Call Us: 1-888-447-1821

• Home
• Entrepreneurs
• Lawyers
• Investors
• Services
  • Company Formations
  • Conversions
  • Equity Incentive Plans
  • Document Portal
  • Certified Copies
  • SureComply Service
  • Corporate Secretary Services
  • Equity Financing Documents
  • Debt Documents
  • Other Services
  • White Labeled Services
• Learn
  • Starting a Business
  • Funding a Business
  • Managing and Growing a Business
  • Key Concepts
• About Us
  • Our Process
  • Team
  • Our Partners
  • Contact

valuation

Valuation is the process of determining the price at which a willing selling would sell an asset to a willing buyer.  In the case of business valuation, the asset is the business itself.  In traditional business valuation there are 3 common valuation approaches.  In early-stage valuation, there are a few variants of these approaches that are important to understand since most early-stage and private equity industry participants, like venture capital and private equity firms, rely heavily on them to make decisions and negotiate. 

Traditional Valuation Approaches

There are 3 common valuation approaches for more established businesses:

1. Income Approach.  The income approach determines the value of a business by estimating the future cash flows of the business and discounting them back to the present using a Net Present Value formula. 
2. Asset Approach.  The asset approach determines the value of a business by summing the parts (or assets) of the business.  The basic theory underpinning this method is that a rational buyer would not pay more for a business than its replacement cost plus some adjustment for how long it would take to build the replacement.  In theory, the asset approach seems reasonable.  In practice, it is easy to value the tangible assets of a company but very difficult to value the intangible assets which often make up the bulk of the value of a company.  For these reasons, the asset approach is rarely used for healthy going-concern businesses.  It is often used effectively for companies who have failed and thus have demonstrated very little intangible value.
3. Market Approach.  The market approach looks for comparable public and private companies that are similar in terms of industry, stage, growth, margins, and risk.  The approach often relies on the assumption that very similar companies will have the same valuation ratios.  So if you can find the valuation ratios for Company A then you can apply these valuation ratios to Company B.  Common valuation ratios include Value / Sales or Value / EBITDA.  If you know the Value / Sales for Company A which is assumed to be similar to Company B and you know the Sales for Company B, you can estimate the value of Company B.

Early-Stage and Private Equity Valuation Approaches

Most of the valuation approaches above have significant shortcomings when it comes to valuing early-stage or high-risk (or highly levered) private companies:

• They often only work well when the company's business model and profitability are clear
• They frequently only apply to historical results, recent results, or short-term forecasted results
• They are not designed to capture widely variant outcome scenarios--though they can be modified to do so
• They involve many layers of assumptions for which the practitioner must have reasonable estimates
• They are not necessarily designed to assume that the company will be completely sold at some finite point in the future
• They use discount rates (or market multiples) that may dramatically underestimate the investment risk associated with early-stage or private equity backed companies

Early-stage companies often have widely varying outcomes from complete failure to becoming a Google-like success.  They often change business models multiple times along their path to maturity so it isn't clear exactly what their ultimate profit magins will be.  Even estimating revenue involves a large amount of assumption, so layering on profitability assumptions seems problematic at best and totally unrealistic at worst.  Early-stage companies by definition often have no historical or even current financial results to speak of (i.e., revenues or profits).  Most early-stage companies and private equity companies are looking to sell 100% of their equity to another buyer or to the public markets (via IPO) at some fixed point in the relatively near future.  Finally, most VCs and Private Equity investors feel that using WACC or CAPM or some other way of getting to a discount rate dramatically underestimates the risks that they are taking. 

For these reasons, most investors use one of two different kinds of valuation methods: 1) the First Chicago Methord or 2) some form of a Rule-of-Thumb method.  The First Chicago Method involves some fairly detailed analysis and comparables work.  The Rule-of-Thumb methods that are often used do not.  They are simple, even simplistic, ways to get to a rough valuation of an early-stage company. 

The First Chicago Method

The First Chicago Method often assumes three outcome scenarios at a fixed time in the future for the business being valued:

1. A base case, or "expected" case
2. An upside case, or "best" case
3. A downside case, or "worst" case

In each of these scenarios the practioner creates an expected value of the company at some projected exit date in the future.  Practioners will often use the market approach to find this projected future value.  For example, they might assume that Startup Inc. will have $50M in revenue within 6 years.  They find that comparable companies to Startup Inc. trade at 2x revenue.  So they assume that Startup Inc. will be worth $100M (2x revenue) in 6 years for the base case, or "expected" case outcome. 

Then the practitioner will discount that future value back to the present using a discount rate that they feel appropriate captures the risk of the investment.  Most firms apply discount rates in the following ranges:

• Seed or Startup stage.  These companies are typically actively engaged in product design and development.  They are not generating revenues and may not even have a prototype product developed.  Typical discount rates are between 50% and 70% for companies in this stage.
• Pre-Revenue with early product prototypes.  As the title indicates, these companies do not have revenue or significant revenue but have developed a prototype product or have a functional product but have not shipped the product yet.  Typical discount rates are between 40% and 60% for companies in this stage.
• Shipping product.  These companies are shipping product and have some revenue but the revenue may still be small and growing.  These companies often still require significant investment to scale the business.  Typical discount rates are between 35% and 50% for these companies.
• Expansion stage.  These companies are growing rapidly.  Sometimes these companies have positive income but many choose to reinvest cash flow into growing the business which limits income.  Typical discount rates are between 25% and 40% for these companies.
• Profitable and growing.  These companies are typically solidly profitable.  If they are not profitable it is simply because they are clearly reinvesting a healthy cash flow into growth opportunities.  They may still desire to raise capital for growth.  Typical discount rates are between 20% and 35% for companies in this stage.
• Bridge or Mezzanine stage.  These companies are performing well enough that they are considered likely IPO candidates.  They need funding only to get them to their IPO which will typically occur within six months.  Typical discount rates are between 15% and 25% for companies in this stage.

Once they have chosen a discount rate, say 60%, they discount the company's value at exit back to the present date.  Using the PV formula in Excel (=-PV(60%,6,,100) this implies that the company should be worth just under $6M today. 

Now if the investor is going to invest $2M into the company and the company is worth $6M now, he should receive 33% of the company (assuming that the $2M in financing was necessary for the company to achieve the financial projections used in step 1 above).  This is because $2M (the investment amount) divided by $6M (the value of the company) equals 33%. 

Rule-of-Thumb Methods

Especially for very early-stage companies like seed-stage companies, idea stage companies, and even Series A companies, many investors believe that applying any kind of scientific valuation methodology is a waste of time.  They also point to "norms" inherent in the venture capital industry where it is very common to see investors get a standard percentage of the company regardless of what any valuation models might say.  As a company progresses beyond the early stages and has significant revenue (or especially profits), investors will revert to more traditional valuation methods.  For mid-stage companies, they will often still use the First Chicago Method but as a company gets closer and closer to a liquidity event where investment bankers will become involved they transition to more traditional valuation models.

So many investors simply use a combination of rules of thumb to estimate the valuation of a company.  They base their estimate of the value on the following facts:

• The stage of the company
  • Seed stage companies often have valuations ranging from $500k to $1M
  • Series A companies often have valuations ranging from $1M to $5M
• Target ownership ranges.
  • Seed stage deals often have ownership ranges from 10% to 40%.  Some investors are OK with putting in only a little money and getting a small stake because they don't plan to spend a lot of their time on the deal unless it starts to grow very big.  In this case, since they are already investors they are in the first position to put more money into the deal as it grows.  Some investors on the hand view seed deals as extremely risky and assume that they will get diluted over time by additional rounds of capital so they expect a lot of ownership.
  • Series A deals often have ownership ranging from 20-40%.  VCs often have a requirement by their LPs to have over 20-25% ownership. 
• Investment amount ranges.
  • Typical seed deals require investments from $25-50K to $500K+.
  • Typical Series A deals require investments $500K-$1M to $5M.
• If the company has raised money before, the post-money valuation on the last round (see Pre- and Post-Money Valuation below)

Examples

For example an investor might just assume a seed-stage deal has a pre-money of close to $500k and just it up or down based on their overall assessment of the business. For a Series A they might give it a valuation of $2M based on knowing that most early Series A deals range from $1-5M and this one is toward the earlier end of the spectrum and they have some concerns about managment. 

Another example occurs when investors do deals based on target ownership ranges.  Investors often start by determining how much money they think that a company will need to get to some value creation milestone--say shipping a functional product.  For example, let's say Company A, Inc. needs $1M to ship a fully-functional product.  Now let's say VC firm, VC Capital Partners, is the sole investor and they target a 25% ownership for companies of Company A's stage.  After doing due diligence, they decide to invest.  Often the VC will simply agree to fund the $1M for a 25% stake without doing any justification for the implied valuation.  The implied valuation in this case is $4M (post-money, see below).  The VC didn't do any detailed DCF analysis, market-based comparables valuation, or asset valuation.  They simply looked at how much the company needed, which seemed reasonable, and matched it to an ownership amount, which seemed reasonable. 

This type of valuation analysis can lead to interesting, counter-intuitive outcomes.  For example, sometimes companies raising money from investors can get more money without giving up more equity.  As long as the VC firm hits its target ownership and isn't exceeding the investment amount ranges they have in mind for a company of that stage, they may require more ownership by putting in more money. 

Pre- and Post-Money Valuations

People in the world of entrepreneurial finance will often talk about "pre- and post-money valuations."  The concept is simple:

Pre-Money Valuation

+ Investment

= Post-Money Valuation

Since investors are often investing large amounts of money into investment companies (portfolio companies), they talk about the value of the company before and after their money goes into the company.  This makes intuitive sense.  If you have a business that is worth $10M on Day 1 and on Day 2 an investor gives the company another $10M, you would be right to think that the company is now worth $20M ($10M + $10M).  The pre-money valuation, or the valuation before any investment money was invested, was $10M.  The post-money valuation, or the valuation after the investment money was invested, is $20M. 

This is an important concept for several reasons.  Whenever you are talking about valuation with an investment firm make sure that you are comparing apples to apples.  Most conversations center around the pre-money valuation since the rest of the math is obvious. 

Sunk Cost Valuation in the Private Investment Industry

Private equity and VC investors are often guitly of sunk cost valuations.  As mentioned above a company that was worth $10M on Day 1 and then receives $10M from an investor on Day 2 is worth $20M.  This is almost certainly true on Day 2 but as time elapses it becomes less and less true.  This is because the company converts the cash into salaries for employees, product development costs, marketing spend, etc.  On Day 365, the company may have spent all of the $10M.  The investors hope that it is worth far more than $20M because the company used its capital so effectively that it dramatically increased its value.  Unfortunately, sometimes the opposite occcurs.  A company will make poor use of its capital and destroy value. 

Because investors often do not want to report back to their investors (limited partners) that they have potentially destroyed value and because valuing illiquid assets can be so difficult, they often just assume that unless their is very strong evidence otherwise a company is always worth at least the post-money valuation on the last round of financing.   This thinking can often become a rule-of-thumb for investors.  As long as they continue to fund the company (without any new firm investing), they will often assume that the value is simply equal to post-money valuation of the last round without doing any "real" assessment of what the company is worth.