Valuation of Early-Stage Companies -- Part IV – Entrepreneurial Scorecard

INTRODUCTION

It should be appreciated by an entrepreneur that investors have to go through their internal processes before they can arrive at a decision to (1) become involved with the opportunity and its leaders, (2) have an opinion on pre-money valuation, and (3) determine the required investment. Investors typically arrive at a proposed valuation without fully disclosing the methods and processes they have used.

Nevertheless, entrepreneurs are well-served by doing their own assessment of new venture value before serious negotiations are considered. In this article, a method for an entrepreneurial computation of pre-money valuation is presented--it is based on four critical factors.

FACTORS AFFECTING PRE-MONEY VALUATION

Presuming that the opportunity is attractive to the investor, for whatever reason, and that marketing and sales plan (MSP), financial plan (FP), and business plan (BP) are reasonably thought out and in order, what the entrepreneur must consider are four quantitative factors central to valuation:

1. Discount rate based on the investor's goal return on cash.
2. Expected free cash flow (or net profit or EBITDA) at investor exit.
3. Terminal value based on the expected cash flow and a P/E ratio (or revenue multiplier)
4. Entrepreneurial Scorecard value (R). 

Discount Rate


The discount rate can be problematic, as investors will have their own notions about risk and return. Provided in Table 2 are computations of IRR for a range of return multiples and years. The darkened areas correspond to IRRs that are not practical for either the entrepreneur or the investor, leaving the bolded numbers and non-highlighted areas as the typical range that can find their way into calculations and discussions. All other factors being equal, lower IRRs are associated with opportunities perceived to have less risk, and higher IRRs go along with higher perceived risk.

Table 2 IRR for a Range of Investment Multiples and Years

Figure 1 shows the relationship among pre-money valuation, investment sought, and discount rate. An entrepreneur's knowledge (or least opinion) of pre-money valuation and required investment can be correlated to the discount rate that would satisfy those financial goals (e.g., investment and valuation). A bit of study of Figure 1 illustrates how the discount rate chosen by an investor dramatically affects founder equity.

For instance, if the entrepreneur estimated pre-money valuation at $3.5 million and the required investment is $2.0 million, the discount rate would be 40%. The underlying equation of the figure is simply:

Pre-money valuation = (1/Discount Rate – 1) × Investment Sought

Figure 1 Investment, Valuation, and Discount Rate

Expected Free Cash Flow

The expected free cash flow (or net profit or EBITDA) is secured from the company's integrated financial statements after proper account is made for sales projections, operating expenses, product cost of goods, etc. Generally, the free cash flow used corresponds to the presumed exit year for the investor(s).

Terminal Value

As a new venture will experience the largest amount of free cash flow in its “out-years,” the issue of terminal value and how it is calculated is very important. Over a five-year time period of interest[1] maintained by a professional investor, the fact that a funded venture may also have rapidly increasing rates of growth during the out-years also has a big influence on the terminal value of the enterprise.

As explained in Part III, there is a conceptually easy way to compute the terminal value of an enterprise: by taking the free cash flow (a.k.a. earnings) in the terminal year and multiplying by an assumed price-to-earnings (P/E) ratio. The assumed P/E ratio is based on comparables from public companies in the same or similar business and adjusted for various competitive and economic factors. For instance, if the free-cash-flow earnings of a new enterprise is projected at $800,000 per year in year five and the P/E for the companies that compete in the market and/or industry was 12, then the enterprise value is estimated at $9.6 million in year five. This scenario presumes the new enterprise becomes public.

Entrepreneurial Scorecard Value

With an established set of financial projections based on well-thought-out sales projections (see Part II of this series), the calculation of the NPV of a new venture is straightforward using the DCF method (Part III). The use of DCF and a supportable estimate of terminal value (at presumed investor exit) provides a defensible and credible valuation for the new venture IF a proper account is made for the developmental stage of the company. This is accomplished with the use of an entrepreneurial scorecard.

An entrepreneurial scorecard is a method an entrepreneur can use to adjust or estimate the value of a new venture based on an assessment of specific metrics that measure in some sense the degree to which the new venture has been developed.

A realistic pre-money value for a new venture can be computed from; for instance, the following simple relationship:

Realistic Pre-money value = maximum plausible NPV (Part III) × R

where R is a factor which accounts for all the important developmental metrics for an early-stage company as illustrated in Table 1 below.

Table 1 Entrepreneurial Scorecard

Thus, for example, if the entrepreneur scored the current status of the new venture at 68% (R = 0.68), with an NPV of $6.15 million, then the presumed realistic pre-money valuation would be 0.68 × $6 million, or $4.18 million.

This scorecard[2] identifies seven criteria for purposes of self-evaluation. The three columns in the center show three stages of development for a new venture—that is, pre-seed, seed, and start-up. A description for each stage is provided along with a range of numerical scores. The last column is for the entrepreneur to enter a score (independent of the developmental stage) reflective of his/her opinion about that criterion for the current state of the new venture or formed company. The score for each criterion is then totaled at the bottom of the form.

In using the entrepreneurial scorecard, the criteria need to be evaluated with intellectual honesty. The following guidance is provided.

1. Sales substantiation. As the new venture is presumed to be pre-revenue, sales substantiation is based on the quality of the MSP and the particulars of the strategic and tactical elements. A credible sales plan should at least describe the target markets with some precision, show a good understanding of the product benefits and unique selling proposition, and define the sales channels and tactical elements of the sales plan. For the start-up stage, the MSP must address all strategic and tactical elements with precision, and reductions from a maximum score would occur if there is no evidence of sales likelihood—as may be true if there is no focus group evaluation, no presales, and otherwise no anecdotal evidence of future sales.
2. Patent protection. An assignment of six points per granted patent is appropriate, up to a maximum of twelve points. Patent applications made would rate four points per application, up to a maximum of eight points. Provisional patent applications would be rated at two points per application, up to a maximum of four points. Fifteen points would be earned for an assembly of patent positions that could constitute an initial portfolio.
3. CEO leader. If the CEO or nominal current leader has no prior experience but has other significant skills (perhaps experience in the industry with high academic credentials) she/he would garner four points. For a very talented CEO with little experience but some experience with other start-ups, as many as eight points is allowed. The best situation is a CEO with a lot of experience in a senior leadership position (ten points) or one who has taken a company public or to investor exit successfully (fifteen points).
4. Executive team retention. One key person could correspond to the CEO, CMO, CSO, or CFO—whoever is presumed to be the visionary leader. Retention implies that the executive person is with the start-up already. As with the CEO ranking, executive leaders with more experience receive higher points. If the board of directors contains members of prominence and success, some points could be added for the board in addition to the points of the executive management team.
5. Product-market match. If the product and market match has no substantiation other than that of the founders’ opinions, then up to four points can be allocated. However, if there is some proof, as from focus groups, then up to eight points can be earned. If the product-market match is proven though focus groups, initial sales, and other evidence of a good match, then up to ten points can be earned.
6. Strategies, FP and BP. If the FP and BP are not complete or obviously flawed, then a maximum score of four points is allowed. A credible FP has a full set of integrated financial spreadsheets, and a credible BP is one that has all important factors at least identified and discussed. Credible plans are lacking only in the degree of precision that normally would be expected by a professional investor, but they would still be adequate for non-professional investors. An “excellent” score would be based on a totally integrated set of MSP, FP, and BPs.
7. Other risk factors. This category allows the entrepreneur to assess perceived risks with one or more factors: markets, product, technology, manufacturing, and sales channel. It would be expected that a new venture may have already formed ideas as to where there are issues that will hinder their forward progress and thus represent either current or future obstacles. It would be unusual to experience maximum scores for any stage of development.

SUMMARY

Valuing your new venture, at whatever stage, requires a disciplined approach and involves two factors under your control: Projections of expected free cash flow and the entrepreneurial scorecard. Two other important factors, the discount factor to be used and the terminal value, are used by investors to "adjust" their perceptions or risk and reward. The entrepreneur, you, must be prepared to not only provide data and opinions to investors, but also negotiate to achieve a fair pre-money valuation. More on the issue of negotiation in the next and final article (Part V).

Footnotes

[1] A five-year time frame has been chosen. Typical investor exits are five to eight years.

[2] This scorecard is solely the author’s.

***

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.