Valuing a Venture

Every business plan that a VC receives includes an attractive budget and aggressive growth plan. Assumptions related to minimum market penetration, product pricing and gross margin are usually over-optimistic. A VC has to rationalize the assumptions and run sensitivities based on various scenarios (competitive pricing pressure, degree of execution, seasonality). The resulting rationalized forecast may be a fraction of original forecasts.

Discounting from the original forecast may reveal significantly greater capital requirements than first expected. However, this revised capital requirement could guide the venture’s long-term financing strategy. How much must be raised now? When will the next financing be needed? What significant milestones will be accomplished during that time? An understanding of the long-term financing strategy is crucial. A seasoned entrepreneur would work with his investors to develop a financing strategy based on building value from one financing to the next and understanding how value will be measured.
Following are the different stages of financing a venture:

• Seed financing: The seed financing will provide the capital needed to support salaries for founders /management, R&D, technology proof-of-concept, prototype development and testing, etc. Sources of capital may include personal funds, friends, family and angel investors. Capital raised is limited due to its diluting impact at minimal valuations. The goal here is to assemble a talented team, achieve development milestones, proof of concept and anything else that will enable the entrepreneur to attract investors for the next financing.

• Series A Financing: Typically the Series A is the company’s first institutional financing—led by one or more venture investors. Valuation of this round will reflect progress made with seed capital, the quality of the management team and other qualitative components. Typical goals of this financing are to continue progress on development, hire top talent, achieve value-creating milestones, further validate product, initiate business development efforts and attract investor interest in the next financing (at an increased valuation).

• Series B Financing: The Series B is usually a larger financing than the Series A. At this point, we can assume development is complete and technology risk removed. Early revenue streams may be taking shape. Valuation is gauged on a blend of subjective and objective data—human capital, technical assets, IP, milestones achieved thus far, comparable company valuations, rationalized revenue forecasts. Goals of this financing may include operational development, scale-up, further product development, revenue traction and value creation for the next round of financing.

• Series C Financing: The Series C may be a later-stage financing designed to strengthen the balance sheet, provide operating capital to achieve profitability, finance an acquisition, develop further products, or prepare the company for exit via IPO or acquisition. The company often has predictable revenue, backlog and EBITDA at this point, providing outside investors with a breadth of hard data points to justify valuation. Valuation metrics, such as multiples of revenue and EBITDA, from comparable public companies can be compiled and discounted to approximate value.

Each financing is designed to provide capital for value-creating objectives. Assuming objectives are accomplished and value is created, financing continues at a higher valuation commensurate with the progress made and risk mitigated. However, problems can and will arise during this time that may adversely affect valuation.