This article outlines approaches to valuing a new venture from a venture capital (VC) perspective. It attempts to help early and late-stage start-up entrepreneurs value their business when raising equity.
At its heart business valuation is the sum of the discounted future cash flows. Easy to say, or write, in practice it's difficult.
Difficult for a mature listed public company where accurate information that's readily available and the business is regularly marked to market, and even more difficult for a mature profitable mid-market private company. But it is probably most difficult of all when it is a new venture that little or no revenue and certainly no earnings.
Firstly let's outline a simple way. If you have a yet to be launched or early-stage venture with little revenue then best you get feedback from investors (probably angels, VCs and the start-up community) on what valuations are being accepted for your sort of venture. You could then assume that amount as the initial valuation.
In my business valuation article I describe this method as:
Fair Market Value = Earnings * Earnings Multiplier (OR Revenue * Revenue Multiplier)
Also known as the Comparative method. Using this method you find the earnings multiples of similar businesses, adjust for differences, and multiply by your earnings to arrive at fair market value.
The justification for using the approach is to not pay more for one business than a similar one down the road.
If the start-up has significant revenue then the market method can be used. SaaS companies are often valued this way on a revenue multiplier. The issue is finding business sufficiently similar given most transaction data will be for larger companies outside of New Zealand making this approach debatable for your much smaller company.
In the same article I describe this accepted version of this method "Discounted Cash Flow (DCF)" as:
Fair market value (or present value) = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k)n-1
The calculation requires assumptions that start to make a mockery of the suggested sophistication of the formula. Here’s what you would do:
- forecast cash flow (not EBITDA, include capex and working capital) over the next five (or ten) years
- add a figure called terminal value that calculates years 6+ (for the “perpetual” profits)
- discount the cash flow and terminal value by the appropriate year discount rate (that is set to equal weighted average of equity and debt, called WACC)
- add them together you have your business value.
But how accurate are your forecasts, and what rate do you use?
Forecasting is difficult for mature companies and, again, difficult and definitely debatable for your own company.
So these two normal valuation methods are contentious and likely unhelpful if you are an early-stage company. They also don't help with forecasting the dilution of an investor's ownership.
Dilution and Valuation
Firstly, some nomenclature on post vs pre-money:
- post-money is the valuation of the company after the VC has invested their money
- pre-money is the valuation of the company before the VC has invested their money
- post-money less investment equals pre-money
The post money valuation should also include any empolyee stock option pool (current and future) and assume all convertible notes are converted into shares. This protects "hidden dilution" of the VC investment.
If the VC is putting $2million (M) on a $10M post-money valuation then the VC will get 20% of shares.
An entrepreneur should probably assume that they will require multiple investment rounds, perhaps one every 12-36 months. Their share of the business is slowly diluted over time but they have a smaller share of a much larger pie.
The VC certainly assumes dilution and investment rounds. When they invest $2M now they will keep in reserve an amount to participate in the next funding round. That "follow-on" amount will hopefully ensure their share ownership percentage is not diluted. When the company is very successful and is sold or IPOed they will want to ensure they maximise their investment return.
A VC is investing in a portfolio of bets on various companies. It needs a few of those bets to be real winners, 10x their investment, that makes up for the losers (0x) or ordinary companies at 1-2x. They want to make sure they maximise their share of the 10x investment and will be looking for 15-30% of share ownership to ensure this. Follow-on investments help protect their share of the 10x investment and minimise the money put into 0x investments.
The investors in the VC fund are looking for a 3x return on the portfolio, the VC firm needs a successful investment to achieve 3x on the total fund in 5-10 years.
So they want and need a 10x return on their investment. If they have invested $2M then in 5-10 years they want to see a $20M return (ignoring any follow-on investments). If they retain their 20% that equates to $20M / 20% = $100M valuation on trade sale (or IPO).
Let's assume that mature Australasian SaaS companies have a revenue multiple of 4x (not real data) and use the market method above. This suggests that to achieve a $100M valuation they need to have $25M of revenue.
Can this company get to $25M in revenue? Is the market size big enough in Australasia and/or the UK...if not can they enter the US market or China or Europe? What do they need to build out, what are the customer acquisition channels and cost, who are the senior team members, have they done this before? The VC will ask lots of questions to try and understand how likely you'll achieve this sort of result.
Which brings us to milestones. The more you can show you hit sales and product development milestones the more confidence investors have in your team, the more confidence the less risk, the less risk the higher the valuation.
Remember you'll be doing several investment rounds before you sell or IPO. You aim to raise sufficient money to achieve key milestones by the next fundraising. Each time you can show you've achieved what you said you'd achieve you'll garner investor confidence.
Because you've provided that confidence and further derisked the company, the next round of financing after the current one will be at a higher valuation.
Key point: your equity raise in the current round should be sufficiently large to meet the milestones needed to drive the next round at a higher valuation.
If you don't achieve your milestones at the time of the future capital raising in 1-3 years time investors may regard risks as higher than before and you may face a lower valuation.
A lower valuation may stall your fundraising and employees will wonder what you're doing wrong. This is the key limit of your valuation. Everyone recognises the valuation as being an estimate, but a down round where the valuation of the current round is less than the previous round is a hard fact. A down round causes investors and employees to get nervous and not participate in future rounds or leave for a comply that has momentum.
Key point: don't aggressively overvalue your company in the current round or you may face a down round in the next round of financing.
The steps for valuing your new venture company are:
- How much cash do you need to achieve your milestones in the next funding round in 12-36 months? Probably requires a business plan.
- Calculate your share ownership. Include an employee option pool (10-15%) and assume any convertible notes are converted to shares.
- What valuation is acceptable to you in this round? This is probably based on your ownership dilution and the VC ownership target of 15-30% equity ownership.
- Check that the valuation is not too high—will you be able to get a higher valuation in the next funding round in 12-36 months if you achieve your milestones?
- Check that you have sufficient cash to achieve those future milestones.
- Discuss with your investors, they want you to succeed and remain motivated.
Not discussed but important terms to consider: option pool size, liquidation preference, and anti-dilution protection. Not to mention governance, vesting, drag along tag along, right of first refusal, pro-rata, preference shares, voting rights...and more. Valuation and share % is only part of understanding a VC term sheet.
Best of luck with your fundraising!