Most traditional corporate finance valuation methodologies do not work well for early-stage companies. Discounted cash flow (DCF) is an appropriate methodology for established companies that have a history of revenues and costs. Assumptions about market growth rates, market share, gross margins and other variables can be made to generate scenarios that will establish a valuation range. These assumptions cannot be accurately approximated for an early-stage company, which makes the results questionable.
Price/earnings (P/E) multiple is not appropriate, since most early-stage businesses are losing money. Price/sales (P/S) may be used if a company has generated some sales for a few years.
Most venture capital funds (VCs) investing in early-stage companies will use two valuation methodologies to establish the price they will pay for an investment:
- Recent comparable financings:The VC will identify similar companies, in sector and stage, as the investment opportunity. Several databases—including VentureSource, Venture Wire and VentureXpert —might provide information that establishes a valuation range for comparable companies. However, transactions that are more than two years old are not considered market. Although some information may not be public, many entrepreneurs and VCs know through word of mouth what the recent valuations have been for comparable companies.
- Potential value at exit:VCs and other investors have a good sense of a company’s exit value. The value can be based either on recent merger and acquisition (M&A) transactions in the sector or the valuation of similar public companies. Most early-stage investors look for 10 to 20 times the return on their investment (later-stage investors tend to look for 3 to 5 times the return) within two to five years.
- For example, assume an exit valuation of $100 million and the VC owns 20% of the company at the time of the exit. The VC would earn $20 million on their investment at exit. If the VC invested $1 million into the company, they would make 20 times their investment. If the VC owned 20% for a $1 million investment, then the post-money valuation of the company at the time of the initial investment was $5 million. As you can see, investors use the post-money valuation to estimate the price an investment must command when they exit or sell the company.
Investors will use these methodologies to set a valuation range. They will have a maximum valuation based on their view of the future valuation and the perceived competitiveness for the deal, but will try to keep the price they pay closer to the lower part of the range.