Wednesday, May 29, 2013
Methods for Valuation of Seed Stage Startup Companies
This post was written by Bill Payne in conjunction with Angel Capital Association.
Much like the real estate market, the starting point for determining the valuation of seed stage ventures is comparable deals. At what valuation have similar deals at the same stage, in the same business segment and in your region been funded recently? Knowledge of local recent transactions is key to establishing the valuation of the target company. And, it is important to acknowledge that the valuation of startup ventures changes with competition (lots of capital chasing deals in a given business sector increases median valuations) and with the business cycle (angels are less likely to open their pocketbooks during a deep recession, driving down valuations).
Having pointed out the obvious, it is also useful to have several valuation methodologies in your tool box to provide a rational basis for determining reasonable pricing. Angel investors have found four methods that are particularly useful for determining the pre-money valuation of pre-revenue companies (with customer valuation and at the cusp of first revenues). And, at the outset, early stage investors seldom find discounted cash flows based on proforma financials to be particularly useful. Entrepreneur-provided financial projections are simply too imprecise for reliable analysis.
Why do we need four methods? There are no scientific methodologies for establishing a valuation for early stage ventures. Better practice dictates that we use multiple methods for estimating the valuation for investment purposes, then based on those results chose a final pre-money valuation (by averaging multiple methods, perhaps after eliminating outliers).
Venture Capital Method
Dave Berkus Method
Risk Factor Summation Method
There is no perfect methodology for establishing the pre-money valuation of pre-revenue seed/startup ventures. Consequently, investors are advised to use multiple methods to arrive at a final valuation, four of which we’ve outlined above. . You’ll find that some methods will be more applicable to specific ventures than others. You may choose to change the ranking, characteristics or weightings of activities described in a given method to better fit a target company. And recognize that using three methods, as an example, will give you three answers: you might find that all methods give you similar results, widely different results, or that one method yields an outlier. Think carefully about the three outcomes and use a rational approach for selecting a final number.
Final word: Using multiple rational valuation methodologies does not preclude other investors from offering a term sheet with a much higher valuation. Your choices then are (1) bite the bullet and invest at the higher valuation or (2) pass on the deal.
Bill is has been actively involved in angel investing since 1980. He has funded over 50 companies and mentored over 100. Bill is also a founding member of four angel organizations: Aztec Venture Network, Tech Coast Angels, Vegas Valley Angels, and Frontier Angel Fund.