VC Confidential digs deeper:
The venture business is driven off of multiples. Early stage VC’s target 10x return of capital and expansion/late stage investors target 3-5x. Why 10x…seems a bit usurious? The classic venture portfolio looks like this. Of ten deals done:
— 4 crater
— 2 are breakeven +/- a little
— 3 are 2-5x capital
— 1 is 8-10x
So, as a VC, you hope that all 10 deals will be the next Microsoft, but reality sets in at the first board meeting. You need to target 10x for your winners in order to pay for the losses elsewhere.
VCs will then try to estimate a) what they think the company might be worth if successful in 3-5 years and b) how much more capital will be needed. In a simple case, lets assume that the company is worth $100m in 4 years and will not take additional capital. Using the 10x rule, the VC will price the deal so that post-$ valuation of the deal is $10m. If the company is raising $2M and adds $1M worth of options to its pool, the VC will pay $7M pre-$.