Ryan Says…

Anyone from the valley will agree there is a certain buzz in the air right now - a buzz very reminiscent of the late 90s. Not only does it remind us of the good times, but also of the dangers of getting ‘caught up in the hype’. It seems everyone is all too aware of this becoming another ‘bubble’ - and everyone, including myself, seems to be cautious about valuing new startups using ‘bubble era’ metrics.

So how should one value a startup? It’s obviously a difficult question because the company typically has no revenues, few assets (apart from people and some IP), and cannot be traded in a market with enough participants (and enough information) to accurately determine a price.

This post is a bit of an educational piece for those who wonder how VCs typically value a startup. The method I describe below, is one of the most widely used (often called the ‘VC method’). At the very least, this method provides a ballpark figure to start with, which can then be adjusted according to a variety of external factors. For more details on the VC Method, see HBS Note 9-288-006.

In describing this method I will start with a simple scenario of a company that takes only one round of venture financing, and then show how this method can be expanded to handle multi-stage financing.

Terminal Value
The first thing we need to calculate is a ‘terminal value’ for the company. That is, a value at some point (say 5 years) in the future. This point may be an expected liquidity event (IPO or acquisition), or failing that should be a point where the company is at least earning a profit. We need to somehow come up with a value for the company at that point in time. The easiest way to do this is to look at a comparable company. For example, if a company in the same or similar industry was recently acquired or went public, this value can be used as a proxy for the terminal value of the company we are trying to value. Another, perhaps more common method, is to look at price/earnings (PE) ratios for companies in the industry, and use this along with expected earnings in the terminal year as shown in the business plan (suitably discounted to adjust for EEE - Entrepreneur’s Enthusiasm Error :)

Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3M profit in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M.

Note: this terminal value is best case - assuming everything goes right. We will account for the fact that everything doesnt always go right in the discount rate (see below).

The Venture Capitalist’s Required ROI
Lets say our VC is ready to invest in Infelidoo and needs to value the company. The company needs $2M to get started - and in this simplified example will need no more cash over the next 5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annual rate of return on her investment (more on determining the rate of return later).

This means in year 5 the VC’s investment must be worth (1 + 0.50)⁵ x $2M = $15.2M. [That’s just (1 + IRR)^years x Investment]

So, in year 5 the VC expects the company to be worth $45M. Her share of the company must be worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%.

Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing the company at $6M.

The Discount Rate
Above we used a discount rate (rate of return) of 50%, which may have seemed somewhat arbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be). The discount rate should be the sum of:

• The risk-free rate
• Premium for market risk
• Premium for illiquidity
• Premium for value added by VC (compensation)
• Premium for “fudge factor” (past experience)

Figuring out the exact discount rate to use is more art than science. Some approximate guidelines for discount rates based on the stage of the company are:

• Seed stage: 80%+
• Startup: 50-70%
• First-Stage: 40-60%
• Second-Stage: 30-50%
• Bridge/Mezzanine: 20-35%
• Public Expectations: 15-25%

Multi-Stage Financing
The above example was overly simple because we assumed a single financing was enough to take the company to the point where it became self-sustaining. In reality companies will generally take several rounds of financing, and each round dilutes the ownership of existing shareholders. Additionally, option pools need to be reserved for future employees. This affects the percentage ownership each investor will have in the terminal year, and thus we must factor this dilution into the calculations.

In essence, we calculate the ’share of the pie’ each investor must have in the terminal year, based on when they make their investment and their required discount rate (using the process outlined above in each case). Then, we take dilution into account when calculating the ownership percentage the investor must take now (current ownership %) in order to achive this terminal percentage ownership (final ownership %).

To make this conversion, use the formula:
current ownership % = (final ownership %)/(retention %)

Retention refers to the amount of ownership that a VC retains, taking into account future dilution. If there are no subsequent financing rounds then the retention is 100%. If there are subsequent rounds then it is some smaller number. To calculate the retention %, add up the sizes of final percentage ownerships of subsequent investors (the size of their slice of the final pie), and subtract this from 1. E.g. if there are three investors, and their final shares of the pie must be 15%, 10% and 5% respectively, then the retention % for investor 1 is 1 - (10% + 5%) = 85%. Similarly investor 2’s retention is 95% and investor 3’s is 100%.

Note: This is further complicated in the case where an investor also participates in subsequent rounds (which is very often the case). A simple formula wont really help here, and you’ll have to model the scenario using a spreadsheet.

After adjusting for dilution, we know the ownership stake an investor must take in the company now in exchange for her investment, which implicity places a valuation on the company.

Well - I think this blog post is now long enough :) I hope this has given any interested readers an insight into the ‘VC method’ of startup valuation. The HBS case note I mentioned at the beginning contains 54 pages of details, for those interested in reading further.

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