from their experiences.
In search of how VCs actually evaluate and make high-quality investment decisions, I come across an interesting article related to this by Frank Moyes & Stephen Lawrence and got to learn so much practical stuff - which I am eager to share in this write-up.
I must say - this write-up will give you a different perspective on investment decision-making and learn something new.
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Just think from an investor’s perspective - what an investor wants from a startup - Simple it’s a successful exit.
They seek a return equal to some multiple of their initial investment or they aim at a specific internal rate of return.
How do they make sure of that?
How do they evaluate startups?
They make use of the “Venture Capital Method.”
This Venture Capital Method assumes that the startup will undertake an Initial Public Offering (IPO) at some point in the future.
And the Future Value of the Firm is determined by multiplying the earnings of the firm in the year of IPO by the expected Price/ Earnings (P/E) ratio that the market will support.
Let’s do simple mathematics to understand this.
Consider a VC firm that just received the startup deal which finds them interesting and now how they are thinking about the potential -
Let’s do some assumptions:
- For a company, the month of IPO is 60 months from the First Investment
- Based on the Financial forecasting, the start-up’s Annualized Earnings at IPO is $6m
- P/E Ratio at IPO= 15
- Market Capitalization at IPO= $6m*15= $90 m
VC Firm Investment Round:
First Round at Month 0:
- Investment Amount= $1m
- Expected IRR= 35%
- Duration of Investment= 60 months
- Firm Value at the Time of Investment
= (Market Capitalization)/ ((1+Expected IRR)^(Duration of Investment/12))
= $90m/ ((1+35%)^(60/12))
= $20.07m
- Future Value of VC Investment at IPO
= (First Investment Amount)* (1+Expected IRR)^(Duration of Investment/12)
= $1m*(1+35%)^(60/12)
= $4.48m
- VC Ownership %= Future Value of VC Investment/ Market Capitalization = $4.48m/ $90 m= 5%
- Investor’s ROI= $4.48m/ $1m= 4.48X
Second Round at Month 12:
- Investment Amount= $2m
- Expected IRR= 30%
- Duration of Investment= 48 months
- Firm Value at the time of Investment= $90m/ ((1+30%)^(48/12))= $31.51m
- Future Value of Investment at IPO= $2m*((1+30%)^(48/12))= $5.71m
- VC Ownership %= $5.71m/ $90m= 6.34%
- Investor’s ROI= $5.71m/ $2m= 2.86X
Third Round at Month 24:
- Investment Amount= $3m
- Expected IRR= 25%
- Duration of Investment= 36 months
- Firm Value at the time of Investment= $90m/((1+25%)^(36/12))= $46.08m
- Future Value of Investment at IPO= $3m*((1+25%)^(36/12))= $5.86m
- VC Ownership %= $5.86m/ $90m= 6.5%
- Investor’s ROI= $5.86m/$3m= 1.95X
- VC Firm’s Ownership= 5%+ 6.34%+ 6.5%= 17.84%
- Founder’s Ownership= 100%- 17.84%= 82.16%
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Now after doing this above analysis, the VC Firm may negotiate with the Founder about their ownership percentage.
- Suppose after the first investment the VC Firm’s target ownership= 10%
- Future Value for Investor at IPO= $90m*10%= $9m
- Investor’s ROI= $9m/ $1m= 9X
- Investor’s IRR= ($9m/ $1m)^(12/60)-1= 55%
Second Round:
- VC Firm’s target ownership= 7%
- Future Value for Investor at IPO= $90m*7%= $6.3m
- Investor’s ROI= $6.3m/ $2m= 3.15X
- Investor’s IRR= ($6.3m/$2m)^(12/48)-1= 33%
Third Round:
- VC Firm’s target ownership= 6%
- Future Value for Investor at IPO= $90m*6%= $5.4m
- Investor’s ROI= $5.4m/ $3m= 1.8X
- Investor’s IRR= ($5.4m/$3m)^(12/36)-1= 22%
- VC Firm’s Ownership= 10%+7%+6%= 23%
- Founder’s Ownership= 100%-23%= 77%
That’s it for today. I hope this helps you to understand the investor's thought process.
If you want to download this vc valuation Excel file - download it here
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