We are used to believing that old clichés are something that one should rather avoid. Alas, in the case of valuation the old saying that “despite the fact that it deals with numbers, valuation of companies is more art than science” is surprisingly accurate even in the best of times.
The common approach suggests building a spreadsheet with as detailed future financial performance projections as possible to isolate the estimated free cash flows and then to discount them back to their present value using a discount rate that reflects the riskiness of those cash flows. The results from discounted cash flow analysis usually are cross-checked and validated using the comparative companies and comparative transactions data. This works fairly well for any established and mature businesses, but how to value an investment at a very early stage of company life cycle?
Since late 1980s the so-called “basic venture capital formula” has been introduced by William A. Sahlman, a Harvard Business School professor, which still remains one of the main valuation instruments for early stage investments (a full case study is available here). The formula focuses on the investor’s required return on investment (ROI) to determine the ownership share in the company that the investor would require in exchange for his/her investment in a start-up.
The simplest version of Sahlman’s formula works in the following 3 steps:
Step 1 Estimate the terminal or exit value of the company.
This may require a lot of assumptions to be made and is likely to be conditional on many ifs and buts, especially in the cases of start-ups with untested business models. Nevertheless, the best effort has to be made to estimate the company’s sales and earnings at the exit and to seek publicly listed companies with most comparable business models to calculate the relevant sales and earnings multiple. The exit value of business can then be calculated by multiplying the sales or earnings by a respective multiple or ration.
Step 2 Estimate the required future value of the investment.
For the risks the investor assumes by investing at such an early stage business he/she would need to be properly compensated. Such compensation is expressed as the required ROI the investor has established for any given investment and which allows to arrive at the required future value of the investment, or the value the investment needs to reach upon exit to generate the expected returns.
Step 3 Estimate the ownership required to achieve the targeted ROI.
In the final step the ownership fraction required today is calculated by dividing the required future value of investment by the exit value of the company.
To illustrate the above, let’s assume an investment opportunity in a business that is seeking to raise EUR 50 thousand. The financial projections suggest that at the end of year 3 the company will generate sales of EUR 1 million and net after-tax profit of EUR 200 thousand. Although it is difficult to find directly comparable companies, all the best estimates suggest that the company at the exit point could be valued at 10.0x times its earnings (or, have a PE ratio of 10.0), or at 2.0x times its year 3 sales. Having assessed the risks the investor believes that he/she would need a required rate of return of 200% over the period, or in other words, the investor would need to triple the amount of cash invested.
Step 1 Exit value = year 3 earnings after tax x Price-to-Earnings ratio = 200,000 x 10.0 = 2,000,000
Step 2 Required future value of investment = investment x (1+200%) = 50,000 x 3 = 150,000
Step 3 Required ownership fraction = required future value of investment/ exit value = 150,000/2,000,000 = 7.5%
Obviously, real-life situations might be not that simple. For instance, the company might be in need of additional financing rounds before it reaches the exit point. Alternatively, instead of expressing his/her return targets as a cash multiple, the investor might be seeking a required annual internal rate of return (or, IRR). It might make the calculation slightly more complicated, but not that much!