There is valuation & then there is VALUATION!

 

I had previously discussed valuation in terms of pre-money & post-money valuation during a deal and its bearing on % ownership among various share holders. The few millions of dollar question is, "how does one arrive upon a pre-money valuation that sets the tone for a deal". After all post-money valuation is simple; Post-money valuation = Pre-money valuation + investment. 

 

If you leave it completely to the founders; you would see high pre-money valuation due to need for minimizing founder dilution and often exuberant speculation of the target addressable markets (TAM). The investors on the other hand, do not want high pre-money valuations for two reasons:

 

• It decreases their ownership in the startup

• Excessively high pre-money valuation would decrease their return on investment at exit.

 

Let me use an example to explain: A company is expected to grow to $100 million at a future liquidity event, established by speculations on current TAM.

 

Scenario1: VC invests $1million at $10million post-money valuation. This amounts to 10% ownership. A liquidity event of $100 million valuation would yield  $10million to the VC. A return on investment (ROI) of 900%.

 

Scenario 2: VC invests $1 million at $20million post-money valuation. This amounts to 5% ownership. A liquidity event of $100 million valuation would yield $5 million to the VC. A ROI of 400%; a good return but still a significant difference from scenario 1. Scenario 1 makes LPs and GPs at the VC firm happier!!

 

The big question is, what are the factors that define if the company is worth $10 million or $20 million at that point in time.

 

Here are some thoughts on a quick method to arrive at that answer:

 

VC's expect very high return on investment when they invest in early stage startups. This is not because they are evil capitalists that they are often portrayed as. An investment in a public market index fund like Dow Jones or S&P 500 have annual returns around 10-15% on an average year. Higher returns may be achieved by more actively managing the investment portfolio consisting of public traded stock.

 

Startups are a combination of high risk ideas, often unprowen talent, unproven technology and unproven markets. In order to assume such significantly higher investing risks, the VCs justifiably expect a higher return. Typically they are looking for an annual return rate of between 40-100%. This is a large spread and the expected return rate is based on the risk profile of the investment. The risk profile may be characterized by factors like; stage of the investment, future funding requirements before the company is self-sustaining or can have a liquidity event, expected time to liquidity, capital required to get to liquidity, team makeup, team completeness, IP landscape. The list goes one. The bottom line being, if the startup is at an early stage, the investors will expect a higher return (closer to 100%). Later stage investors have lower risk exposure so the expected returns are lower (around 50%).

 

Simple Example:

To better understand valuations let us create a scenario of a founder and VC in midst of deal negotiations:

 

Founder: I need $1 million in this investment round at a $10 million post money valuation. Based on our projections I expect to have annual earnings of $10 million in 5 years. I also think my company would be worth $750 million at that time. If you invest in our company right now, you would have 10% ownership which would translate to 7400% ROI at the liquidity event, 5 years from. Isn't that an awesome deal!!!

 

VC:

VC goes back and analyzes data. The projections of $10 million per year earnings in 5 years is on the higher side. A more realistic number for this company would be $5 million per year 5 years from now. A very optimistic outlook would put their earnings at $8 million per year, 5 years from now.

 

The founder's year 5 projection of $10 million in earnings and a $750 million market cap brings the future P/E ratio for the company to 75. P/E or price to earnings ratio is a commonly used indicator to gauge market sentiment around a stock. A P/E ratio of 75 is large and may be an indication of entrepreneurs overvaluing the future value of the startup. If the company goes to IPO, there is a likelihood that the market may ease the valuation, affecting both the return and liquidity of the stock (demand for the stock may be curtailed upon IPO while the stock price reaches a more steady value).

 

In order to avoid inflated P/E ratios, the investor may look at one or more small to medium cap publicly traded companies that are primarily operating in the same market segment as the startup. The investor will observe the industry P/E ratio variations over time and project future trends. Let's assume these companies have a current P/E ratio of 10 and it is expected to grow to 15 in the next 5 years. This is a great indicator of future trend. The startup has a novel idea that adds value and whose IP is enforceable and protectable and for that reason it may be safe to project future P/E ratio (5 years from now) for this startup at 20.

 

Based on projected earnings of $8 million and P/E ratio of 20, the VC can calculate the market cap of the company, 5 years from now, to be $8million x 20 = $160 million. Not a bad valuation, but it is a lot lower than the $750 million valuation that was initially suggested by the founders.

 

Now we need to figure out how much a company worth $160 million, 5 years from now is worth today. Since this is a seed stage company, the VC is assuming a large risk and is expecting a large return rate. In this case, an annual return rate of 100%. Simple interest compounding principles are applied to compute the present value of the company.

 

Present Value = Future Value / ((1 + annual return rate)^ Time in years between future and present)

 

In this case Present Value = $5 million = $160 million / ((1+1)^5)

 

With a $ 5 million current valuation, the VC's $1 million investment to 20% ownership in the startup. If the liquidity event occurs in 5 years with a $160 million valuation and with no dilution of VCs initial investment (no additional investors, convertible debt or warrants), the VC's stake in the company would be worth $32 million at the exit event 5 years from now. This is a ROI of 3100% as opposed to the 7400% that was initially projected by the founders. Similarly, the VC's investment is getting them 20% ownership as opposed to a 10% for the same investment dollars.

 

The demonstrated method is one very simple method of computing current valuations. Things can get very complicated when one takes into account risk factors associated with the company, the market, the investors risk profiles and future funding rounds (and hence dilution); but this is a good starting point.