Venture Capital Due Diligence: Financial Valuation

This is part of GoingVC’s Research Series on Venture Capital Due Diligence

Introduction | The Screening Process | The Market Test | The Scorecard

The Management Test | The Management Team

Product KPIs | Building Product Moats

Accounting 101 | Financial Valuation

Technical Due Diligence

VC Valuation

Knowing the company valuation can help VCs better understand the check size they need to write and for in exchange of how much equity the VC is going to acquire. So low valuations do not always mean a poorly run venture, it may simply be too early or too small a market – things to consider before investing.

If, however, the company has passed all due diligence checks to this point, the next questions to ask are, “How much should a company raise and at what valuation?” We built the below model that contains the most common VC valuation methodologies to help you as a VC begin to pull together a pre-money valuation.

First: How Much to Raise?

The first question any VC will ask at this stage is how much money the company intends to raise. The key here is using the basic financial metrics to determine the financial goals and capabilities of the company over the next eighteen to twenty-four months. Companies should look to raise capital to cover their needs over that time span. Any less and the company will be out raising capital again too soon, and any longer risks capital sitting idle for too long, earning nothing.

The goals differ from stage to stage. For companies raising a Series A round, the team should be raising enough to get them to their B round, and will often include hiring a full team and developing an initial functional beta product. Companies seeking series B financing should be budgeting for a full product release and in the neighborhood of $3-5M in ARR. Why not, at the earliest stages, invest enough in a company to cover multiple rounds and at a higher equity percentage of ownership?

Progress is incremental when building companies. Investors in later rounds should reward execution with higher valuations. Investing too-large sums of money at a single stage will increase the valuation too fast and often set unachievable expectations. Practically speaking as well, for GPs and LPs, capital that sits on a company balance sheet because they do not have a use for the cash earns nothing – and would be better spent having been invested in other portfolio opportunities. Lastly, having more capital than needed in the bank can make CEOs do irrational things, like spend on things they do not need and are of no value add. This exuberance is an immediate red flag, so always be sure that there are uses of the cash lined up.

Now that we have an understanding of the mechanics of how companies generate and measure financial success, let’s look at how we can translate those figures into a valuation. Financial valuation is as much an art as it is a science, so the below methodologies can be used in concert to determine an estimate for a company valuation, or can be used in isolation.

A last few things to note about valuation: there is no direct correlation between the amount of profits generated and the valuation. It is entirely possible that companies have grown their earnings but have seen stagnant valuations. This could be because the targets in the last round were too aggressive and despite growth, it was unimpressive. It could also be due to changes in the market environment (all companies are seeing valuations sour as the economy ebbs and flows). The worst case scenario is simply the valuation in the last round was too high – rounds are independent so the valuation in the last round is not a predictor of valuation in the next, unfortunately. As competition develops or decisions unfold that were unfavorable, the valuation will reflect these, good or bad. This is why getting the valuation more right than not matters.

The most important thing to understand with valuation is the value of a company is nothing more than the value of all it’s future cash flows in today’s dollars (known as the present value). Future cash flows depend on both the assumed growth rate of earnings in the coming years (i.e. why high growth companies that do not make money today can still be valued highly) and the assumed ‘discount rate’ at those cash flows will be normalized back to today’s dollars (i.e. why companies even with potentially high cash flows may be worth less if there is considerable risk in achieving them). At the earliest stages of companies, it is nearly impossible to accurately project cash flows in three years let alone three months. Early stage VCs therefore turn to other non-cash flow based methodologies.

Let’s dive in.

Implied Valuations

The most straightforward approach to valuation implies a company value based on the dollar amount invested and the agreed-upon equity percentage in exchange. For example, it is common for seed and series A companies to seek equity fundraising in exchange for say, 20% of the company. Therefore, a VC who is offering $1M in exchange for 20% of the company is implying a valuation of $4M pre-money and $5M post-money (20% of $5M is the VCs $1M investment).

A more accurate valuation using implied valuation in this manner also considers an employee option pool, which is the equity set aside for future employee stock options. To incorporate the option pool, which is generally set around 10% as a proxy, deduct the dollar value of the option pool. For example, the same company that is valued at a pre-money valuation of $4M will have an option pool value of 10% x $4M = $400,000. The adjusted pre-money valuation is therefore $3.6M.

Step Up

The Step Up uses predefined ‘steps’, each valued at $250,000, to create a company valuation. If the company has achieved or ascended the step, then add $250,000. For example, if the company has successfully achieved 5 of the steps in the model, the company valuation is 5 x $250,000 = $1,250,000. Note these steps are ones most commonly identified in the Step Up model, but can be augmented as VCs see fit.

Scorecard

The Scorecard method is similar to the Step Up method but assigns different weights to different factors, implying some carry more value than others. The VC will score the company across each factor within the minimum and maximum range allowable. For example, Strength of Team carries a maximum contribution of 30% – and would be scored at 30% if the founding team is incredibly strong, and perhaps 10% if the team is inexperienced or incomplete.

The factors are then summed and multiplied by $2M. This is commonly used for early stage companies where metrics are hard to measure. The maximum pre-money valuation here is $2M (if all factors are maximized), but this figure can be adjusted upward or downward based on industry or stage as needed.  

Risk Factor Summation

This methodology uses a similar baseline valuation (here $250,000) and adjusts the subject valuation by comparing different risk factors to peer companies, from “very low” to “very high”. Lower risk increases the valuation and vice versa.

The sum of the values implied from the risk factors are multiplied by the baseline value to determine the pre-money valuation.

Berkus Method

Another pre-revenue model, the Berkus Method, similarly uses five key factors for companies and creates a weighted-average score (0-100% for each factor) and a baseline value of $500,000 to imply a value. For example, a company with a completed idea and working prototype would score 100% on these two factors, with quality management, strategic relationships, and the product rollout or sales steps scored from 0-100% depending on their progress.

Comparables

The comparables method can be used for companies at almost any stage as it uses peers to create a relative valuation. A very simple methodology can simply use the valuation of close competitors, not unlike how real estate agents use similar, recently sold homes in your neighborhood to create a value for yours, adjusting based on the condition of certain aspects such as age, quality of appliances, number of beds and baths, etc.

Our model uses inputs from up to five comparable companies and scores them on seven relative attributes. The VC would rate the comparable relative to the subject company so that if the comparables are worse, the subject company would receive a higher relative valuation. With this model, it is reliant heavily on the quality of the input data (the valuations of the comparables to create a baseline) and the objective measurement of relative value.

The VC Method

The VC Method is commonly used for mid to later stage companies, but can be used for early stage companies and backs into a pre-money valuation by assuming a minimum required rate of return necessary (using industry standards or fund benchmarks) and estimates the exit year revenue and multiple to create a valuation.

For example, if companies in the industry are exiting at a 2x revenue multiple, a $20M ARR company valuation would therefore be $40M. This figure is divided by the desired return multiple of a single investment (say 20x) to generate a post money valuation of $2M. Deducting the VC investment of $1M in this instance generates a $1M pre-money valuation.

While this method relies heavily on estimating future year revenues and multiples, these can be sources from industry reports and knowing the market. The beauty of this model is it bakes in a required rate of return and tells a VC the maximum pre-money valuation to invest at in order to likely achieve this multiple.

Pulling it All Together

Once the valuations across the models have been created, VCs can come up with a simple or weighted average to determine a range of valuations. We put more weight on the option-pool adjusted implied valuation, comparables, and VC method, but these can be adjusted in the model as necessary.