My General Feelings About Valuation
As you know all too well, valuation has many aspects. Investors often talk about the pre-money or post-money valuation of a company at the time they invest. If you get aspects of the percentage of the common stock for your investment, and nothing else, this calculation can be straightforward. But, angels have learned from VCs to negotiate for preferred stock instead of common as the type of security for their investments as well as for other financing terms, such as board seats, controls, warrants, and dividends. Under these conditions, valuation at time of investment becomes complex and not easily quantified. Although explicit valuation can be determined, and implicit valuation can be partially determined by accounting for some financing terms (warrants or dividends, for instance), other financing terms such as board seats or voting controls are difficult if not impossible, to quantify fairly. For example, on a $3 million pre-money valuation, what would the imputed difference in valuation be for getting one board seat instead of two—$25,000, $100,000, $500,000?
Computing the explicit valuation, whether pre-money or post-money, is simple but requires a clear understanding of a few concepts. (For a more complete discussion, see “Valuation of Pre-revenue Companies:”
- Full dilution: Full dilution counts not only shares that have been issued but also all shares that would be issued if all options and warrants were exercised and other promises or contingent agreements to issue shares were given effect.
- Investors’ (initial) percent ownership: The percentage of a company’s full dilution shares that the investors own, at the time of investment, including the shares issued to the investors.
- Money: The amount of capital invested in the round.
- Post-money valuation: Post-money valuation is computed by dividing the money by the investors’ percentage of ownership.
- Pre-money valuation: Pre-money valuation is computed by subtracting the money from the post-money.
If the investors receive no other consideration (warrants or dividends, for example) for their investment, then the explicit valuation is all you need to consider.
However, when investors receive additional consideration for making their investment, the implicit valuation may be different from the explicit valuation. How to quantify an implicit valuation is beyond the scope of this article, but some typical factors are sketched out below:
Warrants: The investors may get warrants (or non-qualified options) to purchase additional shares. The factors to consider:
- Warrant coverage: How many additional shares the investors can purchase relative to the number of shares they purchase outright—10 percent, 30 percent, or even 100 percent.
- Strike price: Relative to the price of the underlying security the investors get.
- Stock choice: Whether the warrants are to purchase common stock or preferred stock.
- Warrant life in years: This varies but can be, for example, one, five, or ten years.
- Kicker versus substantive change: Warrants can provide a small “kicker” (5 percent coverage with a one-year warrant, for example) or can materially affect the valuation (100 percent coverage with ten-year warrants).
- Effect on the valuation: You need to consider the time-cost of money since warrants don’t need to be exercised (converted to shares) until a much later date.
Specific Methods of Valuation
As an angel investor and VC I have used the following methods to determine how a pre-revenue company, like Superchat and Afinos, should be valued. Obviously, each has its benefits and disadvantages as discussed below.
The DCF (Discounted Cash Flow)
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset by using the concept of time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question. Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a present value; the opposite process—takes cash flows and a price (present value) as inputs, and provides as output the discount rate—this is used in bond markets to obtain the yield.
The First Chicago Method
The First Chicago Method takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios; see Quantifying Uncertainty Under Corporate Finance. Most often this methodology will involve the construction of:
An “upside case” or “best-case scenario” (often, the business plan submitted), a “base case,” a “downside” or a “worst-case scenario.” Once these have been constructed, the valuation proceeds as follows: First, for each of the three cases, a scenario specific, internally consistent forecast of cash flows—see discussion under “financial modeling”—is constructed for the years leading up to the assumed divestment by the private equity investor. Next, a divestment price—i..e. terminal value—is modeled by assuming an exit multiple consistent with the scenario in question. (Of course, the divestment may take various forms – see “investments in private equity” under “private equity”). The cash flows and exit price are then discounted using the investor’s required return, and the sum of these is the value of the business under the scenario in question. Finally, each of the three scenario values is multiplied by a probability corresponding to each scenario (as estimated by the investor). The value of the investment is then the probability-weighted sum of the three scenarios.
Market & Transaction Comparable
A comparable transaction is a method of valuing a company that is for sale. Comparable transactions considers the past sales of similar companies as well as the market value of publicly-traded firms that have an equivalent business model to the company being valued. To get a more accurate valuation, more than one comparable transaction should be used. This method of valuation can help identify the current value and potential growth for a company.
Asset-based Valuations such as the book value or the liquidation value
Liquidation value is the total worth of a company’s physical assets when it goes out of business or if it were to go out of business. Liquidation value is determined by assets such as real estate, fixtures, equipment and inventory. Intangible assets are not included in a company’s liquidation value.
Venture Capital Method calculates valuation based on expected rates of return at exit
The venture capital method reflects the process of investors, when they are looking for an exit within 3-7 years. First, an expected exit price for the investment is estimated. From there, one calculates back to the post-money valuation today taking into account the time and the risk the investors takes.
The return on investment can be estimated by determining what return an investor could expect from that investment with the specific level of risk attached.
Berkus Method attributes a range of dollar values to the progress startup entrepreneurs have made in their commercialization activities
This method, which is used and defined by active angel investor David Berkus, involves a lot of estimation. The reason Berkus came up with the method is that he personally found that lengthy revenue forecasts rarely turned out to be accurate. According to Berkus, only 1 in 20 startups hit revenue forecasts, so he opted for an “eyeball” approach using a few key elements. The method applies best to technology companies, but can be applied to other products.
First, Berkus says that investors should believe the company has a potential to hit $20 million or more in revenues by the fifth year of operation. Then, he applies a scale to five components of a startup, rating each at up to $500,000. The components are:
The startup has a sound idea—a product that provides a basic value with acceptable product risk.
There is a prototype, which reduces technology risks.
The startup has or plans for a quality management team to reduce risks in execution.
Strategic relationships are already in place, reducing risks for competition and market.
Product rollout and sales plans exist (not applicable to all pre-revenue startups).
Using the method, the highest valuation would be $2.5 million; a pre-revenue startup could only score $2 million. This is a very back-of-the-envelope method, but it can be a useful tool for angel investors evaluating startups in the earliest of stages.
Some disadvantages do exist with the Berkus Method, however, illustrating the point that no type of data should be considered in a vacuum. For example, this method doesn’t consider market or competitive environment, which may be of importance in many situations.
Scorecard Valuation Method adjusts the median pre-money valuation for seed/startup deals in a particular region and in the business vertical of the target based on seven characteristics of the company
This method was developed by Bill Payne, a veteran angel investor. The entrepreneur starts by researching the average pre-money valuation for similar companies in her given industry and region, which can be obtained from third party sources such as the Halo Report, AngelList or PitchBook. The valuation is then adjusted based on a series of weights, the specifics of which are open to discussion with investors. Below is an example:
Average pre-money valuation = $3.0 million (Halo Report). Weighted percent of Normal = 1.08 (multiply across and sum the “weight” and “% of normal” columns)
Company pre-money valuation = $3.0 million multiplied by 1.08 = $3.2 million.
Risk Factor Summation Method compares 12 characteristics of the target company to what might be expected in a fundable seed/startup company
The Risk Factor Summation Method is the fifth methodology for estimating the pre-money valuation of pre-revenue companies we have described in recent posts. Readers may have noted that both the Scorecard Method and the Dave Berkus Method considered a narrow set of important criteria for investment in arriving at a pre-money valuation. The Risk Factor Summation Method, described by the Ohio TechAngels, considers a much broader set of factors in determining the pre-money valuation of pre-revenue companies. This method may be less useful as a stand-alone valuation method for investors, but it is my opinion that this method should be one of several methods used by early stage investors to establish pre-money valuation, because it forces investors to consider important exogenous factors.The Ohio TechAngels describe the method as follows: “Reflecting the premise that the higher the number of risk factors, then the higher the overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit. Of course, the largest is always ‘Management Risk,’ which demands the most consideration and investors feel is the most overarching risk in any venture. While this method certainly considers the level of management risk it also prompts the user to assess other risk types,” including:
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each risk (above) is assessed, as follows:
+2 very positive for growing the company and executing a wonderful exit
-1 negative for growing the company and executing a wonderful exit
-2 very negative
The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by $250,000 for every +1 (+$500K for a +2) and negatively by $250,000 for every -1 (-$500K for a -2). For more information on determining the average valuations in your area, see the Scorecard Method.
As an example, assume the average pre-money valuation of pre-revenue companies in your area is $2.0 million. If your judgment of the twelve factors above has five neutral assessments (five zeros), five +1’s, one -1 and one -2 (a net of two +1’s), then add $500,000 to the average valuation of $2.0 million, arriving at a $2.5 million pre-money valuation.
As I am sure you’ll agree there are many different ways to value a startup, and the one you use is a matter of preference.
Image credit: CC by Mark