Venture firms valuation

Venture firms valuation

Understanding Valuation: A Venture Investor’s Perspective

You have met with several venture firms, responded to countless due diligence inquiries, and a strong lead investor is finally emerging with intent to submit a term sheet. Only one task remains—establishing a valuation.

At the core of every venture capital financing is a mutually accepted valuation of the company by investor and entrepreneur. A valuation reflects both the entrepreneur’s determination of the acceptable amount of ownership that may be given in return for the venture firm’s capital and expertise, and the venture investor’s determination of the risks and rewards of the investment. This dynamic is often misunderstood—and with harmful consequences.

Understanding valuation from the venture investor’s perspective is crucial. Realizing how valuations are determined and adjusted throughout the life of the company is critical to the investor-entrepreneur relationship and the ultimate success of the company. Valuation methodologies differ by the stage of investment and the availability of quantitative and qualitative data. However, the basic language and components of venture capital valuation is universal, simple, and should be well understood before you engage a discussion of valuation with a venture capital investor.

This article will explain how venture investors consider, construct and justify valuations of early stage companies, and will offer perspective on the dynamic role of valuation throughout the life of a company.

The Basic Math
Any private equity deal will focus on the “pre-money” valuation of the company. This is the estimated or notional value of the company as it stands prior to any purchase of equity. Determining the pre-money valuation of the company, combined with the amount of capital accepted by the company, determines the amount of equity ownership sold in exchange for capital. The resulting valuation after the investment of capital is called the “post-money” valuation. For example, in a company with a pre-money value of $5 million, a $5 million investment would buy a 50% ownership stake in the company.

  • Pre-Money Valuation + Invested Capital = Post-Money Valuation
  • Price per Share = Pre-Money Valuation / Pre-Money Shares

It is important not to focus just on the valuation negotiation. Just as important as the negotiation of the “pre-money” valuation is the entrepreneur’s decision of the amount of capital to accept, which is predicated on how efficiently the company will use capital.

Valuation Methods

Early stage investing is far from an exact science. Early-stage companies are often comprised of little more than an entrepreneur with an idea. Valuations at the “seed stage” are generally driven by factors that by their nature are subjective. These include appraisals of the CEO and management team, novelty of the value proposition, evaluation of intellectual property, expected time-to-market, expected path to profitability, estimated capital needs and burn rate, syndicate risk, sector volatility and deal structure. In post-seed investing, intermediate data points such as events demonstrating proof of principle and product validation will factor strongly in valuation determinations. As a company matures to a revenue stage, more quantifiable data is produced in the form of operating statistics and performance indicators. Actual results allow investors to more accurately model quarterly and annual revenue, EBITDA, cash burn, pipeline close rates, backlog, bookings and enterprise valuation.

Valuation by Stage

Financing Company Stage Data Risk/Uncertainty Value*
(MM)
Seed Incorporation; early development Soft data; value propositioned. Extremely high $1+
Series A Development Validation, time to market Very high $3+
Series B Shipping Product Prelim revenue High $7.5+
Series C+ Shipping Product Predictive revenue Moderate $10+
Later-stage/ Mezzanine Shipping Product, Profitable Hard data; EBITDA, net income Lower $20-50+
Based on 2003 market information.

Seed Financing: The seed financing will provide the capital needed to support salaries for founders/management, R&D, technology proof-of-concept, prototype development and testing,etc. Sources of capital may include personal funds, friends, and family and angel investors. Capital raised is limited due to its diluting impact at minimal valuations. The goal here is to assemble a talented team, achieve development milestones, proof of concept and anything else that will enable you to attract investors for your next financing.

Series A Financing: Typically the Series A is the company’s first institutional financing—led by one or more venture investors. Valuation of this round will reflect progress made with seed capital, the quality of the management team and other qualitative components. Generally, a Series A financing will purchase a 50% ownership stake. Typical goals of this financing are to continue progress on development, hire top talent, achieve value-creating milestones, further validate product, initiate business development efforts and attract investor interest in the next financing (at an increased valuation).

Series B Financing: The Series B is usually a larger financing than the Series A. At this point, we can assume development is complete and technology risk removed. Early revenue streams may be taking shape. Valuation is gauged on a blend of subjective and objective data—human capital, technical assets, IP, milestones achieved thus far, comparable company valuations, rationalized revenue forecasts. Goals of this financing may include operational development, scale-up, further product development, revenue traction and value creation for the next round of financing.

Series C Financing: The Series B may be a later-stage financing designed to strengthen the balance sheet, provide operating capital to achieve profitability, finance an acquisition, develop further products, or prepare the company for exit via IPO or acquisition. The company often has predictable revenue, backlog and EBITDA at this point, providing outside investors with a breadth of hard data points to justify valuation. Valuation metrics, such as multiples of revenue and EBITDA, from comparable public companies can be compiled and discounted to approximate value.

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