Computing Venture Capital Returns
Venture capitalists evaluate the potential and measure the success of an investment using two metrics:
Internal Rate of Return ("IRR")
The IRR of an investment is the discount rate that makes the net present value ("NPV") of the investment's cash flow stream equal to zero. A project may be a good investment if its IRR is greater than the rate of return that could be earned by alternate investments of equal risk (i.e. higher than the VC hurdle rate).
CoC is simply equal to how much the VC receives in proceeds upon exiting the investment divided by how much it initially invests in the company and, unlike IRR, is not dependent on when the exit actually occurs.
Rather than compute single IRR and CoC figures for a given investment opportunity, VCs compute a range of such figures that consider varying degrees of operating success and different exit multiples. A commonly used metric to measure operating performance and compute the exit valuation is EBITDA. The VC typically takes the exit-year EBITDA projected by the entrepreneur and assumes this to be the best-case operating scenario (i.e. 100% EBITDA performance), then multiplies this EBITDA value by other percentages (e.g. 75% and 50%) to yield a range of possible EBITDA performance. The VC also considers a range of possible exit-year EBITDA multiples based on comparable companies, but discounted to reflect the illiquidity of the VC's investment. Returns are then computed over both ranges, and are usually computed for at least two possible exit years.
Before the VC can compute IRR and CoC, it must first determine its ownership stake in the company post-investment. This simple computation is performed in a capitalization table ("cap table"), and divides the common share equivalents purchased by the VC by the total common share equivalents outstanding after the investment is made. The resulting percentage is then multiplied by the exit-year valuation to determine what portion of the exit proceeds are attributable to the VC.
Convertible Preferred Securities
There are a number of securities that can be used to structure a venture capital investment. Among the most common is convertible preferred stock which provides the VC with upside potential (because it can convert into common stock that has unlimited upside) while protecting the downside (because the VC does not have to convert and can instead hold onto senior preferred securities that have priority over common stock in the payment of dividends and the distribution of liquidation proceeds). The choice of security has important implications for the VC's return on its investment.
Exhibit A – Convertible Preferred Stock (Single Round/Investor)
The following example shows how the VC computes returns for a given investment opportunity. We assume that the proposed terms of the transaction offer the VC an opportunity to purchase 1.3 million shares of convertible preferred stock for $1.3 million in Round 1. There are 3.5 million common shares and 0.4 million options outstanding before the deal. We also assume that the exit occurs in Year 4, and that the company has no net debt (so that the terminal enterprise value calculated using EBITDA multiples equals the equity value, for simplicity).
In practice, returns would be calculated for more than one possible exit year (e.g. exit in Year 3 and Year 5), as well as for a range of exit EBITDA multiples and operating performances (using an Excel table, perhaps). Note that if the CAPM return on equity is 12% and the probability of success used by the VC is 25%, this scenario results in an IRR that exceeds the VC's hurdle rate of 48% (=12%/25%).
In our discussion of APV and the example above, we contemplated a single round of financing that took place in multiple stages (i.e. an initial investment by the VC in Year 0 followed by another investment in Year 1). When a single round is so structured, the VC considers funds committed to all stages fully invested at time t=0, and discounts future free cash flows with a hurdle rate that reflects the riskiness of the investment. However, the investment could also be structured to employ multiple rounds, and involve multiple investors. Unlike stages, each round of investment is priced indepently and involves a new term sheet. A Round 1 VC would discount future cash flows with an appropriate hurdle rate, as before, but would only commit to providing funds for that particular round of financing. In Round 2 two years later, the VC would discount cash flows from t=2 at a lower hurdle rate that reflects the improved prospects for the company and lower risk of investment. The entrepreneur generally prefers to structure the investment in rounds rather than stages because with each round the probability of success goes up and the discount (hurdle) rate goes down, resulting in higher valuations in subsequent rounds.
Exhibit B – Convertible Preferred Stock (Multiple Rounds/Investors)
The following example adds complexity to Exhibit 8.3 by adding another round of financing and another investor as shown in the cap table. Assume that all other information is remains the same.
Note the Round 2 post-money valuation shown in the cap table. This value is hard-coded into the spreadsheet as $49mm discounted 3 years at a rate of 40%. Where do these numbers come from? The numerator in the equation is the valuation calculated by multiplying the 7.0x EBITDA multiple by a $5.8mm exit year EBITDA that assumes 100% EBITDA performance. We choose 100% EBITDA performance because Investor 1 would probably only invest additional funds in Round 2 if management is on track to achieve financial targets. For the same reason, we discount at a lower hurdle rate (40%) than previously used in the initial Year 0 valuation (suppose 48%) that reflects the company's improved likelihood of success. Finally, we discount over three years because that is the amount of time that elapses between investment in Year 2 and exit in Year 4.
To this point, we have only considered straight convertible preferred stock in our returns calculations. However, convertible preferred stock in a VC deal often pays a dividend. This dividend may be specified as a percentage of par value, or as a fixed amount. Less frequently, preferred shares may pay a floating coupon that changes with a benchmark interest rate index such as LIBOR. The preferred dividend may be paid when due or, as is more often the case, accrue to the VC and be paid upon exit.
Exhibit C – Convertible Preferred With Dividend
We now consider the same facts presented in Exhibit 8.4, except that the convertible preferred stock pays a 8% dividend that accrues to investors.
Note that dividends that accrue to all investors are subtracted from the exit proceeds before calculating any individual investor's share of the exit proceeds. The dividends attributable to the VC are then added to this share. Also, note that the dividend improves returns to the VC, as expected, and is calculated using compounded interest.
Participating preferred stock entitles investors to receive back their invested principal (plus any accrued dividends) before common stock holders, and then participate on an as-converted basis in the returns to common stock holders. In other words, participating preferred holders get their invested dollars back and then receive their share in the remaining proceeds based on ownership percentage.
Suppose a company raises $4mm at a $4mm pre-money valuation. Accordingly, the entrepreneur and VC each own 50% of the company post-investment. Several years later, the company is sold for $20mm. If the VC holds participating preferred stock, its proceeds upon exit are $4mm of participation + $8mm of common stock return (= ($20mm exit − $4mm participation) × 50%) = $12mm. The entrepreneur receives half of the exit proceeds after participation is taken out, or 50% × ($20mm − $4mm) = $8mm. If the VC instead holds convertible preferred stock, both the entrepreneur and VC each receive 50% of the exit proceeds, or $10mm.
If the VC holds participating preferred, the entrepreneur's share of the exit proceeds declines on a percentage basis as the exit valuation decreases (try another example at a $16mm exit to see for yourself). Therefore, the entrepreneur should not be terribly concerned about the participation feature if he/she believes that the exit will be large. In this case, the VC may request the participation feature as a way to validate the entrepreneur's confidence in a large exit–an entrepreneur who is truly confident in a large exit should not object to the participation feature.
Exhibit D – Participating Preferred With Dividend
Let's now see how to model the participation feature using the information given in Exhibit 8.7 above.
Note how the participation provides an added boost to VC returns.
Adding rounds of financing and other investors to the mix impacts returns to the VC. The type of security also has important implications for these returns, and VCs can use different securities to achieve their required rates of return.
Exhibit E – Comparison of Preferred Securities
Here is how the returns to the VC for each type of security considered in the multiple round/investor scenario compare.
Download the Excel spreadsheet containing the returns analyses shown above.