Lecture 1: Sections 1 & 2
(Chad Jardine, University of Utah, FINAN 6310, 2008–)
Section 1, About Venture Capital. How did we get here, and why does VC exist?
Section 2: Valuation formula and hurdle rate.
Let’s follow along with the slides.
Here’s our agenda
In Finance 6300, I talk about business being a dirty word. You’re going into a career that has a stigma attached in the current climate. Business has a reputation for being uncaring, uninterested in the plights of the masses, and an excuse for unethical behavior.
Business is an easy target for folks not engaged in it.
Business is even parodied as a synonym for evil. I love the satire of Lord Business in the Lego Movie, but there’s a reason this stereotype is out there.
I want to do two things: 1. Encourage you to counter these stereotypes. 2. Do that by celebrating what business does to make our lives better, and participate with the highest ethical standards.
None of the negativity toward business is new. Back in the 1800’s Henry David Thoreau said. “It is truly enough said that a corporation has no conscience. But a corporation of conscientious men is a corporation with a conscience.”
As we launch into a discussion of what it takes to bring a company into existence, and then to give it power by finding a way to finance it, it’s important to keep in mind that these efforts have an impact on our world.
I believe businesses, and startups in particular, can be an incredible force for good.
I believe business amplifies the intentions of those who work in them. I think that means they can be transformative.
I believe that business can solve so many problems and ultimately change the world for the better. Like this simple solution to the difficult and often dangerous problem of transporting water in Africa.
Or this soccer ball that generates power from being kicked around during the day, so children have light to read by at night.
VC, Tomasz Tunguz of Redpoint Ventures, who writes one of the best venture and startup blogs going, wrote about the transformational power of startups.
When we think of just how many industries have been disrupted and improved in the past 20 years, it’s kind of staggering to think of how we got along without these things.
And there are thousands of startups trying to make an impact improving our lives. This list is just those that made the unicorn list before 2016. Private companies with valuations over $1 Billion have been dubbed unicorns. There are only 4 in Utah. Pluralsight, Qualtrics, Domo, and Inside Sales.
The point is that if you want to make a difference in the world, there are few better ways than to start a company.
Keep that in mind as we go throughout the course.
Question: How many of you are interested in technology and tech companies? I know I am.
So, what is technology?
We sometimes get confused and think that technology is circuits or lines of code.
But the heart of technology is simple… Technology requires two things.
An idea.
And execution.
These two are like the sperm and the egg—the concept, or conception rather of a company.
Just like human conception emits a spark of zinc as the sperm meets the egg, a great business is conceived in a spark of inspiration. A solution to a problem. A better way of doing things.
So, ideas and execution. Technology.
Paypal founder and prominent VC, Peter Thiel, said in his book Zero to One, “Humans are distinguished from other species by our ability to work miracles. We call these miracles, technology.
Properly understood, any new and better way of doing things is technology.”
Q. So what other technologies are there besides electronics?
What about military technologies? What about metallurgy, agriculture, animal husbandry, politics, or economics?
By Peter Thiel’s definition, every company is a tech company.
Q. If it isn’t different, better or special, why does it exist? What benefit does it provide? What problem does it solve?
Tech isn’t new. Let’s look at some historical examples.
Here’s a really old piece of tech. Thought to have been developed 26,000 years before another piece of tech… the wheel… this is an Atlatl. It’s a spear thrower. Effectively this stick with a notch in it lengthens the arm of the thrower for significantly more power.
Here’s a military technology, a battle formation called a phalanx. The phalanx required each man to cover the next with his shield, linked together like one giant sword, cutting through the charging mob. This picture is from the movie dramatizing the stand of the Spartan Greeks at Thermopylae where they protected the birthplace of democracy.
The phalanx was strong for a long time.
Then came the formations of the Roman legion. The checkerboard pattern that allowed the soldiers to effectively break up a phalanx and attack it in smaller chunks.
Here’s a painting of the Mongols, who controlled the largest empire by land of any empire to ever exist on earth. What were their military achievements? Silk under armor (so tightly woven that it allowed arrows to be removed without shredding the flesh) and a little thing they borrowed from the Chinese called stirrups. Stirrups allowed them to guide their horses with their knees and use both hands to shoot bows and arrows.
Just like military technologies, we have had advances in financial technologies too. This is Jean Baptiste Colbert and Adam Smith.
Smith would write a treatise on free markets and wealth creation that would get him dubbed the father of economics. Colbert was the father of an earlier system called Marcantilism.
One of the tenets of mercantilism was that there was a finite amount of wealth in the world. Which of course meant that if you wanted to get more than you already had, your only option was to take it from somebody else.
This idea spawned European colonialism. European kingdoms had been fighting each other for centuries and they were all pretty tough. So, they decided to take wealth from easier prey—like aboriginal natives in less developed areas of the world.
Adam Smith on the other hand, showed that wealth could be created by increasing the number of transactions within an economy.
His book, An Inquiry Into the Nature and Causes of the Wealth of Nations was published in 1776. Something else happened to be going on that year… some upstarts in America decided to try their hand at a country whose economic system is based in the principles of free market economics… and they declared independence.
Which brings us to the historical backdrop for Equity Financing.
Back up a few years before the American Revolution, and another financial technology was developed.
In 1602, the Dutch East India Company needed cash in order to make sure its ships carried full loads between Europe and trading partners in Asia.
It was expensive to finance a whole ship full of cargo. They needed a lot of money, but most people individually only had a little.
So, they offered private citizens the ability to purchase small portions, or shares, of the cargo.
In return these investors would receive a proportional amount of the profit or return, when the ship… returned.
This was effectively the world’s very first IPO.
And it wasn’t without risk—ships could sink, be attacked by pirates, or any of a number of hazards involved with sailing around the world in the 17th century!
If we start with this first IPO of the Dutch East India company in 1602, how has investing in public equity evolved since then? Well, the model continued to be refined in shipping and tulips.
By 1776, the nascent (and financially creative) upstarts in the United States actually sold war bonds to help finance the war of Independence.
In 1792, seven years before the U.S. Constitution was signed, 24 large merchants create the New York Stock Exchange by agreeing to meet each day and trade stocks and bonds on Wall Street in New York City.
By the mid-1800s the potential for raising capital in the stock market had become well known, and many companies were selling stock to raise expansion capital.
By 1900, millions of dollars worth of stocks are being traded.
All of this is still happening on the street corners, until…
1921, when the stock market moves indoors. 8 years later…
On Oct 24, 1929, the market crashes hard. The crisis starts the chain reaction that will create the Great Depression. In 1932…
FDR is elected. He had run on a platform of fixes for the depression economy. He begins enacting the regulations of the New Deal, including the passage of the Securities Act of 1933.
This is followed swiftly by the Securities and Exchange Act in 1934 which created the Securities and Exchange Commission. The SEC is still active regulating the sale of securities today.
Ultimately, the point is that publicly trading a company’s equity is the most advanced technology we have developed so far for financing companies.
As a result, there are stock exchanges around the world.
Here are the top 16, all with market caps over $1 trillion. Over 93% of the stock value in the world is in three continents…
North America, Europe and Asia. 87% of the value in the world is in the top 16 exchanges.
And, the NYSE is bigger than the 50 smallest exchanges combined.
Now you’ve got the historical context for how equity financing evolved. But if trading publicly is so great…
…why don’t all companies just go public right after they are founded?
It’s hard. It’s expensive. It’s close to impossible for brand new companies (if you are very sophisticated you can do it, set things up just right, perhaps use a vehicle like a reverse merger into a public shell), but for all intents and purposes this is out of reach, especially for first-time founders.
So, what options do we have? Well, we can try funding it ourselves…
There are some options that don’t require us to get outside help.
Independent wealth is always great if you have it.
Credit cards, sweat equity (we’ll probably be doing that no matter what), personal loans, maybe borrow against some personal assets.
We can apply for grants (depending on the type of business). We might be able to get people to gift us the money. Early crowdfunding was really just getting fans to give you gifts for the promise that they might get your product in the future. For some businesses that works, but most kickstart or indie-gogo campaigns end like a Gofundme campaign. The “what can you do for me?” model isn’t very reliable.
There’s always profits (best and cheapest money you can get).
But, it’s very difficult to do hyper growth all on your own profits. Even if a very profitable company doesn’t manage its cash cycle, if it gets into a scenario where the cash cycle demands more cash faster than it can collect cash from customers, the company will go broke.
Don’t get me wrong. Profits are awesome, but also might not be an option up front. If we don’t have the money, can’t win it or find it (in enough quantity to achieve our goals), we have to raise it.
How do we do that? Well, we are going to need to give something up.
What have we got to give?
We are going to have to give up some of our future.
You’ve heard the expression “Time is Money.” Well the reverse is also true. Money is time. We are going to review options to trade on the time/value of money.
Let’s review our options for trading future income for cash-in-hand today.
Debt. We could get a loan. With a loan we give up future cash flows to pay interest. We also risk any assets pledged as collateral. This might be tough for us if we are very early stage.
What about equity? We can sell some of our stock.
Now, we’ve already identified that selling in in the public markets is probably not going to work for us. So, that leaves those who buy stock in private companies. In other words the private equity market. Private equity is broken into the following groups:
Traditional private equity—typically looking to buy a controlling interest through an LBO of distressed or undervalued mature companies—maybe not us.
Venture capital. A slice of private equity that focuses on riskier new ventures, from seed stage through growth equity with an eye to a future exit at higher valuation (more on this later).
Angels. High net worth “accredited” individual investors making seed and venture investments themselves. Sometimes directly or via angel networks (park city angels, or Angel List) and sometimes through middlemen or “brokers.”
Crowdfunding. A newer category for individuals to invest very small amounts for equity.
This course is going to focus primarily on scenarios where you are an entrepreneur selling equity to Angels and VCs.
So here we are. Our ability to grow a business, realize our dreams, and change the world depends on our being able to fund the business, which means we need to sell some shares.
Now, at this point I think it’s helpful to take a small tangent and understand a few things about the nature of venture capital.
First, venture occupies a tiny corner of the world of finance. Even though the numbers have drifted up a little since he said this in 2014, I think this quote from Marc Andreessen sums this up nicely. He says, “Tech is really small. From a macro standpoint, tech is really tiny. So all of venture capital is $20 to $30 billion a year (that’s up to about $70 billion now). All private tech investing right now is $50 billion a year, and there’s a lot of these bubble articles that talk about, “$50 billion a year, how can you possibly put that much money into new companies?”
“So, against that the S&P 500, just the top 500 companies in the country will give back $1 trillion in the next 12 months in the form of dividends and buybacks. And so, total private tech investing is 1/20th of just dividends and buybacks out of the S&P 500.
“Is 1/20th too much, is that too little? It doesn’t feel like it’s too much.
“Just again to put it in context. The big mutual funds like—my friend Will at Fidelity that does a lot of this… that’s a $120 billion fund. Right?
“It’s like the total amount across all of tech investment is less than that this year. Ans so it’s just a very, very, very small amount of money.”
Here’s a 2021 update to show just how much venture has grown since Marc Andreessen said this in 2014.
Here’s a way of visualizing that. Venture is muy poco.
But it is disproportionately influential.
43% of public companies were venture backed. 57% of the total market cap of public companies were venture backed. 38% of the country’s employees work for a company that got venture money. And 82% of the research and development in the country is done by companies that took a venture round at some point.
It’s also helpful to keep in mind that venture firms are often startups themselves. In San Francisco, you have some huge and venerable firms, like Sequoia, Kleiner Perkins, etc., but around the country most firms are relatively small. Certainly that’s the case for the firms here in Utah. Most can count all their associates and employees on two hands.
That means these small firms have tremendous pressure to deliver returns or they won’t be able to raise new funds and they will fail.
VCs can make money, but the huge money goes to the founders in the most successful deals. Jason Lemkin from SaaStr fund said, “A top founder takes much more risk, but can make a LOT more than even the best VC of all time. A pretty good VC probably makes more than a pretty good and successful founder.”
Keep this in mind as you think about where you want to play in the startup ecosystem.
A few of these things already underscore that it is difficult and there is tremendous pressure on VCs to generate returns. Well if you’re a bigger company, raising larger funds, that can be its own kind of pressure.
Andreesen Horowitz and Greylock Partners for example, both raised over $1Billion in 2016.
Now consider that in order to generate 20–25% returns in your fund, VCs need to average about 100% IRR on each deal that succeeds. That’s because only one in every 3 or 4 deals are likely to survive.
Now think about the challenge for one of the firms on the previous slide. You just borrowed $1 billion from your investors. And the only way you have to generate returns for them is to invest in startup companies. That is no small challenge!
That’s why I call venture the X-Games of investing.
In the intro lecture, I mentioned how we were going to approach understanding this category of finance using this model. Well, now we know the context of public financing, and some of the challenges of VC financing, which makes raising money a very competitive thing.
And one of the first things we have to figure out, is if we’re selling our equity, if we’re trading on future earnings, how much is our equity worth?
With that in mind, let’s open up our first can of worms and talk valuation.
Valuation is at the heart of every question you need to know in startup financing.
How can you decide how much stock to sell if you don’t know what it’s worth? How can you tell if the money you raise is enough to get you to your next milestone if you don’t know the basis for how much money an investor will put in?
At the highest level, any asset is valued one of three approaches:
…the income, asset, or market approach. All three are attempts to answer the same question, what is this thing worth? And all three make the same assumption, it’s worth what someone is willing to pay.
The income approach is based on the present value of a stream of cash flows. Asset approach is your book value. Assets minus liabilities.
Finally, the market approach says, what has someone recently paid for a similar thing.
If your startup is pre-revenue, income is going to be tough. (Note that SaaS companies are mixing it up by trying to add recurring revenue to the tech startup model and strengthen their appeal on this basis.)
The Asset approach is likewise bad because… you have no assets.
As a result almost all valuation methods for startups are some form of the Market approach. In other words, we are going to use some comparables from the market to figure out what this company ought to be worth.
We know that we’re focused on a private sale of equity, not a public one.
But would it make any difference?
If we sold say 100 shares of stock on the public market vs. 100 shares privately, which do you think would bring a higher price? In other words, are private companies or public companies worth more?
Let’s run a quick scenario to compare.
Here’s a company generating $50,000 a year in sales and $10,000 a year in profit.
Real quick, when we talk about Sales or Revenue, those terms are interchangeable. Likewise if we use the terms Profits or Earnings those also mean the same thing.
So, here we’ve got $50k in revenue and $10k in earnings. As an investor, you do NOT have to manage the company. It has a qualified management team in place.
Your shares are privately held. There is no market for you to sell them. You’re locked in until the company sells or does an IPO.
If you find yourself in a situation where you need cash, you’re not going to be able to get it here. You are locked in to this investment with no easy way to get liquid.
Here’s another example…
Company B is doing the same amount of business. It has $50k in Sales and $10k in profit, just like Company A. It also has a qualified management team, so you won’t have to run the company.
The only difference is that it is public. You can sell you stock whenever you want.
So, which company would you pay more for? The answer is Company B of course.
And why is the public company worth more if the companies are otherwise identical? Because investors are willing to pay a premium for liquidity. [Click]
The flexibility of liquidity is worth a lot. The greater the liquidity, the lower the risk.
That’s why when you put your money into a savings account, it generates almost no return. Because a savings account must provide zero risk and 100% liquidity.
Let me mention something here. Startups have both risk and uncertainty. Risk is something that can be priced. You can insure against risk and calculate its probability. Uncertainty, is totally unknown. Private companies are earlier stage, riskier, and have less liquidity AND a huge helping of uncertainty.
That brings us to the final section. What drives the motivation to invest?
If private companies are riskier, riddled with uncertainty, and offer less liquidity Why would any investor in their right mind ever take the risk?
Well, let me tell you a secret. I could introduce you to someone who could get you all to write a check right now today.
He’s got a startup. It’s the only one with the technology to make a new gene therapy for aging. It is guaranteed to extend human life by 40 years. It will soon be mandatory for everyone, just like fluoride in drinking water.
You have the opportunity to be a part of a huge success, earn millions, benefit the world, and get in early.
Are you in?
I use this to illustrate that investors invest because of the opportunity.
Like any process where you want action from others, whether sales, marketing, or fundraising, this model from VC David Skok shows that all that is required is that the motivation exceed the friction and concerns that hold someone back.
An irresistible opportunity provides the motivation for investors.
So, your first hurdle in getting investment, is in articulating an irresistible opportunity.
Your second hurdle is to give your investor a reason to believe that you can make the opportunity a reality. The reason to believe must overcome any friction and concerns. Most of what we talk about in this class will be about how to signal to investors that they can believe in your ability to do this.
But none of that matters if you can’t first show the opportunity.
Your Fundraising Pitch assignment is about understanding how to make an interesting opportunity from your business idea, and which factors contribute to an investor’s well-founded reason to believe that you can pull it off.
Here’s Paul Graham, the founder of Y-Combinator, the most well-known startup accelerator in the world.
He describes the formula for capturing investment as
Make something worth investing in.
Understand why it’s worth investing in.
Explain that clearly to investors.
In other words, show the opportunity, and give them reason to believe.
Another simple but important thing to remember is that they are investors. Philanthropists are donors. They expect nothing in return. Maybe their name on the building and to be remembered for their contribution.
Investors on the other hand are expecting a return. They invest because they believe the value of their investment will go up.
Sometimes founders miss this and think that their job is to woo investors and make them fall in love with their product. That’s wrong.
Investors may care about the product, but if they can’t see a way to make money, they won’t give you any.
This class, is structured to help you think like a venture capitalist. I want you to understand the world from the investor’s perspective, so when you go out (no matter what role you have, whether an entrepreneur, or an employee in a company that is taking on investment, or an analyst from Goldman Sachs that specializes in this asset class) you will understand both sides of this business.
So, putting our venture capitalist hats on, what’s the venture capital model for seeing a return?
We buy equity in companies at risk-adjusted private valuations. Then sell that equity after an IPO at a public valuation.
It’s a buy low, sell high game.
It also allows the investor to influence the success of the company, effectively engaging in legal insider trading. Most investors in venture capital don’t take the company over. But they often take a seat on the board and help founders make connections to talent, to network, and ultimately to a future round of funding.
With the basic backdrop and motivation for venture capital. Let’s move into a more tactical look at some tools you can use.
How do founders and investors get on the same page about valuation?
Here’s a more real-world example. We’ll use Mark Zuckerberg as our founder. Entrepreneurs are questioning whether or not they are giving up too much equity? Are they being taken by these savvy investors who almost always have more experience than they do.
Investors actually have a pretty tough question to solve themselves. They are attempting to look into the future and see where the company is going.
Here’s Ben Horowitz, an early investor in Facebook, as our investor example. For investors, the big question is, “How much equity do I need in order to get my required return?”
What we really need to figure out is…
How to get these two on the same page.
One way to do that is to use the Valuation Formula outlined in this article (full article posted in Canvas if you want to read it). This formula aims to create parity between founders and entrepreneurs in assessing a company’s valuation.
Let’s break it down.
Here’s the numerator. 1+IRR raised to the number of years to exit, times the amount of the investment.
This tells us how much the investor’s planned investment will be worth assuming the required IRR.
The denominator is the value of the entire company at exit. This is calculated by using a multiple for a key metric or exit value.
The key things is that the numerator, divided by the denominator gives us a…
Hurdle Rate! The hurdle rate is the minimum percent of ownership the investor needs in order for the investment to generate the required IRR.
Let’s break down the terms.
IRR is the desired internal rate of return. For purposes of this class we will always use 100% IRR unless another IRR is specified. The reason for that is that just to stay alive, VC funds need to return 20-30% IRR across all of their portfolio. But, VC is risky, and some of those portfolio companies are not going to make it. If three in 5 fail, one breaks even and one generates an IRR of 100% or greater, the average return will be 25%. So, 100% is a good rule of thumb.
The exponent X is time, that is the number of years anticipated until exit.
Investment is the amount the investor puts into the company.
Multiple represents the industry multiple we will apply to a key metric of the business like revenue or earnings.
Exit value is the key metric at the time of exit. So if we used 3 years for our time to exit, we want to use the revenue or earnings projected three years from now.
For starters, we will use the following heuristics for our multiples.
Private companies we will value at 1 times revenue, or 5 times earnings.
Public companies we know are valued higher because they offer more liquidity for investors. So, we will value them at 5 times revenue or 20 times earnings.
These are just heuristics. So, if you have an actual industry average multiple, that is always preferable. But if you don’t have one, these will get you in the ballpark.
Even though this is simple, it’s super important, so you want to make sure you get this. For instance if the company will have earnings of $1 million in three years and it’s a private company, we might value the company at 5 times earnings or $5 million.
Or we could use revenue. Let’s say the company will generate $3 million in revenue in the third year and we are using a 1x multiple for private companies. That means the company is valued at $3 million.
There are other methods for valuing the company. If you have access to these, they can be substituted as the denominator in the valuation formula.
The first two we already used in our example, Revenue or Earnings.
We could also use Book Value, a flavor of earnings like EBITDA or EBIT, Market Cap, Net Income, or MRR/ARR which are popular if the company is growing very fast.
Let’s look at a couple of examples. Refer back to this section if you are still unsure how to do this.
Okay, example #1 a private company valued on earnings. You can see the anticipated revenue and earnings picture over the next 4 years.
So, let’s assume a $50,000 investment with an exit in 3 years. Plug the appropriate info into the formula and we have one plus one to the power of 3 for our three-year exit, multiplied by the amount of the investment, which is $50,000.
For the denominator, we will use the private earnings multiple of 5, multiplied by the anticipated earnings in year 3, which is $120,000.
Multiply that out and we end up with $400 thousand over $600,000, or 66.67% as our hurdle rate.
That means an investor would need to own two thirds of the company in order to get their required IRR.
Let’s do another one…
For this one we will still use earnings, but we will use a public valuation instead of a private one.
The investment amount stays the same at $50,000. However this time when we plug in our numbers we will use a multiple of 20.
When we multiply it out this time, we get $400,000 over $2,4 million, for a hurdle rate of 16.67%
Because the public company is valued much higher than the private one at exit, the investor needs to own much less in order to achieve the desired IRR.