Valuing Early-stage Ventures

Valuing Early-stage Ventures

Agreeing to a valuation of a young and growing business between the existing shareholders and the potential investor can be one of the most difficult issues in an equity investment deal. Valuing a company of any size is never easy but it is especially onerous if that company happens to be a start up or early stage venture without any operating history.

The multiple earnings method is most appropriate for service-based companies with several years of revenue. The Discounted Cash Flow (DCF) method is more dependable and reliable for companies with actual products and revenues. However, the DCF method is next to useless to apply to a venture that is pre-revenues, so settling on a valuation often involves intense negotiations.

I once met an experienced VC who admitted to me that he didn’t actually know how to do a Discounted Cash Flow.  But he did know where a deal would likely close at based on pattern recognition.

Ultimately, the right way to think about VC valuation is not a finance exercise but a negotiations one.

The answer is that most Angel and VC rounds are priced by the market – by supply and demand.

On the investor’s side, the goal is to acquire as large a position in the company and exert as much control as possible while keeping the entrepreneur sufficiently motivated.  On the entrepreneur’s side, the goal is to maintain a much ownership and control as possible while bringing in a helpful and motivated investor.

The bounds between sufficient entrepreneur motivation and the potential to create an attractive return to an investor is a very wide ZOPA (Zone of Possible Agreement).  Where the deal closes is a function of the relative bargaining power of the constituents.  In other words, are there many other investors seeking to invest in the company (rarely)?  Do the Investors have lots of options for where to put their capital (often)?  To steal another negotiations term – it comes down to having a good BATNA (Best Alternative to a Negotiated Agreement).

Remember also that it’s not only about valuation, but a lot of other terms that have value and that shape the Terms Sheet.  Liquidation preference, restrictions on the founder’s shares option pool, founder liquidity and “BOD seats” (Board of Director seats) describe just some of the levers Investors use to make up for higher valuations.  Entrepreneurs should definitely read up on these deal terms and become familiar with the language of the deal. If they don’t, they deserve the Terms Sheet they end up with and shouldn’t moan about it if the hangman comes for them.

That being said, many investors will often base their valuations on management’s own projections and on other deals negotiated in the industry by other companies. Information about comparable companies which have received venture financing can be useful in setting benchmarks for valuation. The investor will want to ensure that the valuation is supported by financial and legal Due Diligence and that the company’s forecasts are reasonable and based on sound assumptions.

Other factors that help form the early investor’s view of value are appraisals of the CEO and management team, the novelty of the value proposition, evaluation of the IP, expected time-to-market, expected path-to-profitability, estimated capital needs and burn-rate, syndicate risk, sector volatility and deal structure.

Entrepreneurs are also advised that the Investor willing to pay the highest price is not necessarily the best one for the business. Another Investor willing to pay a bit less may be a better partner in dynamically growing the business and bringing it to a successful liquidity event – usually in the form of a Trade Sale.

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