Valuing the Early-Stage Company
15 Pages Posted: 21 Oct 2008 Last revised: 10 Nov 2021
Abstract
This note covers several frequently used methods to value early-stage companies and discusses some of the issues and difficulties encountered more generally in valuing privately held assets. The basic assumptions underlying the venture capital and the discounted cash flow methods of valuation are discussed in detail. In addition, the note attempts to provide some direction in making the appropriate tradeoffs between the guidance provided by financial theory and the practical limitations posed by an illiquid asset class. A numerical example is given to highlight the key differences between the techniques.
Excerpt
UVA-F-1471
Rev. Sept. 5, 2017
Valuing the Early-Stage Company
Valuation in any context is a challenging task, one requiring careful consideration of both the risks and potential rewards of an investment opportunity. When valuing publicly traded assets, this task is aided by a wealth of available information on the firm's business fundamentals and performance, benchmarking data on comparable companies, and typically some consensus about the relevant risks faced by investors and how to measure them. By contrast, when it comes to valuing privately held early-stage companies—companies that are frequently backed by angel investors or venture capitalists—both the available information and the consensus about how to measure risk diminish. Although the foregoing increases the challenge of obtaining plausible valuations for early-stage companies, it by no means lessens the need for valuations. This note briefly discusses several frequently used valuation methods and some of the issues and difficulties encountered when applying them to early-stage companies. In addition, it attempts to provide some direction in making the appropriate tradeoffs between the guidance provided by financial theory and the practical limitations posed by illiquid assets.
Conceptually, the value of an asset is derived from the present value of the future stream of benefits associated with it (e.g., interest, income, cash flow) discounted at a rate reflective of the risk inherent in the stream of benefits. Valuations can be obtained from market comparables or more formally by projecting cash flows for an asset and discounting them to the present at an appropriate risk-adjusted rate. The fact that an asset is privately held does not change the conceptual underpinnings of valuation; however, it does require adjustment of basic valuation methods to reflect the greater uncertainty inherent in young companies. We begin with the venture capital (VC) method and then compare it to the discounted cash flow (DCF) approach. For each, we describe some of the adjustments necessary for the methods to be used in early-stage companies.
Venture Capital Method
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Keywords: valuation, early stage, venture capital, investments, investors
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