Valuing a company in Venture Investment
Valuation is the central task to be completed before a venture investor makes an investment. Because there is no active secondary market in the stocks of early-stage companies, valuation is a major challenge for both the investor and you.
Valuation of an early-stage business is extremely difficult because the company usually has no or a very limited operating history for revenues, expenses, and profits. Furthermore, early-stage businesses usually have limited assets, which put them in a different position than a well-established, existing business with physical assets whose value can be determined by well-defined formulas.
Elements in Valuing early stage business
Valuation of an early stage business is a highly subjective process with many elements.
The assessment must include:
- The experience, track record, commitment, and reliability of your management team
- The size and growth rate of the business’s market and the amount of market development required
- The nature of the business (manufacturing, service, or retail)
- The competitive position of the business’s product or service
- The nature of additional financing requirements and other investors’ responses
- The likelihood of an easy exit
Valuation is generally viewed very differently by you and the investor. From the investor’s standpoint, the lower the valuation, the lower the risk, and the greater the valuation, the higher the risk.
Obviously, investors want the lowest valuation in making investments. On the other hand, from your standpoint, the greater the valuation of the company, the lower the company’s cost of capital and the higher the total ultimate reward to you and your fellow owner/managers.
Consequently you want the highest valuation possible for the company when determining the share of equity the investor will receive. This difference in viewpoint and the subjective nature of valuation in early-stage investments can make achieving a satisfactory agreement on valuation very difficult.
KEY POINT: Entrepreneurs typically put great weight on the “sweat” equity (unpaid time and effort) they have put into the business. This perspective focuses on past investment. Investors typically look to the future and the likelihood they can recover their investment and also receive an attractive financial return.
Reality of Valuation – Risk vs Reward
The reality of valuation in a venture investment, particularly for early-stage ventures, is that the investors’ viewpoint wins because of the imbalance in the demand and supply of capital. In valuation, the perceived degree of risk is the critical variable.
The greater the perceived risk, the higher the expected rate of return, investors will demand to compensate for it. Because the rate of return is used to discount the venture’s projected income stream, the higher the perceived risk, the lower the valuation, and vice versa.
The valuation, in turn, translates into the percentage of the business that must be surrendered for a given sum of money. Therefore, the higher the perceived risk, the greater the percentage share of the business the entrepreneur must give up to get enough money.
Startup company is perceived as high risk
The earlier the company’s stage of development, the higher the perceived risk. A startup company is perceived as high risk, with investors requiring an expected return of 60 to 100 percent. A company with revenues and profits, but poor cash, is perceived as a medium risk, for which investors expect a return of between 30 and 50 percent.
A rapidly growing company with revenues, profits, and adequate cash is considered a lowrisk investment and will attract investors if it offers expected returns of 25 to 35 percent. These relationships suggest that negotiations about valuation will revolve around the projected future income of the company, the company’s actual record, and the likely liquidation scenario for the company.
Principles the govern valuation of a company
Reflecting the relationship between projected income streams and the discount rate applied and the relationship between estimated value and the percentage of a company that must be given up, three basic principals govern valuation.
To raise a given amount of capital:
1. The greater the expected value of a venture in the future, the smaller the percentage of a company required to be given up
2. The longer the track record of a new venture, the lower the perceived investment risk and therefore the smaller the percentage of a company that must be given up
3. The shorter the expected period until liquidation, the lower the perceived risk and the smaller the percentage of a company that must be given up
Truisms in a company valuation process
There are several truisms in the valuation process:
1. Investors usually do not share the enthusiasm for the enterprise the entrepreneur has and must be convinced of the merits of the opportunity.
2. Investors are risk-adverse.
3. Investors always discount projections when evaluating an investment proposal.
4. Most exits from early-stage investments come from the sale of the company, not from an initial public offering.
5. Computation of future valuation of the company is irrelevant if the company does not survive.
Consequently, in determining an acceptable valuation, rational investors always focus carefully on the likelihood of the venture’s survival.