Is there a venture capital formula?

venture capital formula
Yes, there is.

But the venture capital formula doesn’t work like you might think.

This basic formula cannot boil a complex financial analysis into a single set of inputs and outputs. But it can deliver useful insights.

What is the VC formula and who developed it?

Bill Sahlman is a Harvard Ph.D. who has taught entrepreneurship at Harvard and written prolifically about startups and venture investing for years. In 2011, he was also part of a special task force pushing for reforms to the IPO process. Which is to say, he is one of the country’s most thorough observers of the venture capital industry.

In 2003—revised in 2009 after the financial crisis—Sahlman published a paper entitled The Basic Venture Capital Formula. In the article, he describes a formula used by some venture capitalists as they screen prospective investments. (He later developed this into a business case for Harvard.) The formula is:

(1+IRR)^time * (investment)/(valuation at exit)

What does this mean?

1+IRR shows the internal rate of return desired by the investor. How much does he/she need this investment to yield in order to make it worth considering?

Time is the number of years capital is deployed in this investment until an anticipated exit.

Investment is how much capital gets invested.

These three factors form the numerator. The denominator is the total enterprise value at the investment horizon or the anticipated exit. This can be further broken down into two factors, a multiple and an exit value.

The multiple is the industry average or comparable multiplier for exit values of similar companies.

Exit value is a key performance metric for the company, such as revenue or earnings.

Combined, we might say the company’s terminal value is estimated using a revenue multiple of three. This means a company generating $1 million in annual revenue in the year we expect to exit the investment, would be valued at $3 million. $3 million is the number we would use in the formula.

That’s how the formula is calculated. But why would investors use it?

The result of calculating the valuation formula is a hurdle rate. That is, a minimum percentage of equity required to hit the investors desired rate of return.

The venture capitalist must own enough of the company at [exit] to realize [the desired] return on the investment.

—William A. Sahlman, The Basic Venture Capital Formula

Sahlman shows how this formula can be used by VCs to see,

  • How many new shares need to be issued at what price per share
  • Pre- and post-money valuations
  • A breakdown of carried interest for any investment round
  • Accommodation for dilution.

On a basic level the venture capital formula also creates parity between how investors view a company’s value and how the founder(s) view it. It serves as a useful way of getting these two on the same page or identifying where they see things differently.

Finally, the valuation formula contains critical building blocks of putting a deal together. It addresses valuation multiples, investment horizons, and returns. This is the reason I include it in my graduate venture courses at the University of Utah, it’s a quick way to bring context to a discussion of each of these elements.

The venture capital formula contains critical building blocks of putting a deal together. It addresses valuation multiples, investment horizons, and returns. Click To Tweet

But is it really that simple? Just plug and chug your data into the formula and away you go? Of course not. There are weaknesses to putting too much weight in the valuation formula.

Additional Reading: You can read more of my breakdown of valuation fundamentals here.

Where does the valuation formula fall short?

It can be tempting to see a formula like this as a secret code to mitigate risk, or see it as a kind of shortcut for due diligence.

The formula is at best a quick gut check to see if the basic terms of a deal make sense. It can tell investors if they are expecting mutually exclusive outcomes in a deal. Such as, if they need 100% return from your investment, but getting it requires that you own an impossible 200% of the company.

What it cannot do is verify the accuracy of the inputs.

That’s like trying to predict the future. There’s no guarantee that a company will hit its revenue or earnings projections, even if its CAGR is on track. There’s no guarantee that an investment will have an exit opportunity that lines up with the investor’s investment horizon.

At its best, investors have a back of the napkin heuristic for sniffing out terms that will definitely not work. The venture capital formula won’t tell them much about an investment that will work.

Venture investing is not about mitigating risk

The nature of venture capital, especially with first or early investments in a company—the angel, seed and series A investments, is not about mitigating risk.

Wait, what?

Certainly startups often have obvious weaknesses and risks that most venture investors will see as signaling a bad investment.

But almost every company raising money in its early stages contain flaws that could metastasize and kill the company. That includes those that pass the initial screening and due diligence. So of the startups VCs determine to be candidates for investment, there’s no sure way to pick winners from losers. There’s no formula for that.

That’s because these bets aren’t calculated risks, they are just well-informed guesses.

In finance, people often use the saying, “Nobody wants to buy a racehorse until they see it run.” This is why repeat entrepreneurs just have an easier time raising money than first-time founders.

But among the ranks of first-time startup founders are winners that nobody has seen run yet. Nobody knows who the winners are until they win.

The best explanation of this I have heard was given by Jerry Neumann in an interview with Patrick O’Shaughnessy (excellently summarized here). Neumann explains that risk is an actuarial problem. Risk can be quantified as a probability and hedged against.

What startups contain is not just risk, it’s uncertainty.

And uncertainty cannot be mitigated by a formula. While the formula can help investors be thoughtful. Unfortunately, it cannot do anything to guarantee winners.

Read more venture capital tips for founders at 101 Venture Capital Pro Tips

@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches graduate courses in venture financing @uutah

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