Valuation of early stage companies
It can be very challenging to put a dollar value on early stage companies, because there are many qualitative factors that play a role in valuation. The earlier the stage, the more variability these factors can have. However, the entrepreneur must always know how to quantify this as best as possible.
What are the factors?
Many of these factors are qualitative, especially because the young company is often pre-revenue and cannot accurately project their earnings, which are at best an estimate. The obvious factors that affect valuation are directly related to the company’s development stage, track record, market presence, intellectual property, and whether there is an “A” team helming the company. The financials of the company play a significant role here too, especially when looking into extrapolated growth potential, and the pricing of the product. Other less obvious factors will include how well the entrepreneur negotiates, whether there is more than one capital source (e.g., another competing VC, or grants), how much available VC funding there is in the market at the time the entrepreneur is fund-raising, and so on. Although there will always be uncertainty, a thorough assessment of these factors will often bring up a ballpark figure. However, there are some methods by which one could get to a number quantitatively. The most commonly used simple calculation is the “VC Method”.
To illustrate, we use an example where a VC wants to get a 20x return on his money, and wants to invest $5M. A recent competitor was recently acquired for $300M.
The simplified VC method for valuation – using multiples
1. The value of the company at exit is defined as the terminal valuation. Frequently, comparable exits are used – in this case, $300M.
2. Decide what multiple is expected of the initial investment – 20x multiple.
3. Post-money = terminal valuation / multiple = $300M/20 = $15M.
4. Pre-money valuation = post-money valuation – investment amount = $15M – 5M = $10M pre-money
This is a highly simplified way of quantifying the valuation of a pre-revenue company, and many complicating factors to account for dilution and further financing rounds have not been included. A slightly more nuanced method would be to use the internal rate of return (IRR) or discount rate instead of using multiples, which further accounts for the duration of the investment, but this is beyond the scope of this short article.
It is important to note that the multiple used to calculate varies based on the round – early rounds always have a higher multiple, and seed rounds are the highest (>30-40x). This is not based on greed, but rather, on risk. The risk is compounded with the earliest rounds, where most companies that obtain investment at that stage are expected to be written off. Given that the investor seeks to achieve virtually all of their return on investment from one or two winners, it is necessary and fair to ask for a high number.
It is important to know your number
As an entrepreneur, it is important not only to understand how VCs calculate the valuation for their books, but you must also be ready to give a number when pressed for it during the fundraising process. This is one topic that you cannot feign ignorance about; perhaps you might even be able to use the knowledge to negotiate with your VC!
This article is the second in a series on Venture Capital. Click here to read the first article on the Basics of Venture Capital.
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