How to determine your valuation

Last evening's Financing Partners event was hosted by Wilson Sonsini and moderated by Nicola Foreman. The following 4 panelists presented their views on valuing early-stage companies:

• Leon Glover III., Band of Angels
• Tom Fountain, Mayfield Fund
• Peter Rip, Leapfrog Ventures
• Come Lague, Nueva Ventures

Takeaways, observations & thoughts...

CL - focues on early stage firms that are not ready for Series 'A' VC funding

PR - just raised a second fund of $200mm, the first fund was $100mm, 3 partners, no associates

Most Series 'A' is getting financed within a band of roughly $3-7mm pre-money. Pre-IPO terminal values are modeled to be around $200mm. Software companies typically need between 15-30mm in capital to get to the terminal value. The VCs need to own 15-20% of the company. Leapfrog Ventures' goal is to have between 10 and 20 firms in the portfolio. The next round needs to be 2X the Series 'A' post-money valuation. PR concludes that based upon his empirical observation, formulaic calculations involving DCF or VC-Method are best used only to bound intuitive notions of valuation.

TF - VC's don't enjoy prolonged negotiations over value. Valuation is an art, not a science. The 3 risks that dominate the VC's decision process are:

1. People Risk
2. Market Risk
3. Technology Risk
   

TF concludes that DCF valuation approaches have no application to valuation, whatsoever.

LG - In contrast to the other panelists, LG gave an overview of the typical MBA finance models. He elucidated the fallacy of entrepreneurs using public company proxies; he suggests a discount rate of 25-35% for the illiquidity premium. LG challenges entrepreneurs to choose the correct driver for their business model when using the Multiples Method. When using the Venture Capital Method, he suggests discounting with a target rate of return of between 40 and 70% for an early-stage firm. For thoroughness, LG mentions the Adjusted Present Value Method and the Option Pricing Models as alternative ways to calculate a valuation range.

CL - Come built a bridge from the frictionless MBA models to the realities facing early-stage entrepreneurs in coming up with a value for their firm. Citing recent original research, PWC -Money Tree, Series 'A' fundings are averaging $3-7mm with investors taking about 50% of the company. Typical M&A exits are between $50 and 75mm. Given a 10 firm sample of a VC's portfolio:

1. 2 Winners would yield 20X returns
2. 5 firms would break-even
3. 3 Losers would return nothing

CL suggests a Milestone-based valuation methodology wherein a program is designed, with the next-stage investor in mind, to get the entrepreneur to a Series 'A'. This approach assumes the entrepreneur has access to information regarding the other levers of a VC transaction. For those who don't, CL suggests a book entitled "Term Sheets and Valuation" by Alex Wilmerding.

Chad Salinas

Philosophically, I am closest to CL's notions about setting milestones. Although, all of my finance training tells me that choosing a target rate of return, using DCF, the VC-Method, and Real Options should provide upper bounds to valuation. In fact, I think a built up r in the WACC ends up systematically over-valuing firms. The lower bound is well guarded by the entrepreneurs need to be incented rather than relegated to indentured servitude. Regardless of a VC's behind-the-scenes valuation model-building, a VC is going to have to syndicate to get deals done. If the majority of potential syndication partners think the deal is too expensive, the deal simply won't get done. Clearly, the data on "done deals" are between self-selecting VCs and entrepreneurs who had the flexibility to come to terms regardless of the imperfect private equity market and its concomitant information asymmetry. However, nobody is asking what rate of return equilibrates the valuation model once a value is determined.
Now, I am purely speculating, but given TF's highly technical background at Stanford, for him to say that formal finance methods have no place in the valuation process, he must have an empirical basis. Clearly, quantitative approaches are far less prevalent in the Valley than in New York. In New York, however, you wouldn't even consider approaching your investment committee without having the obligatory models in hand.
For completeness sake, I need to post an example of the VC-Method and Multiples Method in the near future.

Stay Tuned!