How Should You Value an Early Stage Company?

Investors should try to use a range of methods to validate what is a reasonable valuation. The only certainty in any valuation is that it will be wrong, in hindsight either too high or too low.

Valuing any business is an art not a science, with a lot of room for personal interpretation. There are a number of valuation approaches that investors can use. The best advice is to cross-check several before determining what is or not a reasonable valuation. My own approach:

Value invested to date
Although this is probably the crudest approach, it is interesting to understand how much has been invested to date to get the company to its current position. This should include both cash and an allowance for time (sweat equity). This ‘replacement’ cost can then be adjusted for the following:

• What are the barriers to entry for competitors, such as intellectual property rights?
• How long would it take a competitor to replicate the opportunity?
• Has the investment to date been 100% effective? If money invested is going down the wrong path, the opportunity should be excluded.
• What is a reasonable return on the investment, given the risks taken by the entrepreneur and investors?

The last funding round
If the company has raised money before, what was the valuation at that time? What has the company achieved with that investment to change the underlying value? How has the company performed against the business plan that secured those funds? A word of caution: although the earlier valuation is a starting point, do not necessarily accept it was correct.

Potential valuation
The two earlier approaches are backward-looking and are more useful as a reality check; the value of any business is in the future. My next approach is to try to forecast a value at some point in the future, then discount that back to a value today. Consider:

• If a company is projecting to raise further funding, focus on when that will need to happen.
• A potential liquidity event, such as sale of the business or stock exchange listing.
• A time when the company reaches a more ‘normal’ state of growth.
• The end of the financial forecast period.

You need to consider who the next investor or buyer will be and consider how they will value the business. Then this value is discounted to today’s value taking into account:

• The returns being sought by the investor.
• The timeframe from investing to this liquidity event.
• Dilution that may occur during that time period for subsequent funding rounds.

Market comparisons
The final approach is to look at market comparable transactions. This is obviously more difficult for early stage transactions as there is less public data available and many of the businesses are unique. The New Zealand Venture Investment Fund has released data on its website on a range of valuations for the companies they have invested in, broken down by sector and stage of business.

What a number of entrepreneurs will do is try to point to other company valuations if they are favourable. Two points to remember: comparing international valuations to New Zealand’s is not valid unless the company is raising money internationally and, often in angel and VC deals, the investors have good protection against companies not delivering on the valuation. This allows ‘inflated’ valuations to be reported and is not directly comparable to a straight equity investment.

To read the full article, please click here.