Valuing Early Stage Ventures — Methodologies and Challenges

When evaluating early stage ventures for investments, I often try (in vain) to peg an accurate value to the venture. Almost always, this ends up being more of an art than science. Despite this realization, Venture Capitalists look at various methods to arrive at an accurate valuation of the venture. In this post, lets us look at the commonly used valuation techniques for early stage companies, and more importantly the pitfalls of using each method. Goal is not to critique the use of these methods, but to highlight why these are only assistive at best, and nowhere close to deterministic.

Typically, Venture Capital investors use one or a combination of the below valuation techniques.

1. Relative Multiple based Valuation
2. Venture Capital (VC) Method
3. Discounted Cash Flow

In addition to these, early stage investors also rely on Option Pricing Model to estimate the value of early stage ventures, we can examine this method in a separate post.

Let us look at each of these valuation techniques in more detail.

1. Relative Multiple Method — This is one of the widely used, and probably the most misleading of all valuation techniques when used to value early stage ventures.

Firstly, early stage ventures are looking to differentiate themselves from competition basis a multitude of factors such as strength of founding team, product supremacy, string business model, innovative go to market strategies, etc. Using multiples of other companies (despite adjusting for stage, sector, etc.) does not adequately price-in these differentiating factors, which are probably the reasons why investors are attracted to the venture in the first place.

Secondly, early stage companies are loss making which means investors typically ascribe a multiple to revenue. Here lies one of the biggest flaws. If different companies have different revenue and margin profiles and hence different cash generation capabilities, does using a revenue multiple adequately capture the differences between the firms and help arrive at the right valuation? In all likelihood, the answer is no because when using multiple on profitability metrics (such as P/E, EV/EBITDA) we are accounting for the difference in margin profiles of different companies. Also, revenue based multiple is typically a derivative of enterprise value and revenue, and the enterprise value may as well have been arrived at using some other method with deal specific factors such as control premium, investor rights, downside protection, etc. influencing the valuation.

Thirdly, investors typically invest in companies basis forward looking projections. Given the myriad of external and firm-specific factors, early stage companies, more often than not, miss their projections rather than meet or exceed projections. If so, using public sources to arrive at multiples is likely to result in an incorrect (and most often an inflated) multiple, given that valuation remains the same but business financials are lower rather than anticipated (unless one is privy to the projections agreed between the investors and the venture).

Sample of projected vs achieved financials to illustrate the pitfalls of multiple based valuation

Consider a pre-money valuation of $150 Mn for an early stage venture basis these projections. The Y1 revenue multiple basis which investor has invested is 7.5X (150 Mn /20 Mn)

Now if a peer investor were to be using this deal to benchmark an investment basis, the derived revenue multiple from public sources would be 10X ($150 Mn / $15 Mn), since the revenue of $15 Mn in Y1 is what is available publicly and not $20 Mn of projections.

This difference in entry multiple between 7.5X and 10X can be signifiant enough to impact the IRR of the investment, especially if the future round investors realize (that prior rounds may have been overvalued) and adjust the valuation accordingly.

2. Venture Capital Method — VC method involves estimating the future value of the venture close to end of fund’s life (typically the exit value) and discounting the same using the required internal rate of return (IRR). The exit value is highly dependent on business projections and multiple used to value the firm. In addition to the uncertainty of projections and prevailing multiples for firms in the similar sector and/or business model (consider how re-rating or de-rating may impact exit value), accounting for dilution from future capital rounds is a challenge. A minor deviation between 20% to 25% of assumed dilution can significantly alter the IRR and overall economics of an investment. Despite the uncertainties, VC method is one of the most common back-of-the-envelope method used by VC’s when valuing early stage companies.

3. Discounted Cash Flow — Though commonly used for mature companies generating positive cash flow, early stage investors sometimes use Discounted Cash Flow (DCF) as one of the methods to arrive at a value for the venture. While the negative cash flow situation of early stage companies can be partly addressed using a two stage DCF model, it is likely that a significant contribution of overall value may be contributed by terminal value. Typically, high contribution of terminal value to overall value in DCF is an indication of uncertainty and riskiness of the venture. This coupled with other assumptions such as beta, future funding, cost of capital, risk premia, etc. means DCF is extremely sensitive to assumptions and may not lead you anywhere close to the true value of the venture.

Given the multitude of factors influencing the growth of an early stage venture, it is extremely challenging to assign a value (or a narrow range of values) for an investment. While there is no perfect answer to the conundrum, the trick lies in being aware of the pitfalls of various valuation methods and relying on the age old principle of ‘margin of safety’ when thinking of the price one is paying for these early stage ventures.