Anyone who is familiar with the basics of corporate finance theory will be conversant with the fact that the theoretical value of a business is Net Present Value (NPV) of future cash flows from the business discounted at the cost of capital applicable to the company – or its perceived risk.
Applying the NPV modeling technique to an established business with a history of costs and revenues and with quite predictable future cash flows is appropriate as the size of the markets they are pursuing can generally be estimated and assumptions about current and future market shares can be better predicted.
But the NPV technique is impractical – and many would argue even naive – when applied to early stage, pre-revenue ventures with high growth potential in uncertain markets. At the end of the day, what drives such spread sheet valuation models are people-created assumptions in excel based spread sheets. As the old maxim goes “in the assumption lies the weakness”.
The valuation of a high-growth early-stage venture at a discrete point in time is subject to a certain range of interpretation. Most seasoned venture investors will value a company within a 10% – 15% range of each other, given they are working from the same information set of qualitative and quantitative data. With a good degree of consistency seen in the market, the key factor in choosing one investor over another should rarely be based upon the initial valuation.
In the long term – and we are talking about the 3-5 year average life of the investor’s horizon, early valuations will only factor modestly in the realisation and distribution of proceeds upon exit. It’s important that both camps take the long view. It’s critical that investors keep good management incentivised. The Board needs to avoid arbitrary and ill-explained step-up in valuation from one round to the next. The Board and CEO also needs to be constantly planning for the next funding round and make sure there is ample justification for a step-up in valuation if milestones are achieved according to plan.
In the end, the finer points of the valuation will matter very little. Valuation will make a good investment more attractive but it will never make a silk purse out of a sow’s ear. A high-growth venture will normally receive several rounds of funding before an exit is realized. Building value is the shared objective – and obligation – of the entrepreneur and investor. A mutual understanding between the investor and the entrepreneur of the risk and rewards driving a valuation is critical to starting relationship on equal ground.