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Valuation
Value versus Price
There is an important distinction between value
and price. The sale of shares to an Angel or venture
capital investor seldom reflects “value”
and normally reflects “price.”
Fair Market Value (FMV):
“the highest price available in an open
and unrestricted market between informed and prudent
parties, acting at arm's length, and under
no compulsion to act, expressed in terms of money
or money's worth.”
Price:
“the consideration paid in a negotiated
open market transaction involving the purchase
and sale of an asset.”
More casually, “value” is what something
is worth and “price” is what you get
for it. Here are some of the reasons why the two
results may be materially different:
- Fair Market Value is calculated in a “notional”
market, while Price reflects the real world;
- Fair Market Value assumes equal negotiating
ability between the parties, while Price is affected
by different negotiating strengths;
- Fair Market Value assumes both parties have
equal knowledge, while Price reflects differences
in information or assumptions;
- Fair Market Value assumes there are no “special
purchasers”, while Price may reflect the
influence of a purchaser that has a unique incentive;
- Fair Market Value assumes neither party is under
compulsion to transact while, in reality, vendors
are usually under some financial pressure to sell,
and one or both parties are acting on emotion;
and,
- Fair Market Value assumes there are many buyers
in the “notional market”, whereas
in reality there are often only a few that often
confer.
Notwithstanding this important distinction between
“value” and “price,” most
discussions on the topic inherently use the term
“value” to refer to “price.”
This whitepaper will follow that same practice.
Just remember though, all discussions on value really
refer to price – i.e. what you can get for
your company, not what it is worth.
With the higher risks inherent with earlier stage
companies, the valuation methodologies are much
more subjective than the methodologies used for
Later Stage companies.
Trends in
Pre-Money Valuation
Overall Observations
VentureOne Corporation has been tracking the US
VC industry since the 1980s. Figure 1 presents their
findings respecting quarterly changes to pre-money
valuations across the major venture capital investment
classes (i.e. investee company maturity stages)
during the period between Q1 1998 and Q3 2001. The
NASDAQ performance is overlaid across the VentureOne
research for comparative purposes. A few observations
can be made:
- The further distanced company maturity is from
IPO status, the less dependency there seems to
be on changes to NASDAQ values. Seed Stage pre-money
values seem to be influenced by NASDAQ activity
very little. Valuation methods for early stage
companies are different from traditional methods
used for public companies.
- As compared to Series B and Later Stage pre-money
valuation trends, the pre-money valuations for
Seed Stage and Series A Stage are relatively flat.
Valuation methods for these very early stage companies
result in a narrow band of valuation possibilities.
The choice of valuation methodology should reflect
the maturity stage of the company. Classical private
company valuation methodologies are well suited
to more mature companies that have sales, profits,
and material assets. Seed Stage companies have none
of that. Instead, they offer potential, balanced
by considerable risk. Valuation assessments at this
stage ought to reflect these challenges
Seed Stage
Pre-Money Valuations
A longer period of pre-money valuations is shown
in Figure 2. The data indicates that Seed Stage
pre-money valuations have fluctuated within a narrow
band of between, US$2 million and US$5 million across
more than ten years. This seeming stability contrasts
some meaningful external market forces, such as
a major recession, the “dot com” cycle,
the “telecom meltdown”, and a few major
market “corrections.”
This data indicates that Seed Stage pre-money valuations
are normally between US$2 million and US$5 million.
That same research also includes data on typical
issue sizes, indicating that Seed Stage investors
typically own 20% to 30% of the company's
post-money fully diluted equity. The issue sizes
are normally between US$500,000 and US$2 million.
Given the relatively few possible outcomes, Seed
Stage investors typically use very simple valuation
methodologies. Some of the reasons for a more simple
approach include:
- The final pre-money valuations will be within
a narrow band and will be more affected by negotiating
strengths than “mathematical” determinations
- Many Seed Stage investors recognize that much
of the company's business plan and product
concept will likely change over the next few years
- With so much “uncertainty” and perceived
risk, Seed Stage investors typically rely on more
“intuitive” or subjective valuation
models and support their subjective views with
reality checks (i.e. due diligence) in a few key
areas
- Seed Stage investors also recognize that, without
a lot of substance in the companies upon which
to do meaningful due diligence, they should be
able to reach an intuitive assessment relatively
quickly.
- Many Seed Stage investors recognize the “subjective”
nature of their Seed Stage investment decisions
and expect a high “mortality rate.”
To offset this exposure, most Seed Stage investors
are prepared to invest in one or two more financing
rounds for the more promising investees.
Here are a few “data points” supporting
the above summary observations:
MIT Entrepreneurship Center
- Research Findings February 2000: Seed stage
technology ventures were typically US$500,000
to US$3 million. Pre-money valuations greater
than US$5 million required an extraordinarily
compelling story.
The Tech Coast Angels:
- Website: “we look for pre-money valuations
below US$5 million”
- Presentation March 2002: "sweet spot"
for investing is a pre-money valuation of US$1.5
million to US$3 million.
Sand Hill Angels:
- Website: invest US$250,000 to US$2 million at
a valuation of less than US$5 million.
New Jersey Entrepreneurial Network
Angels:
- Presentation: Valuation of US$1 million to US$5
million, for 20% to 30%
Winning Angels, Amos/Stevenson
(Noted Book):
- Most Angel investors want pre-money valuations
between US$2 million and US$5 million, with US$2.5
million as the “sweet spot”
Seed
Stage Valuation Approaches
Berkus Method
Dave Berkus, an active Angel investor, developed
a pre-money valuation methodology that focuses
on the primary drivers for value increases between
the Seed Stage and the Series A Stage. The approach,
highlighted in Table 1, provides a valuation boundary
for a subjective assessment in a few key areas.
Table 1: Berkus Valuation Method
Sound idea |
 |
US $1 million |
Prototype |
|
US $1 million |
Quality management
team |
|
US $1 million
to US $2 million |
Quality board |
|
US $1 million |
Product rollout
or sales |
|
US $1 million
|
Source: Dave Berkus 1993, reported by Amis/Stevenson,
Winning Angels
Rule of “Development Milestone”
The more diligent investors will attempt to provide
more “quantification” to their assessment
of pre-money value. As one such attempt, some Seed
Stage investors estimate the amount of cash required
to achieve a major development milestone and, often
without regard to how much that is, equate that
amount to 50% to 60% of the company (post-money,
full dilution).
Rule of “Thirds”
The Rule of “Thirds” simply implies
that 1/3 of a new company's equity should
go to the Founders, 1/3 to management (i.e. an Option
Pool), and 1/3 to the Seed Stage investors. This
methodology is used most often as a “sanity
check” to other valuation methodologies.
Source: The Ottawa Capital Network
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