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March 01, 2011 at 07:00 PM
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.
