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Best method for valuing pre-revenue startup?


Topic Expert
Joan Varrone
Title: CFO
Company: Cloud Cruiser
LinkedIn Profile
(CFO, Cloud Cruiser) |

If you are asking this from a perpective of a pre money valuation for an investment round, then the answer is that the premoney valuation is a fall out from four items

1) Amount of money being raised
2) The percent of the company that the investor wants for the money raised
3) The size of the stock option pool
4) Is the pool formed before or after the investment.

John Herndon
Title: Senior Director of Revenue Recognition.
Company: WideOrbit
(Senior Director of Revenue Recognition., WideOrbit) |

There are many ways to calculate the value of of a company. Unfortunately, the only truly valid method would involve an analysis of revenue traction over time and overall profitability of the business model. The least reliable is to base a valuation on tangible assets, I would never buy a company or recommend a purchase based on something that could be purchased from secondary market sources at a cheaper value; there is no reason to do otherwise.

In conventional formal valuation circumstances, the organization would retain someone to perform a 409(a) valuation model that private companies use to substantiate the valuation basis of the company. Most public accounting firms can provide this service, in the Bay Area Moss Adams is a good firm to utilize or Armanino and McKenna.

The 409(a) valuation model utilizes several data inputs, generally speaking the following would be considered:

1. A five year forecast indicating major assumptions applied to each element (i.e., revenue growth, headcount addition or RIF, etc).

2. Updated CAP table showing, Common Stock, Preferred, Convertibles, Warrants, etc.

3. A DCF model based on the Net Free Cash Flow Model

4. Black Scholes Value Model (for calculation of call value needed inputs are strike price, risk free rate, etc)

Once the inputs have been determined, the model will provide an estimate of the intrinsic value of the firm.

DCF models are relatively straightforward and can be accomplished by someone who has done the work in prior situations.

Unfortunately you don't have time to go through and both learn and perform all that crap so your best bet is to go with #3. A DCF model based on the Net Free Cash Flow Model.

This is a complicated step by step process, certainly not found in 'Valuation for Dummies' or 'an Idiot's Guide to Valuation of a Company'. This is a sophisticated request, not a 'plug' type of problem. Developing a five year forecast takes time and involves significant assumption and analysis. Choosing the discount factor alone can cause you to cover ground that involves an understanding of statistical models, risk, etc.

As I stated, the most difficult aspect of this analysis is creating an objective model. There will be a big difference of opinion depending on which side of the table you sit. From the investor's side, you want the traditional 'buy for a little and sell for a lot'. From the owner's side there is too much ownership and separation anxiety from a company that is almost viewed as a child in that the owner raised it, nurtured and watched it grow from nothing to something.

The real tricky part of the strategy is, ' to get a motivated investor and an entrenched owner to compromise?'

The answer is to first define where the sticking point is, assuming talks can continue after the offer was made and rejected.

The second step is to create an understanding of the plan, if there really is such a thing, and how the owner was going to execute in that plan

The third step is to make a tranches investment offer. This involves offering a tiered incremental investment stream based on the owner executing to milestones correctly. Otherwise the original offer stands.

This strategy has some beautiful implications: First is to have the owner remain and observe their operating style and business practices; learning priceless information like difficult customers and how to handle them to subtle rules of thumb such as who are the most critical customers or which vendors are the key vendors.

Secondly, the observation process will provide the best indication on the owner's ability to execute.

Lastly, you get to see first hand exactly what type of leader the owner really is, which employees he goes to for fixing the worst in house situations, approach to problem solving, etc

The financial statement preparation steps are a very sexy part of the discussion. In fact it becomes a cornerstone to the company's inherent value assuming you have a developed product and revenue traction.

The financials have to be correct. Even though this may not seem like a priority it is actually a very critical step. Consider your company's long term strategy; if you are going for an entry into the US Equity markets you will need GAAP compliant financial statements. No underwriter in the US will touch your company until the financials have been audited and reviewed. If you are looking for an exit strategy, the valuation process will most certainly involve an analysis of comparable companies. In the very least the accounting methodology will be highly circumspect given how far the target company’s financials are from US GAAP. This can all be a very expensive lesson to learn, you can save time by having a level of GAAP knowledge when reading these statements before hand.

You don't use WACC as the discount rate for DCF in a valuation; this is not the common practice in VC, S-1 preparation, equity valuation using conventional 409(a) analysis, or IPO valuation through the underwriting process.

WACC is a metric used for internal project financing, in terms of application it evaluates the cost of funding a project or effort by the returns offered through Debt and Equity in the existing capital structure. It does not help nor is it appropriate when determining the value of a firm for an external equity event.

How can you determine the impact of an event based on the cost of an offering that by definition is not part of the capital structure yet? It is literally a catch 22.....chicken before the it what you will.

Valuation multiples are a means of expressing a dollar valuation of an asset or a technology in terms of a baseline. For example, the company was purchased 10x Net Assets (meaning the dollar value was 10 times the net asset value).

There is very little credible evidence to suggest this method as a means for valuing an entity or a technology. Conventional valuations such as a 409(a), a valuation performed by an underwriter or other DCF valuation would be performed with the intent of creating an ask, a bid or other tender offer.

Valuation multiples are used for comparative purposes only. In many respects, multiples are very similar to another type of comparative analysis called 'Common Size'.

Again, these are used for comparative purposes. No one buys an business based in 10X of net assets or other such nonsense. You can buy assets for pennies on the dollar, the real value is its Net Free Cash Flow.

Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

The responses so far have been great! However, I will say the politically incorrect thing...... (my apologies to the group)

It does not matter (valuation method), what matters is your investors' perception of your value. What matters is HOW YOU SELL AND DEFEND YOUR ASSUMPTIONS! You can use the most technically savvy/appropriate method, but if your investors question your assumptions, then it is all for naught.

Now, can that perception be influenced? Yes'Sure. For a pre revenue they say..."It is the assumptions, stupid!" (no, not directed at the poster....just want to make sure).


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