From the March 2011 issue of Investment Advisor • Subscribe!

March 1, 2011

Putting a Price on a Promise

Last month, we identified the typical ranges of equity that private venture investors end up with as the result of their “seed stage” (angels, friends and family) investment, and the subsequent “Series A” round. This month we promised to look at the question of valuation. Specifically, how do you assign a value to a new company at the startup stage?

Investment advisors who make individual investment decisions on publicly-traded securities rely upon a wide variety of models and fundamental valuation metrics such as earnings per share, price-to-earnings, price-to-sales, growth rates, return on invested capital, PEG ratios, market cap, enterprise value and EBITDA multiples. The more mature the company, the more objective the valuation methodology.

On the other hand, private venture investors typically have to turn to more subjective analysis when attempting to assign a present value to a startup or early-stage company in the pre-revenue stage. The cliché is apropos—valuing a startup is indeed “more of an art, than science.”

The analytically-inclined will insist on applying the Discounted Cash Flow model as it relies upon a quantitative approach and produces a single valuation number in the form of the implied present value of a private enterprise. With DCF, one forecasts several years of revenues and expenses and then discounts the resulting cash flow back in time to the present by way of an expected rate of return.

But it’s just applesauce. Excel-enabled egghead entrepreneurs can game DCF by adjusting the “discount rate” or the forecasted revenue growth to produce the valuation they desire. Serious investors invariably will not accept these numbers, unless of course the DCF output is the result of their inputs.

To be blunt, valuation is all art. Placing a credible valuation on an untested idea, concept or business plan is impossible. Privately-held companies are typically valued at a multiple of their discretionary cash flow that finds its way to a company’s bottom line. Of course startups don’t have a bottom line, which renders the process nearly entirely subjective—inuring to the benefit of the investor.

Truth be told, when most investors seek to determine the valuation of a company that they are contemplating an investment in, the formula most often applied is, “What percent of the company must I own for this investment to make sense to me?” It’s a mercenary method, but it is practical and undeniably elegant. If an investor wants his $500,000 to own 50% of a company, that company is priced at $1 million.

Nevertheless, both investor and entrepreneur should exercise some quantitative basis for valuation. Personally, I look to assess:

• The Team—assign a value to the founders, executive team and key personnel. The people executing the business plan are, in my opinion, the most predictive indicator of the potential success of any early-stage venture. Founders, CEOs and CTOs who have had previous success at the business sector and model contemplated genuinely command higher valuations for their companies.

• The Proprietary Advantage—assign a value to the company’s “unique sustainable edge” by valuing intellectual property, physical location and other distinct differentiators in the business model. The value of patents, trademarks and other IP are generally not certifiable at the provisional stage but certainly weigh heavily into the valuation equation.

• The Relationships—key distributors, early customers and executed contracts add quantifiable value.

• The Market Opportunity—Evaluate the size of the addressable market and the growth projections for the sector going forward. Look at the competitive landscape and barriers to entry, and attempt to quantify potential market share.

The entrepreneur will seek to apply an intangible “goodwill” premium to these tangible factors that can account for a couple of million dollars in valuation. Inevitably, valuation is arrived at as the result of either a concession by the investor or entrepreneur, or by reaching a mutual consensus between the two parties.

Another frequently-heard but nonetheless credible cliché is the applicability of the “Golden Rule” to startup valuation—“he who has the gold, makes the rules.” Ultimately, this is the case, as in the end, early-stage private company valuations are market-driven. The investor has final say. Companies get priced where they need to in order to get the deal done. It is the reality that entrepreneurs are forced to live with and, in the end, if the entrepreneur doesn’t like the size of his slice of the pie, it becomes his responsibility to bake a bigger pie.

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