Most people in the space industry are familiar with the concept of tyranny when trying to leave the planet, especially as so eloquently summarized by Austin Morris in a blog post appropriately titled "The Tyranny of the Rocket Equation":
The concept of a rocket (generally) is to put some mass together, put some fuel behind it, and burn that fuel to put the mass somewhere else. If you want to put the mass further away, you need more fuel to do so. But the fuel itself has mass, so now you have more mass to push. So to push that mass, you add fuel. But now you've added more fuel mass, so you need to add more fuel mass to fuel the mass that you've already amassed atop your fuel. And herein lies the tyranny of the rocket equation: the more fuel you have, the more fuel you need.
It's truly a wonder that rockets work at all! However, today's conversation is about another tyrannical equation, the one that governs what we do here at SpaceFund: the venture capital equation. Space startups must take this equation into account, along with all the other difficult math they must do to get their spacecraft into orbit, create something of value, and then sell that product or service into a growing and sometimes volatile market.
In most cases, space companies need investor funding to get their product to market. And venture capital investors, specifically, operate under the constraints of their own tyrannical equation that all startups seeking funding must understand. If you don't understand this math, you'll never be able to successfully communicate with the venture capitalist investors that you're pitching. And if you can't make a business case for how you'll produce the returns they need, you'll never get a meeting.
Understanding company valuations, venture capital return requirements, and how your company may fit into a VC portfolio are key data points for successfully negotiating an investment deal.
Approximately 10% of startups fail within the first year. According to the United States Bureau of Labor Statistics, the startup failure rate increases over time, and the most significant percentage of businesses that fail are younger than 10 years. Over the long run, 90% of startups fail.
Yikes! 90% is a high failure rate. However, with some strategic thinking, executive team coaching, and a good understanding of business and market dynamics, some venture capitalists have a much lower failure rate. VCs also have a duty to their investors to plan for this type of failure rate in advance.
So, let's use an example of a seed-stage startup company that is raising $1M on a $5M valuation. If the investor is managing a $100M fund, the $1M company investment equates to 1% of the fund. This means that in order to return the fund ($100M+), the startup company would have to increase the value of that $1M investment by 100x within the 7-year lifetime of the fund (typically VC funds are ten years long, with a three-year investment window at the beginning of the fund, meaning that all calculations are based on this 10-3 or seven-year time frame). This means the startup would need to have a $500M ($5M x 100) valuation and real exit prospects within 7 years.
Valuations at exit (typically IPO or M&A) are typically calculated on an EBITDA / EV multiple (a ratio calculated by dividing company annual earnings - Earnings Before Interest, Depreciation, and Amortization - by the company's Enterprise Value). The industry standard for valuing a company is 7X earnings, meaning a company's valuation should be seven times its earnings. This number varies widely based on industry, company health, and market conditions, but for the purposes of our equation, 7X will be the baseline.
So if early investors are expecting a $500M valuation at exit (100X that initial valuation of $5M), that means the company must be able to create $72M ($500M/7) of earnings (not revenue) by the seventh year after the initial VC investment. This is a hard hill to climb for a startup, especially a space company that may have several years of R and D before a product can even start producing revenue. As mentioned above, most startup companies will fail before they can accomplish this. But the point is, the VC has to believe that the company has a CHANCE of accomplishing this, otherwise, the company is not a fit for the VC investment model.
Venture capitalists will use the earnings multiple as a gut check while taking a first look at your financial projections. They'll take your year seven revenue and multiply it by 7 to estimate future value.
Then, if they're smart, the VC will double your expenses and time to market to see if the business can still be successful at creating investor value, even when the inevitable supply chain risks, technical failures, staffing problems, customer acquisition issues - or a million other possible risks - come to bear on the business.
These updated financial projections may then be put through a Discounted Cash Flow (DCF) calculator, which is based on the time value of money - a dollar today is worth more than a dollar in the future. One way to think of the DCF is the opposite of an interest earnings formula. The DCF formula discounts projected future cash flows back to today, using a discount factor - a percentage - that represents the risk of the business. This calculation results in an estimate of the current valuation of the business. Discount factors can vary widely, are often punishing, and can be upwards of 30%. Imagine if your future cash flows are discounted by 30% per year for each year between then and now! This means future earnings may have little effect on the current valuation of a company, especially if they are many years in the future.
A DCF calculation will then be compared to other deals in the industry, or 'comps.' Your venture capitalist has probably seen dozens of deals similar to yours, so they'll have an idea of the 'typical' valuation for a company in your industry, stage, and level of technical progress. Sometimes, an average of industry comps is used as a baseline for a company valuation, or specific competitors are selected as the most comparable.
Then more of the 'art' part of this calculation occurs. Very rarely do the revenue multiple, DCF calculation, and industry comps result in the same valuation number. So which is more reasonable? Which is more defensible? Is the truth somewhere in the middle? Were the DCF calculations incorrect? Have other VCs in the market mispriced comparable rounds? All of these factors, and more, will inform the VC investor what the company's valuation should be.
Once the investor has a solid mathematical and artistic foundation for your valuation, they will then step into the world of tyranny.
What multiple would the company need to achieve to 'return the fund'?
(100X in this case - $100M/$1M)
What is the company's valuation now and in the future?
(if the company has a $5M valuation, that means they would need a $500M valuation - $5M x 100 - at exit within seven years)
If the company has a reasonable exit strategy for the seven-year timeframe, what are the company's projected earnings for Year Seven?
(in our example above, $72M per year)
If this earnings number is multiplied by an industry-standard multiple, will it 'return the fund' at exit?
(using a standard 7X valuation, this calculation becomes $72M x 7 = $504M. The investor's initial ownership percentage ($5M/$1M) of 20% would result in a payout of just over $100M, thereby this exit would 'return the fund.' We will save the topics of dilution and follow-on investments for another blog post)
This is one of the hardest conversations to have with founders. At SpaceFund, we regularly encounter folks who have intriguing technology, boast great teams, and serve a valuable market niche. But often, the math doesn't math. And if we don't believe the company can return the fund, then we won't invest. This is, fundamentally, why most companies aren't VC investable, and the ones who are will likely need to raise funding on lower valuations than founders would like, especially at the earliest stages when the time value of money is more punishing.
If a VC doesn't perform with stellar upround valuations and exits that return capital to investors, they will not be able to raise additional funds. In this high-risk, high-reward world of venture capital, each investment must be able to realistically return the fund within seven years. And most companies can't do that. It's not personal. It's just the tyranny of the VC equation.
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