Ensmarten Saturday: How does early stage valuation work?

Money

In our work with entrepreneurs, there are a number of perception gaps.

One of the biggest is that early stage valuation is a science. Many believe that if they just knew the parameters then they could get more outside investment.  Most of the time, this is simply not true.

Very few businesses ever receive outside equity investment. Instead, most investment comes either through the founder’s own savings (or credit) or through bank loans.

These forms of early stage financing are not as glamourous as venture capital, but they are more frequent. For example, last year (2018) in Nebraska there were 308 SBA 7(a) loans totaling more than $98 million in financings for small businesses. Conversely, according to Pitchbook, there were 27 deals that received some form of early stage or venture investment for a total of $26.25 million.

Thus, most companies should not worry about how an investor would value their company because they are unlikely to ever receive meaningful outside investment. That being said, there are some accepted processes associated with valuation.  For example, one of the most prolific is called the Berkus Method after Tech Coast Angel (TCA) co-founder David Berkus. Rather than attempting to place a strict mathematical formula around a company with limited history and limited sales, the method focuses on broad stroke valuations against five different areas:

1) Is the business based on a sound idea that has clarity and a business model? If so, based on TCA formula – the company receives a bump of between $0-2 million in valuation. Most structures in the Midwest or at the entry to accelerator are more likely to put that valuation closer to $0-$250k, in our experience.

2) Has the company produced a prototype of the product or service? If so, the formula continues to be $0-250k (or whatever the appropriate scale is). This measurement is one reason that early stage prototype grants through the SBIR program, or a state program such as Nebraska’s prototyping program, are valuable. They help create an instant valuation bump.

3) Does the team have a quality management team? The answer by every entrepreneur is always yes. But this measurement is usually based on past experiences as both an entrepreneur and in the industry. Thus, for example, a team of students does not get the same mark as seasoned entrepreneurial vets. Again, the scale is used to put the team on a range.

4) Does the company have unique strategic relationships that will provide a significant boost to likely success? This is one that is again measured in the eye of the beholder, which means the investor. There are certain types of strategic relationships that are valuable – early paying customers for example. And there are strategic relationships that may have future unique value – such as a large supplier taking a small equity stake in a company. However, knowing someone exists and having a signed Memorandum of Understanding or Letter of Intent are two different things.

5) Has the company sold anything or rolled out its product? In our opinion, there is no substitute for market traction illustrated through paying customers.

This method of valuation can create a mechanism to provide a back of the napkin value to companies based on some specific indicators that most investors can identify quickly.

However, other methods exist. For example, the First Chicago Method is a commonly used mathematical model for early stage investors. This model focuses on using the idea of discounted cash flows (DCF) and forecasted scenarios. However, most companies that are pre-revenue have very poor abilities to accurately predict forecasts. Therefore, while many early stage (pre-Series A) investors may look at a First Chicago-like method, rarely is this dispositive because of the difficulty of creating the forecasted cash flows.

Thus, our analysis of valuation tools used by early-stage investors suggests that valuations are more art than science. While it is useful to know how an angel comes to a specific valuation, there are no strict rules that all investors use.