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Nuances of Early and Late Stage Company Valuation

On the art vs. science scale for private market investing, if late stage buyout is science heavy (#DCFs&LBOs4Life), early stage VC valuation is very artsy. Why so? The answer is simple: time & data availability.

A company headed for a traditional growth equity round (typically Series B+) or an exit usually has years of financial performance data under its belt that can be utilized to: 1/ conduct rigorous historical financial analysis and 2/ create robust financial forecasts, empowering the landing of an intrinsic valuation via a discounted cash flow analysis (DCF).

A company seeking venture capital is likely in its first few years of business with a comparatively limited historical data set. As a result, investors at this stage need to make more assumptions, mental leaps, and bets that are not strictly based on financial data. With that said, no matter the stage of business, all valuation requires a good dosage of art because forecasting is artistic. And for those who have never heard the expression ‘art vs. science’ …. science = certainty, factual … art = subjective, judgmental

The fundamental methodology for valuation is discounted cash flow analysis. We won’t spend a ton of time explaining the DCF because it is quite unsuitable for venture capital valuation (we will explain why). In fact, if you’re reading this with an early stage hat on, do not stress at all about comprehending the DCF explanation to follow.

Click here to skip the below excerpt on DCF

Creating a DCF entails:

1) Projecting the future cash flows of a business (typically 5-10 years out + a terminal year cash flow that captures the estimated cash flow in the final year of the forecast period, representing the present value of all future cash flows beyond that point). Finance 101 but remember, cash flows do not = Net Income. In short, we must consider how CAPEX investments will affect cash outflows and the timing of collecting cash from customers and disbursing cash to vendors for services (aka working capital) in addition to adding back non-cash expenses such as D&A.

2) Discounting the cash flows by a discount rate (usually called a WACC), to account for the time value of money, and landing on the net present value of the cash flows, equating to a valuation (aka enterprise value). The simple way to think about the discount rate is that is that it is the opportunity cost for a fund’s investment – if I could earn 15% elsewhere, then that should be the discount rate. With that said, there is an entire formulaic playbook to derive WACC.

The key word as you may have noticed is 💸 cash flow. Businesses seeking venture capital dollars typically have a minimal history of generating cash flow (hence why VC exists: to help fund the cash burn of early stage startups in hopes that these businesses will generate massive robust cash flows long term). Again, it ties back to the lack of time (often takes years to become cash flow generative) and data availability.

Attempting to forecast cash flow into the future for an early stage company (that isn’t cash flow generative) is very challenging and largely a waste of energy. “We can make the excel say whatever we want.” Early stage ventures have too much of their value weighed in the terminal value, making the DCF rather useless. Even many of the most mature companies see material fluctuations in generated cash flows each year, so the DCF method is certainly not bulletproof even for late stage businesses (hence ‘all valuation involves art’); however, more predictable cash flows based on a longer history makes mature businesses a superior candidate for the DCF.  

Basic Venture Capital Valuation Terms

In today’s overview we will talk about a few commonly used methods for valuation in early stage venture capital:

1) Comparable Company Analysis

2) The VC Method (aka what you have to believe #WYHTB)

3)  Discounted Cash Flow Analysis - discussed ✅ 

Before we dive into valuation methodologies, there are a few essential fundamental VC terms to understand. These terms form simple mathematical equations with each other that often drive what a cap table will look like pre and post-financing.

Pre-Money Valuation (P_M): what the investor is valuing the company at TODAY, prior to the investment

Round Size or Investment Amount (R): how much capital the founder is raising for the financing

Post-Money Valuation (P_O): Pre-Money Valuation + Investment Amount

Price Per Share (PPS): the cost of acquiring a share of the company, typically determined by dividing pre-money valuation by fully diluted shares outstanding prior to close of financing

Ownership (O): the % of a company a shareholder possesses prior to or post-closing of a financing

Employee Option Pool (EOP): stock that is reserved for existing and future employees to compensate, retain, and motivate workforce

Dilution (D): a reduction in your percentage ownership as the company sells equity to investors

We will talk more about dilution in future posts and how it also relates to EOPs and the conversion of outstanding SAFEs and convertible notes.

Fully Diluted Shares Outstanding (FDSO): total shares of stock outstanding; when determining the price per share, generally all outstanding and as-converted stock will be used in the calculation, including company stock held by any party and any rights for a party to acquire stock of the company in the future (warrants, SAFEs, convertible notes, granted/available shares in the EOP)

Daniel’s Check Size (D): for the sake of the equation below, we’ll call Daniel’s check size: D

Up Round: when the pre-money valuation of a future financing is higher than the post-money valuation of the prior financing; often seen as a positive sign for the company

Down Round: when the pre-money valuation of a future financing is lower than the post-money valuation of the prior financing; often seen as a negative sign for the company

Venture Captital Valuation Equations:

(1) P_M + R = P_O ➡️ the pre-money valuation plus the round size = the post-money valuation

(2) P_O – R = P_M ➡️ the post-money valuation minus the round size = the pre-money valuation

(3) P_M / FDSO = PPS ➡️ the pre-money valuation divided by fully diluted shares outstanding = price per share

(4) R / P_O = O ➡️ round size divided by the post-money valuation is the amount of ownership acquired in a financing by participating investors

(5) D / P_O = Daniel’s O ➡️ Daniel’s investment divided by the post-money valuation is the amount of ownership Daniel is acquiring in a financing

All these equations can be intuitively re-arranged.  

Pre-Money vs. Post-Money Valuation Impact

⚠️ IMPORTANT: knowing the difference between pre-money and post-money.

A deal pinned on a pre-money valuation vs. a post-money valuation can have huge implications for ownership/dilution. For example, if a VC group wants to invest $3M at a $10M valuation, a $10M pre-money valuation would equate to acquiring 23% of the company but a $10M post-money valuation would equate to acquiring 30% of the company… a 7% difference when you replace the word pre with post…

$10 pre-money example:

$10M (the P_M) + $3M (the R) = $13M (the P_O) AND $3M (the R) / $13M (the P_O) = 23% (the O)

$10 post-money example:

$3M (the R) / $10M (the P_O) = 30% (the O) ➡️ 7% more ownership taken by investor!

Many VCs provide for term sheets with a pre-money valuation and an assumed post-money valuation (depending on round size). Daniel and many other VCs anchor term sheets on post-money valuations to ensure ownership is precisely defined. If a round size (R) isn’t 100% defined (not abnormal as it’s hard to know exactly how much a founder is going to be able to raise), anchoring on a pre-money valuation doesn’t provide certainty on how much ownership an investor will have in a company post-financing ➡️ a shifting R would shift P_O since P_O = P_M + R … and if we have uncertainty surrounding R and P_O then we also have uncertainty on our projected O since O = R / P_O. This problem is solved for a VC by anchoring a deal on a post-money valuation. If we apply our investment to a defined post-money valuation, we can determine our projected ownership precisely.

Now let’s see how these terms and equations work in practice with a cap table simulation!

Cap Table Simulation - Watch Video

Valuation Methodologies:

Now that we’ve covered cap table basics, let’s discuss the art of valuation in early stage VC. From our perspective, venture capital valuation methodologies serve to help VCs land on an initial number that then gets adjusted based off the findings uncovered after completion of the diligence process and negotiation with the founder. Lead investors (often the investor with the biggest check who is likely to take a board seat) typically set valuations with follow-on investors agreeing to the set terms. We will discuss SAFEs and Convertible Note dynamics in more detail in future issues; however, it’s important to note that the valuation or price per share of a startup is not technically defined unless the transaction occurring is in the form of a priced round. 

Startups are fundamentally difficult to value. First, as mentioned, since profits occur well into the future, cash flows are difficult to forecast. Secondly, startups tend to raise funding multiple times using a variety of complicated contracts during their life cycle. Forecasting what each raise will look like is nearly impossible. Due to such complexity, VCs use various rules of thumb and simplified versions of traditional methodologies.

The two most common valuation approaches that we’ve come across are comparable company analysis (comp analysis) and the VC valuation method.

Comparable Company Analysis: if you’ve worked in M&A or valuation-related work in some capacity, you are likely familiar with comp analysis. While the VC valuation method entails looking at the future and working your way back to the present, comp analysis generally entails looking at the past (hopefully recent past) as a guide for the present.

In executing comp analysis, our goal is to find companies that have transacted in the past that are comparable to the company that we are valuing. In general, we at least want to look at companies that are in the same category. A dream “comp” shares not only a similar category focus, but also a similar business model, growth rate / profitability level, channel split, etc. Comps can come in the form of private transactions (that you somehow grab access to – maybe you text your banker friends), public transactions, or public companies based off where they are trading today (in which case the comp is classified as a comparable company as opposed to a comparable transaction). In early stage VC, we typically are looking for comparable transactions as it’s impossible to know at what valuation a private asset is trading at any given moment in time, unlike a public company.

Once comp(s) are identified, it is typical to aggregate the multiples associated with each transaction comp in a list. A multiple is simply a ratio that is calculated by dividing the valuation of an asset by a specific item on the financial statements. For startups, we almost always use revenue multiples (typically enterprise value / net revenue) because as previously mentioned, early stage startups are rarely profitable. As VCs spend more time focused on a specific category, they tend to develop a natural “feel” for the right multiple often to the point in which even conducting this comp analysis formally isn’t needed.

For example, early stage CPG businesses should typically be trading somewhere between 2-4x net revenue run rate these days whereas (non-AI) software businesses are largely trading between 10-15x ARR. There are certainly exceptions at times. With AI businesses we’ve seen lately, gloves are off… There’s no “one size fits all” approach to finding comps. You can make friends with other VCs, lawyers, founders and bankers who may be willing to share or point you in the right direction, you can scour databases, and you can follow the media for deal info (financings, acquisitions), etc.

Note: for pre-seed valuation, you will still often gauge comparable transactions… but since most pre-seed startups don’t have revenue or even a developed income statement, one should simply consider the enterprise value of the comparable transactions as guidance instead of multiples (you can’t derive a multiple for a company that essentially doesn’t have an income statement yet). On top of these comparable enterprise values, we will touch on the importance of qualitative factors in the context of pre-seed valuation.

One drawback of comp analysis is that it doesn’t consider future dilution. You are technically pinning valuation based off transactions you’ve seen historically with less of a regard for what will happen to the company that you are valuing in the future. A major benefit of comp analysis is that you are leveraging real life, relevant comparable data AND you are directly considering today’s actual financial status of the company you are valuing.

Comps Simulation - Watch Video

PS: as a founder, try to also come armed with comps that prove why you deserve a certain valuation multiple as well. This can go a long way when negotiating with a VC.

The VC Valuation Method: there are many flavors of the VC valuation method so our definition is certainly not an absolute truth; however, the method entails predicting what the future will look like and backing into a valuation in the present. Specifically, you are asking yourself “what do I need to believe” for this company to be a meaningful return driver, or winner, for my fund in 5-10 years. Some literally refer to the VC Valuation Method as What You Have to Believe Analysis (aka WYHTB).

There are varying levels of sophistication to the VC approach. In general, the VC method starts with a projection for what a VC believes a company can exit or sell for from a valuation perspective by forecasting exit year sales (or EBITDA) and the associated exit multiple (derived from comps!). The second step is to define the VC’s required return as a VC (i.e., 10x, 20x, etc). VCs often define their target multiple on invested capital (MOIC) within their fund model before they officially launch a fund. The third step is to calculate the value of the VC investment at exit such that the VC earns their required return. Lastly, the VC backs into their required ownership (%) stake and implied valuation at the time of their investment.

Example #1

Let’s assume 1) Term Sheet Pitfalls is seeking a $2M seed investment today, 2) the VC investor believes TSP can sell for 4x on $25M in Net Revenue in 2030, and 3) The VC requires a 10x return on their investment.

Step 1: exit projection ➡️ $25M x 4 = $100M (note: we likely would have gathered comps to land on the 4x multiple)

Step 2: VC requires 10x return (note: for fund model to work VC underwrites 10x for all investments)

Step 3: A return of 10x on a $2M investment = a value of $20M at exit

Step 4: Therefore, the VC must own 20% of the business at exit ($20M / $100M); as a result, the VC’s $2M seed investment today must reward VC with 20% of ownership. $2M / 20% = an implied post-money valuation of $10M.

In conclusion, VC is willing to write a $2M seed check at a $10M post-money valuation to get 20% ownership in the company. At a $100M exit, 20% ownership will earn the VC $20M or 10x.

Relatively simple right?

One material problem: this example works under the assumption that Term Sheet Pitfalls does not raise any follow on capital in the future. As a refresher, if a business raises more capital in the future, prior investors are at risk of dilution (or a reduction in percentage ownership). So how do we adjust our math to ensure that we consider the potential dilution associated with follow on financings while still reaching our target return profile as VCs?

Read on or skip this section if desired.

Example #2

Let’s assume 1) Term Sheet Pitfalls is seeking a $2M seed investment today and the associated investor (VC #1) will require a 10x return, 2) Term Sheet Pitfalls will raise a $5M Series A investment in two years and this investor (VC #2) will require a 5x return, and 3) TSP can sell for 4x on $25M in Net Revenue in 2030

Step 1: exit projection ➡️ $25M x 4 = $100M

Step 2: start with follow on investor; VC #2 requires 5x return

Step 3: A return of 5x on a $5M investment = a value of $25M at exit

Step 4: Therefore, the VC must own 25% of the business at exit ($25M / $100M); as a result, the VC’s $5M Series A investment in two years must reward VC with 25% of ownership. $5M / 25% = an implied post-money valuation of $20M (or a pre-money valuation of $15M)

Step 5: from the work we did in example #1 we know that VC #1 must own 20% of TSP following the Series A. Therefore, VC #1’s stake in TSP must be worth 20% x $20M post-money = $4M following the close of the Series A.

Step 6: If VC #1’s stake in TSP must be worth $4M following the close of the Series A, then VC #1’s stake in the seed round must equate to $4M / $15M pre-money of Series A = ~26.67%. Alternatively, we could calculate this by taking VC #1’s target ownership at exit, 20%, and dividing it by (1-25%), VC #2’s ownership after the A. 20% / (1-25%) = ~26.67%

Step 7: Therefore, VC #1’s $2M seed investment today must reward the VC with 26.67% of ownership. $2M / 26.67% = an implied post-money valuation of $7.5M. Notice how VC #1 must get in at a lower valuation, acquiring more ownership, to counter the impacts of dilution from the Series A to achieve a target return of 10x.

The VC method is quick and relatively simple. It requires minimal inputs (exit valuation and target return multiple) and outputs ownership % required and implied valuation. It can be problematic because forecasting exit valuation 5+ years from now and funding round dynamics between now and then is a crap shoot and the method also ignores downside protection offered by preferred stock (will talk about preferred vs. common and liquidation preferences in another post).

Daniel typically leverages an approach to valuation that combines elements of comps and the VC method to land on what hitting his target MOIC could look like. He shares a simulation of his underwriting approach here:

Returns Summary Simulation - Watch Video

Qualitative Considerations:

Ultimately, executing valuation methodologies in early stage venture capital such as comparable company analysis or the VC Method doesn’t necessarily determine what ends up in a signed term sheet. Leveraging these approaches helps land on a ballpark valuation which is then adjusted up or down based off 1/ findings a VC uncovers after completing due diligence and 2/ negotiation dynamics. Some examples of typical factors that impact valuation irrespective of approach:

1. Competition with other funding sources: when VCs feel they are competing with other VCs, price tends to work more favorably for founders. Founders should aim to be as honest as possible about competitive round dynamics but also not be afraid to share when they’ve received term sheet(s).

2. Level of experience of the leadership team: experienced teams and exited founders can often garner higher valuations

3. Stage of the company: valuing a pre-revenue company is determined mainly by team, idea/opportunity, product/IP, etc

4. Market size and growth: some VC’s value TAM, others not as much

5. The VC’s typical entry point: some VCs prefer early stage and lower prices and may draw a line in the sand on a price irrespective of if the multiple is fair, unfair, etc

6. Macro environment: the supply / demand ratio of capital available to capital requested

7. NUMBERS: growth, profitability/capital efficiency, etc, etc

And much more… especially for pre-seed/seed valuation, in which financial data is scarce, the factors above can have a huge impact on landed valuation!