Determining the value of a company in its early stages presents unique challenges. While the potential for future income may be significant, there may be significant uncertainty about the timing and amounts of future revenue, income and cash flows. The absence of meaningful financial metrics may also make it difficult to identify comparable companies.
Because traditional methods such as the market and income approach can be problematic, valuations of early stage companies are often based on transactions in the subject company’s equity instruments. For instance, the valuation may be based on a new round of financing raised by the company or on secondary transactions in which existing shareholders sell shares. When these new rounds or secondary transactions are stale and traditional methods are not appropriate, establishing a valuation process often involves significant judgment.
To help investment companies, auditors, and valuation specialists establish such a valuation process, the AICPA issued a guide, titled Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The guide points out that “for early-stage companies without a recent financing round, the valuation will very likely involve a technique that "rolls forward" the value from a previous (now stale) financing round that reflected fair value at initial recognition.”
The guide lists the following five questions to consider when using this technique:
1. Was a calibrated valuation model developed at the time of the previous financing?
If so, evaluate if the inputs need adjustment. For example, if the calibrated valuation model was based on a market approach, the market comparisons would need to be updated to reflect the multiples observed as of the valuation date.
2. Is the company performing in accordance with its business plan?
If the company is successfully executing its business plan ahead of schedule, this may suggest an increase in value. Consider the time to a successful exit: shortening it would support a higher value, while extending it would suggest a lower value.
3. Have any significant internal or external events occurred that may affect value?
A variety of events, either internal or external, could affect the valuation. The AICPA guide lists these examples of a company’s significant internal value events:
- Achieving a significant milestone
- Assembling key members of the management team
- Delivering a proof of concept or prototype
- Obtaining regulatory approval
- Establishing ongoing relationships with strategic players
- Executing contracts with key customers
The valuation impact of these types of internal events will vary depending on the amount of execution risk that remains. For example, developing a water treatment technology prototype would have a different impact than signing contracts with municipalities to install the technology. There is less execution risk once a contract is in place as opposed to the prototype phase.
External factors may also have an impact. For example, if a company is developing a technology to address a market need, the company’s value will be impacted if an external event eliminates the need or another company is first to market a competing product. Significant movements in the market overall or stock movements of similar companies in an industry are another type of external event to consider. Macro and micro economic factors can also impact the company’s valuation. An example of this is the way the financial crisis of 2008 affected the valuation of venture capital-backed portfolio companies across various industries.
4. Does the company need additional financing to survive until a successful exit event?
Consider whether the company will be able to continue pursuing its strategy with the financing it has available. How is the company’s cash position in relation to its burn rate? A company that is low on cash and cannot sustain operations for long at its current burn rate is at a disadvantage when negotiating valuations for financing. This may result in a down round.
How is the company doing relative to the business plan it had in place at the time of the last financing? The company’s negotiating power is further diminished if the company is not performing in accordance with its business plan. On the other hand, a company that has achieved a significant milestone ahead of schedule may have an increased valuation in the next round despite being low on cash.
5. Is the entity attempting to raise additional financing as of the valuation date?
Another element to watch out for in the development of fair value estimates is whether the company is having valuation discussions at or prior to a valuation date. If there are current negotiations regarding additional financing underway, the value indicated by these negotiations should be considered. This value should be adjusted for any uncertainty that exists relating to the pending transaction. Numeric models established to assist in the negotiations, such as a discounted cash flow method, should be considered.
With careful attention to these five questions, fund managers should be in a position to develop a valuation estimate despite limited traditional metrics. Additionally, documenting the answers to these five questions will improve your valuation process and prepare you for an audit.
For more information about valuation of early stage companies, contact a Weaver professional.
Authored by Danielle Darley, CPA.