You may be confronted with the need to value a startup way before the traditional methods of business appraisal can be applied directly. A young company can represent considerable value despite current lack of earnings, uncertainty surrounding its unproven intellectual property assets, and little comparative data on which to base your value conclusion.
Seasoned entrepreneurs and professional investors are well aware of this challenge and have come up with valuation techniques that capture the difference between early stage companies and their established counterparts.
One of the common methods used to value startups is known as the Venture Capital Valuation method. The method is essentially an adaptation of the income-based discounted cash flow technique.
However, there are significant differences between these two methods.
Venture capital (VC) investor valuations use the rate of return across the portfolio of investments. This is quite different from the typical discount rate that is specific to a particular business. Since many of the companies in the investor portfolio may not succeed, home runs must make up for losses.
In this sense, the rate of return in the VC valuation method is actually required by the investor, and not necessarily based on the company’s fundamentals as the discount rate is. From the investor’s perspective, companies that qualify for investment must meet the rate of return targets.
Hence, the typical required rates of return in VC valuations tend to be considerably higher than the discount rates for established companies. The return on investment (ROI) of 12 times over 5 years means the annual rate of return of about 65%. This is easily double that for an established company.
The VC valuation method demands the assessment of the future value of the business. There is no expectation of significant owner distributions until the investment is liquidated. In fact, venture backed startups are unlikely to pay dividends. If a portfolio company is able to distribute a portion of its earnings to the owners while maintaining its growth targets before harvest, this represents a value premium.
That future value, known as the terminal value, represents the estimate of the business selling price when the liquidity event, such as an initial public offering (IPO) or acquisition, occurs. The terminal value is essentially the capitalized value of expected business earnings at a point in time when the investors exit.
The post-money value of the company then is the present value of that expected selling price. It is calculated as the ratio of the terminal value divided by the ROI. This is pretty much the discounted cash flow math minus the discrete cash flow part.
One of the key questions VC investors have is the percentage of ownership interest acquired for a given amount of money. This gives rise to the so-called pre-money and post-money valuations, concepts unique to venture backed company valuations.
Dilution is a real risk for early stage investors and translates into lower company valuations. This is not a factor when valuing privately owned companies that grow organically.