Valuation of Early-Stage Companies – Part I – Introduction

INTRODUCTION

Entrepreneurs at any point in time are always asking the question “How much is my new venture or company worth?” especially so when a next round of funding is being considered.

Why is the determination of value so important to an entrepreneur-founder?

Of course, the answer is simply that the value of an enterprise at any point of time prior to an investment (e.g., pre-money value) is a principal determinant of how much founder equity must be given away to secure the next round of investment.

Two simple relationships capture the importance of pre-money value and should be embedded in an entrepreneur’s mind:

Post-money value = Pre-money value + external investment made

Investor equity = external investment/Post-money value

WHAT IS AN EARLY-STAGE VENTURE?

There can be differences of opinion amongst professional investors on how to define the developmental stages of a company. Herein, I offer my own, generally accepted, definitions.

A pre-seed developmental stage new venture has not raised money except for some relatively minor amounts from its potential founder(s). Those involved, typically only founders and key management persons, are simply doing their initial due diligence, perhaps filing provisional patent applications, researching the markets, and thinking about products and services.

A seed stage new venture has evolved to the point where the founders realize they will need investment to move the company forward, the amounts to be raised are relatively small and the sources are typically the founders themselves, friends and family, and perhaps select professional angels. The company is fully formed with corporate and patent attorneys, corporate filings, and formal processes (i.e., board meetings, minutes, etc.). Funding goes towards initial products, testing the target markets, and resolving issues standing in the way of formal entry into the marketplace.

The startup stage for a company requires more substantial investment and allows the company to manufacture and sell goods and services intended to product profit. The goals at this stage are many but principally to increase customers, sales, and revenue as quickly as possible. In brief, they are in the marketplace and competing. At this stage it is presumed that the principal risk remaining to the success of the new venture is that of execution; that is, the company’s plans simply don’t lead to the success intended.

The use of the term early-stage may be applied to each of these developmental stages and also to more mature companies that have more significant revenue, sales, and customers but are still pre-profit.

BASIC APPROACH TO VALUING AN EARLY-STAGE COMPANY

When an enterprise has revenue and profit from sales and historical financial data are available, investment bankers have a relatively easy task to estimate pre-money value following accepted financial principles and standards.

However, the determination of value for an early-stage company is a slippery slope because the projections of revenue, sales, expenses, and profit are, by necessity, speculative and subject to differences in opinion between entrepreneur and investor. The more the company is developed (closer to profitability) the less the complexities of valuation and disputes amongst entrepreneurs and investors.

From an entrepreneur’s perspective there are four important elements (discussed in subsequent parts) to valuation:

1. Substantiation of Sales Projections—Part II
2. Financial model, projections, and discounting to NPV—Part II
3. Use of an entrepreneurial scorecard to arrive at a realistic valuation—Part IV
4. Negotiating to determine value—Part V

The first two elements discussed in Part II and Part III require the research and collection of relevant data and the development of assumptions that are well thought out and can withstand scrutiny from others (e.g., investors). The subsequent reductions by the entrepreneur to secure an idea of pre-money value (NPV) based on projections of sales, revenue, expenses, and profit should be as robust as practical and thus more able to withstand criticism by investors.

As will be shown in Part IV, deriving a realistic pre-money value is also based on the actual state of development of the new venture. What constitutes realistic can be argued but the use of a entrepreneurial scorecard can considerably aid the process.

Entrepreneurs and investors will independently arrive at their own opinions of pre-money value and amount required for investment to achieve agreed-upon goals. Guidance for how to conduct the necessary negotiations are discussed in Part V.

Each of the four subsequent articles of this series provides specific actionable along with the details of HOW to accomplish the task at hand.

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Rocky Richard Arnold provides strategic corporate and capital acquisition advice to early-stage companies founded by entrepreneurs wishing to successfully commercialize high-value-creation opportunities, ideas, and/or technologies. More information about Rocky can be found at www.rockyrichardarnold.com. His book, The Smart Entrepreneur: The book investors don’t want you to read, is available for purchase on Amazon at http://tinyurl.com/pv248qq. Financial software for use by startups can be purchased on Amazon at http://www.amazon.com/gp/product/B00K2KPSI2. He posts articles about entrepreneurship on his blog at http://thesmartentrepreneur.blogspot.com. Connect with Rocky on Twitter @Rocky_R_Arnold; Facebook at www.facebook.com/rocky.r.arnold; Google+ at www.google.com/+RockyArnold01.