UVA-F-1471

Rev. Aug. 20, 2009

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 gathering available information on the firm’s business fundamentals
and performance, benchmarking data on comparable companies, and arriving at some consensus
on the relevant risks faced by investors and how to measure them. Unfortunately, when it comes
to valuing privately held assets, both the available information and the consensus about how to
measure risk disappear. Although the foregoing increases the challenge of obtaining plausible
valuations for privately held assets, it by no means diminishes the need for such valuations. This
note briefly discusses several frequently used valuation methods and some of the issues and
difficulties encountered in valuing privately held assets. 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 an illiquid asset class.

Conceptually, the value of an asset is the present value of a future stream of benefits
derived from the asset (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 (e.g.,
price–earnings or EBIT multiples) 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 method and then compare it to the discounted cash
flow approach. For each we describe some of the adjustments necessary for the methods to be
used in early-stage companies.1

1
Real options is another method that is conceptually appealing for valuing early-stage companies. The real
option method is compared with other valuation methods, such as the discounted cash flow method, in “Methods of
Intellectual Property Valuation” (UVA-F-1401). Also R. Shockley, S. Curtis, J. Jafari, and K. Tibbs, “The Option
Value of an Early Stage Biotechnology Investment,” Journal of Applied Corporate Finance 15, no. 2, (Fall 2002),
and T. Luehrman, “Investment Opportunities as Real Options, Getting Started on the Numbers,” Harvard Business
Review, reprint number 98404.

This note was originally prepared by Susan Chaplinsky, Professor of Business Administration. This version was
revised in August 2009 with the assistance of Brendan Reed (JD ’09). Copyright © 2005 by the University of
Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
[email protected]. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of the Darden School Foundation. Rev. 8/09. ◊
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Venture Capital Method

The venture capital (VC) method is a widely used method of valuing early-stage
companies. At its heart is a simplified net present value (NPV) framework stripped of many of
the details associated with the more widely used discounted cash flow method. Practitioners will
argue that these simplifications are justified by the large uncertainty associated with projecting
many of the inputs required for valuation. Others, as we discuss later, argue that the
simplifications go too far, leaving practitioners relying on the VC method open to serious
omissions.

Venture capital investors frequently present their valuation in terms of a premoney and
postmoney value. Premoney refers to the value of the company prior to the addition of an
investor’s capital. Postmoney is the premoney value plus the amount of the investor’s capital
commitment. More generally, the postmoney value is the current perception of the potential
value the enterprise can achieve over its investment horizon with the provision of an investor’s
funds. The postmoney value is often presented as the amount invested in the round (I) divided by
the percentage of equity an investor obtains in the round (F). These basic two terms interact in a
manner illustrated by the formula below.

Number of new shares purchased A

Number of shares, warrants, options outstanding B
Fully diluted shares FD=SUM(A+B)
Percent of total shares investor purchased F=A/FD
Amount invested in this round I
Post-financing valuation POST=I/F
Prefinancing valuation PREPOST- I

The VC method usually begins with investors estimating how much they plan to invest.
Of necessity, the amount invested must come from an analysis of the firm’s financial situation
and an assessment of the funds necessary to take the firm to the “next stage.” Based on the
formula above it appears that the postmoney value is derived from the funds going into the
enterprise. This appears to belie the usual notion that value is derived from cash invested in the
firm today (cash out) in relation to the cash received from the firm at some future point in time.
Underlying the VC method, however, is a conceptual link between cash out and cash in. To see
the link, investors must forecast an entity’s exit value over the planned investment horizon. As
shown below, their percentage equity ownership determines their realizations of cash from the
investment.

Today Exit (T years later)

Amount invested Exit value of firm’s equity
× investors’ equity stake %
= Cash received upon exit
(– Cash out) (+ Cash in)
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The foregoing leaves a key question remaining: How do investors determine what
percentage ownership they seek in exchange for the funds they provide? To determine their
equity stake, investors must also know what return they hope to achieve on their investment.
This rate of return is known as the target rate.2 Exhibit 1 reports the common target rates and
horizon periods of private equity investors by stage of investment. In general, the greater the
target rate and horizon periods are, the less developed the enterprise. For the sake of argument,
let’s assume a target rate of 50%. While the merits of this can be debated, the VC method
generally disregards all interim cash flows, so that an investment is evaluated based on the
money invested today in relation to the amount to be received t periods later, or its terminal
value. Let’s assume an investor is contemplating investing $1.5 million today and foresees at exit
the enterprise being worth $50 million five years from today.

Figure 1. Illustration of the VC method.

Target rate 50%

Years 0 1 2 3 4 5

Investment cash flows (millions) ($1.5) 0 0 0 0 $50.0

PV of exit value (millions) $6.58
FV of amount invested (millions) $11.39
Ownership stake (%) 22.78% 22.78%

In Figure 1, the present value (PV) of the exit value is found by discounting $50 million
at 50% per period for five periods (i.e., $50 million ÷ 1.505 = $6.58 million). The ratio of $1.5
million invested today divided by the present value of the exit value gives the percentage
ownership stake an investor must negotiate to achieve a 50% target return. The present value of
the exit value is in actuality the postmoney value of the enterprise. In concept, this represents the
value today of the potential value the enterprise can achieve given the infusion of funds. The
premoney value is simply $6.58 million – $1.5 million = $5.08 million.

Alternatively, one can approach the problem by focusing on the future point of exit. In this
case, we determine the future value (FV) of $1.5 million invested today at 50% per year for five
years. This turns out to be $11.39 million (i.e., $1.5 million × 1.505 = $11.39 million). If we
anticipate exiting at $50 million, then an investor needs to realize $11.39 million in order to
achieve a 50% return. Therefore, he or she needs to own 22.78% of the firm’s equity at the time
of exit (i.e., $50 million × 22.78% = $11.39 million). Given the symmetry between present and
future values, one can view the problem from either perspective. Given the importance attached
to the postmoney value in negotiations, however, one is more apt to encounter the VC method
from the first perspective of present value.3

2
Be careful to distinguish the concept of a target rate from that of an expected or required rate of return. The
target rate is the return one hopes to achieve in the best outcome. The expected return is the return one is likely to
achieve factoring in the probability that things do not always work as planned.
3
All else equal, it should make sense that if investors increase their investment to say $2 million that the
required ownership stake will increase from 22.8% to 30.4%. It will take a higher percentage of the firm’s equity at
exit to realize the 50% return.
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Number of Shares and Price per Share

So far, we have not said anything about the number of shares or price of the equity
shares. There is a reason for that—for the most part, the number of shares and the price per share
are fungible. They are often determined after a postmoney value and a percentage equity stake
are established. By analogy, one might think of the example of a stock split. The price and
number of shares is of lesser importance than the overall value they equal. Nonetheless, it is
useful to consider how the number of shares and price per share are determined because
ultimately those values must be entered on the term sheet and stock purchase agreement for the
round. Let’s assume in our example that the firm had 500,000 founders’ shares outstanding prior
to this round’s investment.4 We know from our prior example that investors wished to achieve a
22.78% equity stake. Therefore, the number of new shares, N, can be found as follows:

N
New Shares ( N )   0.2278
( N  500,000)

Solving for N yields 147,501 new shares, which, when added to the founders’ shares,
results in 647,501 total shares outstanding following the round.5 The price per share can now be
determined several ways.

 Based on the postmoney value, $6.58 million ÷ 647,501 = $10.17 per share.
 Based on the premoney value, $5.08 million ÷ 500,000 = $10.17 per share.
 Based on the amount invested, $1.50 million ÷ 147,501 = $10.17 per share.

It goes without saying that the per-share price must be the same in all three cases.

A $10 per-share price probably falls outside the norm that investors hold for a first-round
investment. As we noted earlier, the number of shares and prices are fungible, and in this case,
one can well imagine that the firm will undergo a “mini-recap” wherein the number of founder
shares will be increased and the new shares adjusted accordingly to result in a lower per-share
price for the round. From a valuation viewpoint, such adjustments are cosmetic. There are many
examples, however, of norms or reference prices in practice, and this is an example that pertains
to private equity.

Option Pools

In negotiating other issues relevant to valuation, the parties should also consider a third
constituency, the firm’s employees. The entrepreneur and investors will likely agree upon the
importance of reserving a pool of shares for future use as an employee incentive, both to
4
Founders’ shares are shares of common equity as opposed to preferred shares
5
One can also find the number of new shares as the number of preexisting shares × [F ÷ (1 – F)]. (500,000 ×
(0.2278 ÷ (1 – 0.0.2278) = 147,501 new shares).
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augment compensation or to hire and retain highly talented workers. Although the entrepreneur
and investors will agree on the need to reserve shares for employees, they may not agree on the
number of shares that should be reserved or how such shares should be incorporated into the
company’s valuation.

Investors should discuss up front how the share reserve pool will be incorporated into the
valuation with the entrepreneur. Using the above example, we can see the importance of this
determination. Suppose the preclose valuation is set at $6.58 million, and 250,000 shares have
been allocated to the share reserve pool. Investors will seek to include those reserved shares in
the number of shares outstanding. Therefore, they will argue that a total of 750,000 shares rather
than 500,000 shares are previously outstanding. Since investors are bargaining for 22.78% of the
company, their share allocation should be 221,251 (versus 147,501) shares, which would result
in a larger total of 971,251 (versus 647,501) shares outstanding after the close of the deal. Since
more new shares are issued, the price per share falls from $10.17 to $6.78 ($6.58 million ÷
971,251), but since investors own 221,251 shares, their investment is still worth $1.5 million
(ignoring rounding).

It is in the entrepreneur’s interest, however, to try and exclude the reserve pool from the
valuation. If the entrepreneur is successful, investors will still receive 147,501 shares as
originally calculated. As the reserved shares are granted to employees, they will dilute the value
of the investors’ shares. The fully diluted price per share is still $6.78, but investors would hold
only 147,501 shares. Therefore, the value of their investment would be worth $1.0 million
instead of $1.5 million. In this circumstance, investors actually purchase 15.2% of the company
(147,501 ÷ 971,251 = 15.2%) rather than the 22.8% they originally sought.

The treatment of the share reserve pool not only affects the price per share and the value
of the investment, but other aspects of the deal that have to do with control rights. One such
example concerns the corporate governance provisions. Credible governance mechanisms help to
maintain the value of an investment by providing the investor with monitoring capabilities that
can be used to discourage misbehavior by the entrepreneur. The strength of those monitoring
provisions often depends on the percentage of ownership and control investors’ possess.
Therefore, for a number of reasons, investors should be mindful of the treatment of reserve pools
in negotiating the terms of the deal.

Discounted Cash Flow Method

The discounted cash flow (DCF) approach typically attempts to determine the value of
the company (or enterprise) by establishing the NPV of cash flows over the life of the company.6
Since a corporation is assumed to have infinite life, the analysis is typically broken into two
parts: a forecast period and a terminal value. In the forecast period, explicit projections of free

6
One can value the enterprise or the equity of the enterprise, but this note focuses on valuing the company as a
whole (the enterprise). When valuing the equity, residual cash flows are used, which are after-interest payments and
debt repayments. One must discount residual cash flows at the cost of equity.
 -6- UVA-F-1471

cash flow (FCF) that incorporate the economic benefits and costs of the firm must be developed.
Ideally, the forecast period should equate with the interval in which the firm enjoys a competitive
advantage (i.e., the circumstances where expected returns exceed required returns). More often
than not, 5- or 10-year forecast periods are used in lieu of careful thinking about the subject. The
value of the company derived from FCFs arising after the forecast period is captured by terminal
value. Terminal value is usually placed in the last year of the forecast period and capitalizes the
present value of all future cash flows beyond the forecast period. Often the terminal region cash
flows are projected under a steady-state assumption that the firm enjoys no opportunities for
abnormal growth in this interval or that the expected returns from the target equal the required
returns. In summary, to capture the firm’s ongoing nature, we break the valuation of the firm into
two regions:

VALUE (V) = PV(FCFs in Forecast Period)

+ PV(FCFs after Forecast Period)

Once a schedule of FCFs is developed for the enterprise, the weighted-average cost of
capital (WACC) is used to discount them and to find the present value. The present value of
those cash flows provides an estimate of company value or enterprise value. Since few start-up
firms make extensive use of debt financing, the WACC is usually based on the company’s equity
cost of capital.

In contrast to the target rate used in the VC method, the WACC used in the DCF method
represents the opportunity cost or expected return on investments of similar risk to the enterprise
in question.

Free Cash Flows

The free cash flows should be operating cash flows attributable to the company, but
excluding financing charges. Generally, cash flow will be the sum of after-tax earnings, plus
depreciation and noncash charges, less investment. From an enterprise valuation standpoint,
earnings must be the earnings after taxes available to all providers of capital or NOPAT (net
operating profits after taxes). Cash flows should include the expected synergies (cost savings,
growth opportunities, etc.) of owning the firm in question. The cash flows must also be expected
cash flows meaning they reflect the level of performance that is most likely for the firm and not
the best or worst cases possible. By comparison, the VC method uses a success or best case
scenario. That distinction is especially important for early-stage companies: Research suggests
that 50% to 60% of all startups fail within four years of their founding.
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The inputs to free cash flow (FCF) are as follows:

EBIT (1 – T) = Net operating profit after taxes

+ Depreciation = Noncash operating charges including depreciation, depletion, and
amortization recognized for tax purposes
– Capital expenditures = Addition of long-lived capital assets during year (net of dispositions)
– ΔNWC = Change in net working capital (NWC), defined as current assets less
non-interest-bearing current liabilities.

To determine the expected FCF, the best-case forecast of FCF must incorporate the high
probability of enterprise failure for an early-stage company. The expected FCFt is given as:

E(FCFt) = Best-Case FCFt × (1 – Probability of Failure).

Enterprise or project failure is what is referred to in portfolio theory as diversifiable or

unique risk. Across a portfolio containing several investments in early-stage companies,
diversifiable risk is reduced until the risk of the portfolio comprises largely nondiversifiable or
systematic risk. For diversified investors in private equity, which would include most categories
of limited partners (e.g., pension funds, insurance companies, endowments, or high-net-worth
individuals), the discount rate used in the DCF method is based on the systematic risk or beta of
the enterprise. Note that this does not mean that unique risk is unimportant. Rather, under the
DCF method, the cash flows are adjusted directly for the possibility of enterprise failure or
unique risk rather than adjusting the discount rate, which captures systematic risk.7

Even the simplest income statement (Figure 2), which provides key inputs into the
estimation of FCF, requires assumptions about the level and growth rate of revenues, production
costs (COGS), and marketing expenses (SG&A). In addition, estimates of the amount of capital
expenditures upon which depreciation depends, and the sustainability of operating margins are
required. Such forecasts are difficult to make for mature companies, let alone for start-ups.
Nonetheless, those projections are at the heart of any business plan, and their reasonableness is
often the basis upon which investors make their judgment of an entrepreneur’s understanding of
the business and marketplace realities.

7
The greater the percentage of an entrepreneur’s wealth that is invested in the company, the higher his or her
opportunity cost or discount rate will be in relation to that of investors. Leaving aside differences in future
performance expectations for the firm, the difference in risk between entrepreneurs and investors is one reason why
valuations can differ so markedly between the parties. One paper estimates the cost of capital for venture capital
investors and entrepreneurs in high-tech initial public offerings (IPOs). It reports for the sample average a 16.7%
cost of capital before management fees and carried interest for a well-diversified investor. By comparison, an
entrepreneur with 25% of his or her wealth invested in the venture and 75% in a diversified market portfolio is
estimated to have a cost of capital of 40%. See F. Kerins, J. K. Smith, and R. Smith, “Opportunity Cost of Capital
for Venture Capital Investors and Entrepreneurs,” Journal of Financial and Quantitative Analysis 39, no. 2, (June
2004).
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Figure 2. Income statement.

Sales
– Cost of goods sold (COGS)
– Selling & administrative expenses (SG&A)
Earnings before interest & taxes (EBIT)
– Interest expense
Taxable income
– Taxes
Net income (NI)

The DCF approach cannot eliminate the need to make difficult forecasts, but it can
handle several problems that occur frequently with early-stage companies. First, by including all
FCFs in the forecast period, the method captures the value associated with the fact that early-
stage companies frequently lose money in their first several years in business. Second, it includes
capital expenditures and the purchase of other long-lived assets. These items are not included in
COGS or operating expenses, which are annual or short-term expenses. These expenditures can
have pronounced effects on both the funding requirements and ultimately the viability of early-
stage enterprises. Third, it can address the problems of high (or varying) growth rates and
uncertainty in a straightforward manner through the use of probability-weighted scenarios. The
DCF method, if properly employed, allows an investor to account in a fuller sense than the VC
method for the uniqueness of each company. After all, it is the uniqueness of the company and
its particular circumstances upon which success in private equity depends.8

Terminal Value

To capture the longevity of the cash flows, the DCF method typically uses a terminal
value (TV) at the end of the forecast period to value the cash flows beyond that point. As a base
case, terminal value can be estimated using a constant-growth-rate DCF formula:
FCFN × (1 + Growth)
TVN =
WACC – Growth
TVN = Terminal value in year N that values cash flows beyond year N
FCFN = Free cash flow for year N
Growth = Long-term sustainable growth rate of cash flows—normally equal to GNP growth or
inflation plus 1% to 2% real growth.
WACC = The discount rate should reflect the risk of the cash flows. Since early-stage
companies are private, we find an appropriate rate based on the beta coefficients
from publicly held companies that are comparable to the target.

8
For further discussion of the merits of the DCF method in this context, see D. Desmet, T. Francis, A. Hu, T.
Koller, and G. Riedel, “Valuing Dot-coms,” The McKinsey Quarterly 1 (2000).
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If carefully applied, a growing perpetuity can provide a reasonable estimate of TV for

established companies, but determining one sustainable growth rate for an early-stage company
can be problematic. For this reason, market comparables are often used to supplement the base-
case TV estimate.

Some of the frequently used multiples in private equity are evaluated in Figure 3 for a
typical company included in Standard and Poor’s (S&P) Small Cap 600 Index. The publicly
traded companies that make up the index are generally larger in size, more transparent, and
liquid than a privately held company. For those reasons, the public company valuation multiples
are reduced by a 30% liquidity discount to reflect the fact that investors have been shown to pay
more for more transparent and liquid companies.9 Assuming a five-year exit horizon and that the
value of the firm is based only on the terminal value cash flow (something that violates the
assumptions of the DCF method), the Figure 3 shows the comparative postmoney valuations
derived using alternative valuations approaches. The growing perpetuity method provides the
lowest valuation, most likely because the assumed growth rate of 5% is less than the embedded
growth rates of the other multiples. The range in estimates underscores the importance of
examining alternative estimators of terminal value.

9
Two studies attempt to more rigorously estimate the size of the liquidity discount by comparing publicly
traded firm valuation to private firm valuation for a sample of firms in the same industry over the same period of
time. J. Koeplin, A. Sarin, and A. Shapiro, “The Private Company Discount,” Journal of Applied Corporate Finance
12, (Winter 2000): 94–101 reports a 30% liquidity discount for a sample of firms from 1984–98. S. Block, “The
Liquidity Discount in Valuing Privately Owned Companies,” Journal of Applied Corporate Finance, (Fall/Winter
2007): 33–40 finds an average discount of 20% to 25% for a sample of firms between 1999 and 2006. His study also
examines the discount by industry and finds that the discount is highest for manufacturing firms (30% to 40%) and
lowest for financial firms (8% to 10%). Block attributes the lower discount in the latter period to the reduction in the
length of holding period from two years to one year under Rule 144 before which private assets can be sold publicly.
Because after 1997, Rule 144 requires investors to hold an investment for one year, these assets are more liquid than
the typical early-stage investment, and we use 30% as a more representative discount in the absence of more detailed
information about the assets being valued.
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Figure 3. Comparative postmoney valuations.

Enterprise
Growing Price–Earnings Value ÷ Enterprise
Valuation Multiples Perpetuity Ratio EBITDA10 Value ÷ Sales
Inputs:
Discount or target rate (%) 17% 50% 50% 50%
Market
Numerator Free cash flow capitalization Enterprise value Enterprise value11
Denominator (WACC – g) Net income EBITDA Sales
Terminal year cash flow ($ mil.) $80 $91 $165 $960
Valuation multiples – 20.30 10.90 1.90
Less liquidity discount 30% – 30% 30% 30%
Multiple applied – 14.21 7.63 1.33
Terminal value $70012 $1,293 $1,259 $1,277
PV of terminal value $319 $170 $166 $168
Less probability of failure 50% $160 – – –
Postmoney value $160 $170 $166 $168

Although multiples are widely used in private equity, there are several caveats that accompany
their use. These concerns take on added significance if only one method of valuation, such as the
VC method, is used.

 Multiples require careful research to find other firms comparable to the target company.
Finding the right comparables is one of the biggest challenges for start-up companies.
Many analysts begin by matching the target company to peers based on a four-digit
standard industrial classification (SIC) code. While that approach provides a first cut, it
may not yield a sufficient number of peers, or it can miss good peers that are somewhat
more diversified in their revenue sources than the target firm. Often research analysts’
reports can be used to supplement the identification of peer firms. Having identified a
peer group, the closest comparables will be those of similar size to the target. Market
capitalization or the level of sales is often used as the basis for judging comparable size.
 The multiple used to compute terminal value should be the expected multiple at the time
of exit. But how often is the current multiple likely to be a good guide to the future
multiple at the time of exit? Exhibit 2 summarizes the historical price–earnings (P/E)
ratios for the S&P500 Stock Index from 1900 to 2008. Although the S&P500 represents
much larger firms than the typical early-stage company, it has a long history over which

10
One will often see the multiple derived using earnings before interest and taxes (EBIT), too.
11
The FCF used in the terminal value formula should be the forward FCF for the next period. The terminal
value calculation assumes a 17% WACC based on a beta from peer companies of 2.0, a risk-free rate of 5%, and a
market risk premium of 6%. A 5% growth rate into perpetuity is also assumed.
12
Enterprise value is the market value of equity (or market capitalization) plus interest-bearing debt less cash in
excess of that required for operating purposes.
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valuation can be gauged.13 Multiples, like equity prices in general, have a tendency to
exhibit regression toward the mean. This can be seen in Exhibit 2 where high (low) P/E
ratios have a tendency to decrease (increase) toward to the historic P/E ratio of 16.3.
Whether due to behavioral biases or the self-correcting mechanism of markets, as prices
and therefore multiples go higher, capital flows into those assets increase, which
eventually drives down returns, reducing capital flows, and thereby decreasing prices.
Because there is a tendency for regression to the mean, those buying at high multiples are
more likely to experience a lower multiple at exit-especially if the exit occurs several
years later. For example, were we to determine the terminal value using the P/E in 1999
of 42.1, then assuming a five-year exit horizon, we would overestimate the P/E of 26.4
that occurred upon exit in 2004. Although the phenomenon that investors overpay for
growth (or, conversely, underpay for the dull) is documented in many studies, the speed
and degree to which prices revert to the mean is not easily predicted.
 Exhibit 3 shows how market valuation, venture capital funding raising, and the vintage
year internal rates of return (IRR) are related. One observes a tendency for investments
made at times of high P/E to subsequently yield lower returns. Research confirms that
investments made during times of high valuation underperform for several reasons. First,
as seen in the exhibit, more capital and investors are attracted into the market during
periods of high valuation, so that competition and therefore prices are higher for deals.
Compare, for example, the years 1991 and 2000. In 1991, the NASDAQ had its lowest
P/E (18), and the lowest amount of capital was raised, but the funds invested that year
produced an IRR of 28.9%. In 2000, the NASDAQ reached its highest P/E (60), and the
highest amount of capital was raised, which produced an IRR of –0.50%. Second, for
unknown reasons, during hot markets, investors become more accepting of risk than
during cold markets, which enables, all else being equal, lower-quality firms to receive
funding, and these firms subsequently disappoint investors. Through experience and
training, one must learn to watch for signs of overvaluation and factor appropriate down-
side scenarios into the valuation to capture that potential effect. Some candidates that
might offer clues to overvaluation are elevated multiples (P/E, EBIT, and EBITDA
multiples) of market indices, a large number of recent IPOs with a high degree of
underpricing, and significant increases in the capital commitments to particular sectors of
venture capital.

In addition to the above, there are some other considerations that apply any time
multiples are used.

 Multiples must be consistent with the appropriate underlying cash flow they capitalize.
For example, if a multiple is used in place of the constant growth model for terminal
value, the multiple must be based on FCF, EBIT, or EBITDA (unless the companies are
all equity financed). Only those multiples are consistent with the prefinancing cash flows

13
We plot the S&P500 Index rather than the Russell 2000, the most widely used index of small cap stocks,
because it originated in 1988. Also the NASDAQ Composite, an index that features many technology-oriented
companies, originated in 1973.
 -12- UVA-F-1471

available to all capital. Alternatively, if the underlying cash flow is net income, the return
to equity holders after interest has been paid, then the appropriate multiple to use is the
P/E.
 Multiples depend on accounting practices. There are a number of acceptable ways to
determine operating earnings or net income.
 Multiples assume an undefined growth rate into perpetuity.
 Multiples can ignore the critical differences between profits and cash flow, for example,
new capital expenditures and investment in net working capital and depreciation.

Adjusting for Multiple Rounds of Financing

Early-stage companies are capital-intensive by nature, and one investment by venture

capitalists is rarely enough to bring a company to maturity. If fact, evidence suggests that it
typically takes four to five rounds of investment to reach the point of a sale or IPO exit.14 Unless
investors continue to invest on a pro rata share basis in successive rounds, dilution of their equity
positions, a loss of ownership due to the issuance of additional shares, is likely to occur. While
legal tools such as antidilution provisions and liquidation preferences provide investors some
defense against dilution, venture capitalists still see dilution as their “greatest enemy.”15

Some notion of the potential effects of dilution can be gleaned from the number of rounds
and percentage of equity sold in successive rounds of financing. Figure 4 shows the median
percentages of equity sold for a sample of 400 venture capital financings that occurred over a
two-year period prior to September 2006.16 Notice as the rounds continue, the median percentage
of the company sold in each round decreases. This is consistent with the idea that the earlier
rounds are more “more expensive” to entrepreneurs because VCs are asked to bear more risk in
these rounds and, for a given amount of funding, are compensated with a higher percentage of
equity.
Figure 4. Median percentages sold by round.
Series A B C Later
Number of Deals 154 148 65 67
Median % Sold 42.9% 37.1% 25.2% 20.9%

14
S. Chaplinsky and S. Gupta-Mukherjee, “The Rise of M&A Exits in Venture Capital: Implications for Capital
Recovery,” Darden School working paper, August 2009.
15
Justin J. Camp. Venture Capital Due Diligence: A Guide to Making Smart Investment Choices and Increasing
Your Portfolio Returns. (NY: John Wiley & Sons, Inc., 2002), 108. For a discussion of the legal terms employed in
term sheets, see S. Chaplinsky, “Early Stage Term Sheet,” UVA-F-1444.
16
Cooley’s Private Company Financings Report is published quarterly and is based on private company
transactions in which the firm served as counsel to either the issuing company or the investors. See Private
Company Financings Report, Cooley Godward LLP, September 2006,
http://www.cooley.com/files/tbl_s5SiteRepository/FileUpload21/869/PCF%202006%20Q2%20final.pdf (accessed
August 25, 2009).
 -13- UVA-F-1471

Let’s return to our previous example in Figure 1 where an investor was considering a
$1.5 million investment in a company whose terminal value was expected to be $50 million in
five years. In the absence of considering the effects of additional rounds of financing, that
analysis showed a VC making a $1.5 million investment at a target rate of 50% per year would
need to own 22.78% of the firm’s equity at the time of exit.

If investors had anticipated that additional rounds of financing would be required after
this round, they would have needed to negotiate a higher percentage of equity than 22.78% in the
seed round to account for dilution.

For each round i, the fraction of ownership sold to VCs (F) is measured as Fi = Ii ÷
POSTi.. To capture the cumulative effects of multiple rounds of financing, we calculate the total
aggregate percentage ownership stake sold to VCs (VC%T) for each portfolio company that exits
at time T after N financing rounds in the following manner:

.
Assume the $1.5 million was a seed round of financing, and that, thereafter, an A and B
round will follow after which the firm will be exited. Assume further the percentages of
ownership sold in those rounds conform to the medians reported in Figure 4 (i.e., Series A =
42.9% and Series B = 37.1%). Each round of subsequent investment results in a larger
cumulative share of the company being sold to other investors, as the seed round investors’
stakes are diluted.

VC%T = 42.9% × (1 – 37.1%) + 37.1% = 64.08%.

Subsequent to the seed round, a cumulative total of 64.08% is sold to the Series A and B
round investors. One minus the amount sold to investors is referred to as the retention ratio
(35.92%). With this information, we can adjust the seed round stake to account for the effects of
this dilution.

Adjusted Initial Ownership Stake (%) = 22.78% ÷ (1 – 64.08%) = 63.43%

Intuitively, if the seed round investors anticipate additional rounds of financing, they must
negotiate a higher stake in the seed round to be left with 22.78% of the equity at the exit point to
achieve a target rate of 50%. That is, if the seed investors had negotiated an initial stake of
63.43%, after the completion of the Series A and B rounds, they would be left with 22.78% of
the equity prior to exit [63.43% × (1 – 64.08%) = 22.78%].
 -14- UVA-F-1471

Additional Considerations

Of necessity, this analysis has simplified a number of factors required to fully account for
the effects for dilution. In reality, early round investors (and most especially the founders!) must

1. estimate the number, timing, size, and discount rates of investors for the successive
rounds of financing that the company will undertake
2. estimate the required final ownership percentages that
i. they and other subsequent investors in those rounds will likely demand
ii. future management and key employees will be granted
iii. the ownership percentage (if any) that will be sold in an IPO17

In addition, market conditions can influence the size, terms, and timing of the financing.
For example, Fenwick & West Venture Capital Barometer of venture capital financings showed
an average price decrease of 3% for companies receiving venture capital in Q1 2009 compared
with the companies’ prior financing round, the first decrease since Q1 2004.18

Valuation that considers successive rounds should remember that founders may need to
be compensated with additional equity over time to maintain their incentives by ensuring a
minimum equity threshold. In even a successful company with multiple rounds prior to an IPO,
founders can be left with a small percentage of the total shares. Although investors expect their
investment to increase in value in each successive round, founders must anticipate that they will
likely experience some dilution with each successive round. Thus, their primary “consideration
should be to what extent any current round, and the dilution it involves, will generate a rise in the
long-term value of their holdings.”19

Summary

Often practitioners will argue that the level of uncertainty is so pronounced for early-
stage companies that formal valuation of the enterprise, whether dilution from successive rounds
is contemplated or not, is a meaningless exercise. Our goal in valuing an early-stage company is
not to develop a precise estimate of its value. Rather, valuation serves as a rigorous check on the
credibility of our assumptions and knowledge of the company, industry, and market. Because
forecast precision is a problem, strategic issues must also be considered carefully. These include

17
Camp, supra note 15, at 220–2.
18
Two good sources of information on the changing terms of venture contracts can be found here: “Venture
Capital Survey, Silicon Valley First Quarter 2009,” Fenwick West LLP,
http://www.fenwick.com/publications/6.12.1.asp?vid=9; Cooley Godward Kronish LLP, “Cooley Report Highlights
Q1 2009 Venture Capital Financing Trends,” press release, http://www.cooley.com/59015 (accessed August 25,
2009).
19
Oren Fuerst and Uri Geiger. From Concept to Wall Street. (Upper Saddle River, NJ: Pearson Education, Inc.,
2003), 127.
 -15- UVA-F-1471

realistic assessments of the size of the market and the opportunity, the ease of entry (which is too
often assumed to be difficult), and the quality and depth of management. Be wary of the
sustainability of barriers to entry created by technology, a common claim of early-stage ventures.
Experience suggests that when there is rapid technological innovation, it is possible to be
“leapfrogged,” and when technological innovation is slow, it is easier for competitors to catch
up. By combining a candid assessment of both the financial and strategic strengths and
weaknesses of the company, one can prepare to successfully deal with the uncertainty of early-
stage investments.
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Exhibit 1
VALUING THE EARLY-STAGE COMPANY
Target Rates of Return (ROR) Sought by Venture Capital Investors

Typical Expected Holding

Stage Annual ROR% Period (years)
Seed and startup 50%–100% or more More than 10
First stage 40%–60% 5–10
Second stage 30%–40% 4–7
Expansion 20%–30% 3–5
Bridge and mezzanine 20%–30% 1–3
LBOs 30%–50% 3–5
Turnarounds 50%+ 3–5
Data source: Jeffrey A. Timmons, New Venture Creation, 4th ed. (Chicago: Irwin, 1994), 512.
 -17- UVA-F-1471

Exhibit 2
VALUING THE EARLY-STAGE COMPANY
Price–Earnings Ratios for the S&P500 Composite Stock Index: 1900–2008

Note: P/Es are based on average inflation-adjusted earnings from the previous 10 years.
Source: Robert Shiller, Yale University.
 -18- UVA-F-1471

Exhibit 3
VALUING THE EARLY-STAGE COMPANY
Price–Earnings Ratios for the NASDAQ Composite Index, Capital Commitments,
and IRRs for Venture Capital Funds

No. of Funds Gross Period Vintage Year

NASDAQ with New Amount Raised Since Inception
P/E Ratio Commitments ($ millions) IRR (%)
1985 22.9 161 $4,688 9.2
1986 35.0 132 4,619 10.1
1987 40.8 144 5,470 13.5
1988 40.9 137 6,126 19.8
1989 36.5 156 6,502 16.3
1990 24.7 144 5,097 24.4
1991 18.0 77 3,592 28.9
1992 22.7 119 6,097 29.4
1993 23.0 164 6,500 28.6
1994 24.1 212 12,949 33.1
1995 20.3 276 14,320 57.1
1996 22.9 301 17,234 59.2
1997 26.7 461 28,119 46.0
1998 27.1 571 43,821 23.5
1999 35.6 881 77,198 –7.2
2000 60.0 1,472 158,834 –0.5
2001 33.7 772 59,664 1.3
2002 46.4 489 18,303 1.1
2003 31.1 360 19,470 6.4
2004 35.2 439 31,320 1.2
2005 22.2 490 48,613 2.0
2006 24.2 546 60,815 –7.5
2007 24.5 538 72,295 –17.1
2008 23.8 542 65,624 –48.2
Average 30.1 399 $ 32,386 13.8
Median 25.7 330 $ 17,768 11.8
Data source: P/E data are from Datastream, and data on commitments, gross period amount raised, and
IRRs are from Thomson Reuters. IRRs are capital weighted returns.