Overview of Valuation Methods
Valuation methods are particularly important in startup ventures, as valuation affects the interest of potential investors and reflects the expectations of the firm’s future performance. Equity investors in startup ventures seek a return on their investment via a future exit event. Examples of exit events include selling one’s equity investment to a future round of investors, selling it back to the company, or selling it to the public via an initial public offering of the business’ stock. Capitalizing on a future exit event contrasts with the intentions of an investor who seeks a routine dividend from an established company. Given these expectations, startup investors will only invest in a company that has potential to achieve a certain terminal value or value at the time of exit. Specifically, investors will be concerned that the valuation reflects a terminal value that is sufficient to compensate the investor for the risk incurred by investing in the business. The terminal value will reflect the current value of the firm based upon future expectations of firm performance.
Pre-money and Post-Money Values
While the terminal value is the investor’s objective, the amount of money an investor is willing to invest depends entirely upon the present valuation attributed to the business. The present valuation is split into two categories: pre-money and post-money valuation. The pre-money valuation is the value attributed to the firm prior to infusing any new capital. The post-money valuation is the value of the firm immediately following the infusion of capital. Divide the amount of money invested in the company by the post-money valuation and the result is generally the percentage of the company (the equity interest) that the investor will own following the investment. With this in mind, the prospective investor is concerned with the method used to derive the current valuation of the firm.
Various Valuation Methods
How do the entrepreneur and investor arrive at an appropriate value or percentage of business equity to exchange for the investor’s funds? Historically, investors have used a litany of different methods to value the business, including industry or transaction comparables, net present value calculation, adjusted present value calculation, or the venture capital method. These methods are generally categorized into three approaches to valuation:
- asset-based (or cost-based),
- market-based, and
- cash-flow-based methods of valuations.
Each of the above methods are addressed in individual lectures. Numerous hybrid methods exist that combine elements from these methods or employ complex financial principles based on assumptions derived from the above methods.