Thursday, February 19, 2015

Valuation of Early-Stage Companies – Part III – Net Present Value

Prior to engaging in negotiations with interested investors, founders and their executive management team need to have developed a keen understanding of how a new venture is valued and what is a reasonable value for them to expect for their new venture.

In the prior article (Part II) the key aspect of sales projection and their veracity was discussed. Combining sales projections and revenue with operating expense and the costs of manufacturing and delivery of product and services enables a complete set of integrated financial statements to be developed. This article presumes that these statements have been completed and are available. Furthermore, it is understood at this point in the valuation analysis (Part III) that these financials implicitly presume that execution is perfect and the team can overcome all problems. Valuation in the face of imperfect situations and developmental stage is considered in the subsequent article (Part IV).


When considering cash flows that vary over time, perhaps even changing from negative to positive and back again, the term net present value (NPV) is used to account for the variability of cash flows.

A well-known expression for future value, FV, and its relationship to present value, PV, and interest rate (i), is:

FV = PV × (1+ i)^n

where n is the number of periods corresponding to the interest or discount rate, i. As an example, for an interest rate of 10% per year for five years (n=5) and a PV of $100, then FV = $100 × 1.61, or $161.

When it is desired to determine the present value of a future cash flow the interest rate is referred to as the discount rate; thus for a future value of $161 and with a discount rate of 10% over five years, the present value is $100.

NPV is a perfectly fine method of determining value in the present day provided all the underlying assumptions are accurate. Established enterprises can depend on their record of sales and thereby construct a reasonable financial extrapolation to the future. Less established companies, however, have to make assumptions about sales and expenses that become increasingly problematical as sales history decreases. Pre-revenue companies have the most difficult task and secure the highest discount rates as a result.

Discounted cash flow (DCF) analysis is a concept used in financing to account for the value of future cash flows derived from investments in equipment, business, mortgage contracts, bonds, dividends, etc. DCF analysis is also used frequently to evaluate and discriminate among different potential projects, each with its own set of unique investments and returns. Its adaptation to the valuation of start-up ventures, while straightforward, does have its limitations, as will be explained. However, understanding DCF analysis is important to an entrepreneur because it provides one method of new venture valuation that is quantitative and based on logical financial principles.


A further example of DCF analysis is provided in 1. A series of free cash flows for Years one through five is shown. The PV for each year of free cash flow is determined using the formula above and then summed. The discount rate of 27% provides an NPV of zero. Other choices of the discount rate, either lower or higher, would provide an NPV that is either higher or lower. When the discount rate is chosen so as to produce an NPV of zero, the discount rate is called the internal rate of return (IRR), a common term used by professional investors to measure fund performance. The rate of 27%, while an example[2], is a common goal for a portfolio of investments by angels and venture capital firms; of course, some investee companies may be successful, while many others may have failed in varying degrees.

Table 1 Discounted Cash Flow and Net Present Value


Omitted from the analysis of Table 1 is the terminal value of the investment or enterprise. Terminal value, also called residual value or continuing value, is the value of the enterprise in the years subsequent to an end period of time (often an exit for professional investors). The residual value recognizes that the enterprise will continue to generate cash flow of benefit to other parties beyond investors.

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[3] 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.

Fortunately, 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.

The terminal value is discounted to the present day as shown in Table 2. The discount rate of 50% is more typically applied by a venture capital firm to an individual investee company with outstanding prospects. It is immediately obvious that determination of the terminal value is a critical aspect for the pre-money valuation of a pre-revenue opportunity.

As observed in Table 2, the NPV of the new venture is $1.12 million. Given that an investment of $550,000[4] is made, the investor ownership (in the absence of any dilution complexities from subsequent rounds of investment) would be 33% ($550,000/$1,673,000)[5]. In this example, the value of assets (e.g., equipment, facilities, and cash) is not included in the valuation, though it would be in an actual situation, especially if the cash component is large.

Table 2 Discounted Cash Flow and Terminal Value

The presumed accuracy of the DCF analysis is dependent upon the accuracy of the free-cash-flow assumptions that drive the calculations (along with the discount rate, of course). In the case of a new venture, inattention to the sensitivity of the calculation of NPV (e.g., new venture pre-money value) can lead to misleading conclusions about the pre-money value of the opportunity. It should also be remembered that the terminal value of the enterprise is a major component of the NPV of the new venture, notwithstanding the intermediate positive cash flows.

Opportunities that are slow to develop positive cash flows are disadvantaged by the lower out-years of positive cash flow. That is why “time-to-revenue” and revenue growth rate are so important to both entrepreneurs and investors.


DCF is often used to conduct sensitivity analysis for various sales and expense scenarios. DCF is also used in conjunction with other methods to guesstimate the value of a pre-revenue company, as will be explained in the next article (Part IV).  Financial analysis can be extremely complex when issues of equipment, salvage value, good will, and other factors are considered.  These issues are not typically a part of new venture valuation except in unusual situations. Furthermore, experienced professional investors and experts in financial analysis and valuation often rely upon sophisticated spreadsheets and tables to arrive at risk adjusted conclusions. .  For the new venture considered herein these complexities are not pertinent.

There are critics among professional investors in regard to using DCF methods for pre-revenue companies. This is especially true with the entrepreneur has not taken account of the development stage of the company. Professional investors also have many rules of thumb and may examine a number of different valuation methods in an attempt to “range” the new enterprise’s value in preparation for a final decision and offer.


Entrepreneurs should understand the important concepts of NPV, DCF, and terminal value so that subsequent and eventual discussions with investors are adroitly managed.

The next article (Part IV) takes the somewhat theoretical concepts of this article to the real world where a particular new venture's developmental process and important risk factors are incorporated into a realistic valuation at least from an entrepreneur's perspective.



[1] Free cash flow is a financial term that is generally determined by adding depreciation and amortization to the earnings and subtracting changes to working capital and capital expenditures.

[2] Implicit in this example is that the investor not only makes an investment (not shown) to cover the negative cash flows in years one and two, but receives all the subsequent positive cash flows. In real situations, the positive cash flows would be used to expand the business, provide dividends to investors, and other beneficial activities. The investor is rewarded upon exit at a future date.

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

[4] Sum of negative free cash flows in years one and two.

[5] In this example, the enterprise retains the positive cash flows, and the investor who has waited five years for a return garners 49% of the terminal value, which is assumed to occur from a sale of the investors’ interest in the company.


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 His book, The Smart Entrepreneur: The book investors don’t want you to read, is available for purchase on Amazon at Financial software for use by startups can be purchased on Amazon at He posts articles about entrepreneurship on his blog at Connect with Rocky on Twitter @Rocky_R_Arnold; Facebook at; Google+ at

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