Valuation – what is the company worth? This may be the single most important question that entrepreneurs and venture investors need to resolve prior to an equity investment in the entrepreneur’s company. Many aspects of the entrepreneur-venture investor negotiation are potentially win-win; valuation however is usually not. In an equity investment, the investor injects funds into the company in exchange for equity, most often in the form of ownership shares in the company. The key issue then becomes: how many shares will the investor receive for a given investment in the company? The answer depends on the valuation of the company. The investor will receive a percentage ownership of the company equal to the investment divided by the (post-money) valuation of the business. Post-money valuation means the value of the business after the investment. For example, if the investor puts in $1 million and the pre-money valuation (value of the business before the investment) of the business is $3 million, the investor will receive 25% of the company’s shares [1 / (3 + 1)]. So far, this all seems simple enough. It should seem simple at this point, because we have skipped over the most difficult part – how to assign a value to the business.
Valuing a business is not a simple exercise. A naïve approach using the balance sheet or market value of assets, or a multiple of book value will arrive at a kind of valuation, but not one that will make sense in valuing a company for venture investment. This type of valuation will give the liquidation value of the company, whereas venture investors are valuing the company on the basis of its future prospects.
There are two major approaches to forward-looking valuation – fundamental value and technical value. In fundamental value, it is assumed that there is a firm foundation for the value of the company. The company has an intrinsic value equal to the present value of its future cash flows. In technical value, the company’s value is determined solely by the market price – it is equal to whatever someone is willing to pay for the company. This is also sometimes referred to as “the greater fool theory,” meaning that as long as you can find someone to pay more for the company than you paid, the value is whatever they are willing to pay.
The main determinants of value in a fundamental value approach (as applied to venture investing) are the expected growth rate of earnings and the degree of risk in the investment. Fundamental value is generally calculated using pro-forma (forecast) financial models of the company over a 3-5 year time horizon. The company’s future stream of earnings and cash flows are estimated and the intrinsic value is calculated from these streams. This approach seems to be quite rigorous, but there are some big issues that arise when valuing companies this way. Expectations about the future cannot be proven in the present, fundamental inputs are all crude assumptions, the assumptions can be manipulated to arrive at almost any result and the model may exhibit extreme sensitivity to a few inputs.
There are four methods that are widely used to value private companies by venture investors:
- Discounted cash flow (DCF)
- VC method
Broadly speaking, the first two methods are fundamental, and the last two are technical.
In the DCF method, a pro-forma model is used to forecast the company’s cash flows, which are then discounted back to their net present value (NPV). The key assumptions in the DCF model are the growth rate of revenues and the discount rate used. In a DCF valuation, the discount rate is usually the company’s weighted average cost of capital (WACC). Since venture invested-companies are usually 100% equity-financed, the company’s WACC should be equal to its equity cost of capital, which should be equal to the investor’s required return on investment (ROI or annually an internal rate of return - IRR). Issues with using the DCF method are the uncertainty of the projected cash flows (garbage-in/garbage out) and the extreme sensitivity of the calculation to the choice of discount rate.
The VC method is a variation of the NPV/IRR method, but one which works backward from the investor’s required ROI, rather than forward from the cash flow forecasts. The inputs to this calculation are:
- The expected sale price of the company on exit (e.g. 4 years from now)
- The amount of investment
- The investor’s required return on investment
Using these inputs, we can calculate how much equity is required by the investor in order to achieve the investor’s desired returns. For example:
- The expected value of the company at exit is $25 MM. (This can be calculated as a multiple of the forecasted earnings or revenues, etc. in the exit year).
- The investment is $1MM
- The investors require a 60% IRR
- The post-money valuation is $2.4MM ($25MM discounted at 60% for 5 years)
- The equity required is therefore 42% - $1MM/2.4MM
As a variation of the NPV/IRR method, the VC method suffers from the same limitations as the DCF method, with the additional challenge of calculating the likely exit price 3-5 years hence. The further in the future forecasted numbers occur, the higher the degree of error in the calculation. The calculation of equity required also needs to take into account dilution that will occur in future financing rounds.
The comparables method uses a value that has already been established through a valuation of a similar company. The valuation of the current company is then adjusted up or down based on its differences to the comparable company. The difficulties with comparables valuation mainly revolve around what constitutes are comparable company (industry, market, stage of development, etc.) and how much to adjust for the differences between the companies. Applying comparables to private companies, as venture investors will need to do, is further complicated by differences between valuing private companies (of interest to the investor) and public companies (for which there will exist the most data). Data to compare private companies to one another may be sparse and difficult to obtain.
The rule of thumb method is similar to the comparables method, except that rather than comparing the company of interest to one or several comparable companies, the company of interest is compared to the overall market. For example, the pre-money valuation of seed/start-up companies has typically been in the range of $1-$3 MM. An investor using the rule-of-thumb method to value a seed stage company will therefore estimate the valuation to be in this range. Where the company falls within this range will usually be determined by the investor’s qualitative assessment of the company’s product, IP, market, management team and other critical factors to investors.
In practice, investors will often use a combination of several or all of the above methods to arrive at their valuations. In the end, the valuation of a business, like all prices, is determined by negotiations between entrepreneurs and investors. Valuation effectively determines the share price, and prices are always determined by supply and demand. But in a principled negotiation, both sides must have a rationale underlying their positions. This is especially important in entrepreneur-venture investor negotiations, because although they are on opposite sides of the table before the investment, after the investment they will become business partners, with both of their interests served by the success of the company. It is critical that both sides feel they were fairly treated in their negotiation; otherwise one might have won the battle but lost the war. Since valuation is such an important issue to both sides, it will serve both of their interests to arrive at a fair and reasonable valuation.