The Arcane Method Of Valuing Early-Stage Companies

By Mark Peter Davis

I was recently asked by a reader to explain the arcane math used by VCs in valuing early stage companies.

I should begin my response with a caveat – early-stage investment firms likely vary in the process that they use to determine valuations for seed and series A investments. Companies at this stage are often pre-revenue (or even pre-product). That said, the common thread between the various approaches to valuation early-stage companies is that they all ultimately are as much art as science. Judgment and experience are key inputs into the process; a mathematical equation alone rarely yields the appropriate output.

Unfortunately, no single equation is designed to optimize all of the VC's key objectives. In general, VCs need to find a deal structure that balances three key considerations. The terms must be:

• More attractive than the entrepreneur's other options,
• Provide the VC with ownership sufficient to generate an acceptable risk-adjusted return, and
• Designed to provide key managers with enough equity to align incentives.

Because there isn't a single equation that solves for all three of these objectives, valuations are most often determined through a process of scenario analysis. A range of valuations and capital investments are input into a capitalization table model. The output, which illustrates the ownership of all of the involved parties after the investment, is then evaluated to determine if it achieves the three objectives stated above. If it does not, the inputs (valuation and capital invested) are adjusted until a viable scenario is identified.

As part of this math, VC's typically do an additional analysis whereby they project their expected ownership levels after future dilution to understand the likely return on investment in various exit scenarios. This analysis can help them better assess how much of the company they need to own initially in order to generate an acceptable return after dilution.

The fact that the valuation process is based on judgment does not mean that it is invalid. I would argue that all company valuations, whether the company is early or late-stage, are in no small part based on judgment. Regardless of what equation or process is used, some of the inputs ultimately are dependent upon investor experience. For example, in a discounted cash flows model (an approach often used for valuing more mature companies), the process used for selecting a discount rate is often less than scientific (and often arguably arbitrary). Small variances in discount rate can have a large impact on the ultimate valuation. The same holds true for the process of selecting and adjusting comparables used in both early and later stage valuation exercises. Picking one comparable company over another or selecting one arbitrary adjustment over another can substantially impact the valuation.

Regardless of the methodology used to arrive at a valuation, investor willingness to pay will determine the range of acceptable outcomes. Simply put, investors won't pay more than their perceived value of the company.