By Andrew Maxwell
Investors and entrepreneurs often ask me to shed some light on how to value pre-revenue companies – an issue often raised when entrepreneurs are looking for external investment.
Teaching courses on entrepreneurship and innovation, which include raising finance, suggests that I have a level of expertise in this area, which enables me to provide a definitive answer. Unfortunately, the opposite is true. The more I teach this issue and research different valuation techniques, the more I recognize that valuation of pre-revenue companies is more of an art than of science.
Essentially, the purpose of identifying a formula to provide a company valuation is simply to provide a base number from which both parties involved in a negotiation can start. This can be inhibiting, as most valuation techniques limit the potential upside of the venture – despite the fact that the entrepreneur is often optimistic. However, it is an approach that has merits, as the investor and entrepreneur have different knowledge and experience of the business and industry and the process of discussing the current status of the venture, the market opportunity and the long-term vision, creates an improved understanding that can enhance the relationship. That said, about 50% of the businesses that receive investment offers, turn them down as they cannot agree on company valuation.
The traditional way of calculating company value for pre-revenue companies is to rely on one of two approaches. The first is based on the calculation of equivalent value, whereby forecast profits (or revenues) are estimated in five years time, and current industry multipliers (such as price to earnings (P/E) ratio) are then applied to this forecast to calculate the future value. Armed with a valuation, post-investment, in the future, the current value of the venture can be calculated backwards. This simple approach has a number of benefits, but two fundamental limitations: it’s very dependent on the accuracy of the forecast profit or sales and whether using a standard P/E ratio reflects the fact that a possible acquirer is likely to pay significantly more for the venture. Specifically, this approach assumes that the investor will exit from their investment through an Initial Public Offering (IPO) whereas a strategic acquisition is a much more likely option. In this case, the strategic acquirer will see value in their ability to leverage the acquired company with their existing business, and therefore be willing to pay much more for the business. Accurate forecasting of five-year profitability and the P/E ratio that might be offered by a strategic acquirer becomes quite a challenge.
The second valuation method, is one that is traditionally preferred in business schools and large companies, and uses the forecast cash flow of the business to calculate in the net present value. It is calculated by taking the forecast cash flow for each year and discounting that value back to today’s net present value, based upon assumptions about interest rates. While this is a reasonable way of looking at valuation in an ongoing business and an accurate method for making the decision to invest in a fixed asset, it is less useful when used to measure the value of a pre-revenue company.
This technique suffers from three fundamental problems when used to value a pre-revenue company. First, it is very dependent on the cash-flow that is forecast in the final years of the period chosen. Estimates of cash-flow in at some time in the future are likely to be inaccurate, and small changes to them can have a significant impact on the calculated value. Second, it is very dependent on assumptions about the interest rates used, and small changes in the interest rate can dramatically change the valuation. Third, this technique traditionally uses a standard interest rate for each year, despite the fact that interest rates are meant to reflect uncertainty, and that uncertainty about cash flows in future years are much greater – suggesting a standard interest rate for each year might not be appropriate.
Given this problem with using traditional calculation methods, two other methods might be more useful, but are much more subjective. First, there is the Berkus method (www.berkus.com), which calculates an estimated value based on the achievement of certain milestones. This is a much more useful technique, partly because it highlights the importance of certain factors (such as availability of a prototype, or the signing of a strategic alliance) that fundamentally changes the value of the business. Also, this process tends to provide a framework for investment, which encourages the achievement of specific milestones before more investment is received. Finally, the VC shortcut method is based on a simple estimation of how much someone will pay for the business in five years, and what that is worth in today’s terms, assuming that they make a required interest rate (usually around 35 % per annum) in the period.
At the end of the day, the valuation of a business is a function of a negotiation between an investor and entrepreneur that reflects the ability of the entrepreneur to share his or her vision with the investor. Importantly, most pre-revenue valuation negotiations should focus on identifying the amount of money needed by the company and how the entrepreneur and investor wish to divide control of the company. As a result, the convertibility of debentures issued and the inclusion of specific contract clauses in the shareholder agreement, become more important than the actual calculation of the company value, which underlie the shared vision of the entrepreneur and investor.
Andrew Maxwell is currently working at the Canadian Innovation Centre and pursuing a Ph.D. in the area of new venture creation at the University of Waterloo. In his spare time, he enjoys teaching technology entrepreneurship at UTM and the University of Waterloo.