How VCs Make High-Quality Investment Decisions? | Why Top 1% Of Founders Quit Their Startup? | Best Traits That Investors Look In Founders | VC Remote Jobs and More
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📢 How Do VCs Make High-Quality Investment Decisions?
Understanding how leading investment firms like Tiger Global, Sequoia Capital, and Antler make investment decisions is a subject of great interest to many. For a founder, understanding this process can be beneficial as it will help them to get the mindset of investors and eventually help them to pitch in front of investors.
In search of how VCs actually evaluate and make high-quality investment decisions, I came 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. So grab your morning coffee and let’s deep dive into it!
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.
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 make 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%
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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📢 Featured Article: Why The Top 1% Of Founders Quit Their Startup?
I read this article on why the top 1% of founders quit their startups, by the entrepreneur handbook. It’s one of the interesting articles. So sharing the summary of it.
“ Daniel Kang, Founder at YC and ex-investor at Softbank, shares a stark reality about startups: the leading cause of death for most early-stage, pre-product-market fit companies is the breakdown and demoralization of founders, referred to as "The Struggle." The reasons are manifold: limited control, the pressure of results, and the harsh realities of personal finance.
Is quitting ever acceptable? It's a question rarely discussed, but Kang suggests founders ask themselves a set of questions to reach that decision: Do you have ideas left to grow your startup? Can you drive that growth profitably? Do you want to work on the startup that results from that growth? Do you want to work with your co-founders on the startup that results from that growth? The answers could be the key.
In the age of AI, Daniel Rizea, Director of Engineering at Google, believes trust will be the biggest competitive advantage. His Say/Do/Show formula encapsulates the essence of building trust: Say what you will do, do it, and show that you have done it. Avoid common pitfalls like forgetting to say what you will do, not doing it, or not showing that you have done it.
Remember, in the world of startups, survival is the name of the game. And in the age of AI, trust is your biggest asset.”
If you want to read the full article - here is the link.
📢 Major News Of This Week In Startup Ecosystem
Venture capital hit Y Combinator for frothy valuations. Read Here
Air Street Capital Raises $121 Million for AI Startups Read Here
Why some companies can’t land a deal Read Here
Coinbase to discontinue services in India later this month Read Here
How founders can prepare for the fall fundraising ‘marathon’ Read Here
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📢 Tweet: The Best Traits That Every Investor Lookout For In Founders.
Recently Romeen Sheth shared a tweet on the common traits that founders have who generally get the funding / to build successful businesses.
I have been talking with multiple founders and have found the same traits in most of the founders. As an investor do you also check out such traits in founders, If you have a list feel free to comment! Have a look - 👇
📢 Weekday’s Reading on Startups, Venture Capital & Technology
📑 How Do LPs Evaluate VC Fund Performance? Read Here
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📮How Much Should You Raise For Your Startup? Read More
📪 The Game-Changing Clause For Entrepreneur. Read More
🗃️ How Do Investors Protect Themselves from Down Rounds? Read Here
📜 Decoding Startup Valuations with the Venture Capital (VC) Valuation Method Read More
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