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Valuation of Pre-revenue Companies: The Venture Capital Method

William H. (Bill) Payne, Senior Program Consultant, Kauffman Foundation

In 1987, Professor William Sahlman of the Harvard Business School published a fifty-two page case study, "The Venture Capital Method," HBS Case # 9-288-006. In its most simple iteration, the method provides the following formula for calculating the post-money valuation of seed/start-up companies:

The formula is based on the following assumptions and definitions:

Simple iteration: This approach assumes that no more shares in the company will be issued after this round of funding, so the percentage of ownership of the investors will remain constant from investment to harvest. For high-growth companies, this assumption is unrealistic, but it's useful for illustrating the post-money valuation concept. In practice, such companies will likely require substantial additional cash to fund growth. Both debt (with warrants) and equity sources of cash will dilute founders and early investors alike. Building a management team requires providing option pools that often need to be refreshed. In the article "Seed- and Early-Stage Ventures" also available in the eVenturing Collection titled "Valuing Pre-revenue Companies," Luis Villalobos estimates that this dilution can reduce the return on investment by 3x to 5x.

Post-money valuation: The valuation of the company immediately after a round of investment is closed. The relationship between pre-money investment and post-money investment is as follows:

Pre-money valuation: The valuation of the company just before closing a new round of investment, including the value of the idea, the intellectual property, the assembled management team, and the opportunity.

Terminal value: The valuation of the company at exit; that is, the proceeds of the sale of the company via a merger or acquisition or an initial public offering and at which time the investors' ownership can be liquidated.

ROIn: The cash-on-cash return on investment expected for such an investment in the year of the harvest, or exit. This ROI is commonly expressed as a multiple of invested cash—that is, 10x, for example—regardless of the time since investment (n years).

Terminal Value

The valuation of an investor-funded company at exit in the nth year can be estimated by a variety of techniques. One common method is to (a) estimate revenues in the exit year; (b) use industry standards for earnings as a percentage of revenues; and (c) find price/earnings ratios for companies in the business vertical.

For example, 1) we estimate our target company can achieve revenues of $50 million in the exit year; 2) well-managed companies in this business segment typically earn 15 percent after-tax earnings; and 3) the market value for companies in this business is typically 12x earnings (a P/E ratio of 12). We can then calculate the terminal value in the nth year at $50 million x 15 percent x 12 = $90 million.

Another method for estimating terminal value is to use a multiple of annual revenues. Companies similar to the target company in the previous example might be selling for twice revenues in the nth year. The terminal value by this method, would be 2 x $50 million = $100 million.

These are only two of many methodologies for estimating terminal value. Careful investors often use a weighted average of multiple methods to calculate the estimated terminal value for the formula at the beginning of this article.

Anticipated Return on Investment (ROI)

My target ROI for investing in the first professional round of funding in a seed/start-up company is 30x. This number assumes the company has a first-time entrepreneur building a management team, a prototyped product, identified customers, some intellectual property as a competitive advantage, and no revenues. For companies that have met additional milestones, I might accept a lower ROI for calculating post-money valuation with Professor Sahlman's formula.

"Why so high?" some might ask. Isn't this really greedy? Not at all! Recall that Villalobos estimates investors in high-growth companies are likely to suffer 3x to 5x dilution between investment and exit. This dilution substantially reduces the eventual ROI at harvest. Even so, dilution is only part of the logic behind such a "high" anticipated ROI for seed/start-up investments.

Very early-stage investing is very high-risk investing. In a typical portfolio of ten companies, seed/start-up investors can expect three to five of those companies to fail completely: no return of capital; a total write-off. Another three or four will provide some return of capital or a small return on investment. Investors hope that these three or four companies will return all the invested capital of the original portfolio at exit. For harvesting the funding of seed/start-up companies, investors expect to achieve virtually all of their ROI beyond return of capital from one, or perhaps two, companies.

To provide an ROI for their portfolios that justifies the considerable risk involved in seed/start-up investing, the winners must be home runs yielding 10x to 50x invested capital. And since home runs are so rare, investors must make sure that all companies in their portfolios are sufficiently scaleable to potentially achieve these whopping returns. Expecting a 20x to 30x ROI in the simplified post-money valuation calculation is a necessity for successful seed/start-up investing.

Using the Simplified Venture Capital Metho 

So, if the terminal value of a company seeking seed/start-up capital is estimated to be $60 million and we assume the stage of the company is appropriate for investors to expect 30x ROI in year of harvest, then the post-money valuation of this company can be estimated at $2 million. If the required investment is $0.5 million, then the pre-money valuation would be $1.5 million. These calculations are shown in the following formulas:

Summary

For the past decade or so, the average pre-money valuations of seed venture capital deals have been between $1.5 million and $2 million. Furthermore, my experience is that typical pre-money valuations for seed/start-up companies are between $1 million and $3 million. Higher pre-money valuations can be justified based on experienced management teams that have more valuable intellectual property and that achieve more milestones than companies with lower pre-money valuations.

© 2007 Ewing Marion Kauffman Foundation. All rights reserved.

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