When is a Valuation Required? Part One: Valuation for Early Stage Venture Capital Financing
February 17, 2021
There are many stages throughout a company’s life-cycle where a valuation might be helpful or even required. These include the following situations:
Raising capital to fund your new venture
Expanding the business with equity capital
Attracting and retaining talent by issuing shares or options to key employees
Buying out a shareholder to settle a dispute about how the company ought to be run
Reorganizing the share capital to achieve an estate freeze or other planning objectives
Determining the value of family assets in a divorce proceeding
To assist with planning your exit strategy and retirement plans
To evaluate an unsolicited offer to purchase your business
This article is the first part in a series of articles that will describe common circumstances that give rise to the need for some sort of business valuation. In these articles, we will convey some of the key valuation issues that should be considered in each situation.
Raising Capital to Grow your New Tech Company
If you are entering into financing discussions with a venture capital (VC) investor, you will need to understand key terms and how VCs calculate the value for an early-stage company.
Early-stage companies have the following characteristics which make traditional valuation methodologies impractical to use:
No positive earnings: A valuation based on the Income Approach attempts to quantify the value of a future earnings stream. Some form of earnings or cash flow multiple is applied to the indicated earnings level. However, at an early stage of development, there are often no earnings to apply a price-to-earnings multiple to.
Often pre-revenue: There may even be no revenue to attach a multiple to. Even if there was some limited revenue generated through the sales of prototypes for testing, this methodology would likely significantly undervalue the business and therefore would not be used.
Financial forecasts are speculative: Discounted cash flow analysis is usually impractical or at least highly speculative, since developing financial forecasts five years out into the future would be almost futile, especially for a brand-new market.
Limited tangible assets: Often there are no tangible assets in the company, apart from computers, materials and supplies. All the value is usually tied up in technology under development, software code, product designs and other intangible assets. These intangibles are often developed resources limited to the founder’s own sweat equity, so they don’t even show up on the balance sheet. So, using a Price-to-Book multiple to value the company is not possible.
Since none of the financial metrics typically used to value a business are available for an early-stage company, business valuators are rarely engaged to prepare a formal valuation report for VC financing purposes.
How do Venture Capitalists Value the Investment Opportunity?
Most VCs investing in early-stage companies will use the Market Approach to value potential investments. In doing so, they will frequently apply one or both of the following valuation methodologies:
Comparable company financing transactions: The VC will identify companies that are similar to the subject company (in both sector and stage of development). Several databases—including Pitchbook, CBInsights, Thomson VentureXpert and others—might provide information that establishes a valuation range for comparable companies. Although some information may not be publicly available, many entrepreneurs and VCs know through word of mouth what the recent valuations have been for comparable companies.
Potential Exit Value: VCs and other investors have a good sense of a company’s exit value. The value can be based on a recent takeover transaction in the same industry or IPO valuations for similar companies that have recently gone public. Most early-stage investors look for 10x to 20x return on their investment within three to five years. For example, assume the VC plans to purchase a 20% interest in your company, which has a potential exist value of $100 million. At the time of exit, the VC would receive $20 million for their investment. If they determined that a 20x return was required, they would be willing to pay $1.0 million into the company for a 20% share interest. This would imply a “post-money” valuation of $5.0 million ($1.0 million divided by 20%) and a “pre-money” valuation of $4.0 million ($5.0 million, less the $1.0 million investment).
Investors will use these methodologies to establish a price range for the investment. Although they will try to get the lowest price possible, there are some things you can do to maximize the valuation:
Demonstrate that there is a huge market opportunity. This will help lift the investor’s estimate of the size of the potential exit value for your company.
Address any weaknesses upfront. For example, if there are any gaps in your plan (management, technical or commercial), then explain how they will be closed after the funding is secured.
Try to find examples of valuations in your industry (both VC financing and exit valuations) to support your proposed deal terms.
Find at least two serious investment competitors. The additional competitive tension will likely lead to a higher valuation.
Venture capital investors almost never request an independent valuation report to be submitted as part of a financing proposal. This is because early stage companies have not yet established the metrics needed to value their shares using traditional valuation methodologies. However, a Business Valuator can still aid in terms of estimating potential exit values, finding comparable transactions and providing general guidance throughout the process.