Venture Valuation of Angel and Seed Companies 
 
 
 
 
 
 
 
 

Darien Kusler

Oregon Health Sciences University – Oregon Graduate Institute

Winter Term 2005

Introduction

Several academic business valuation methods exist for determining the potential investor return on capital in seed and angel investments, also referred to as new venture investments. These methods include specific industry heuristics or comparables; the Net Present Value (NPV) method; Adjusted Present Value (APV); Monte Carlo Simulation; Real Options analysis; and the Venture Capital Method (VCM). 

Each of these academic models are helpful in valuing private companies, but the high level of uncertainty (risk) and lack of liquidity involved with a new venture investment opportunity coupled with the dynamics of capital markets compels investors to practice valuation as an art form and not a precise science. From the entrepreneur’s perspective, a thorough working knowledge of business valuation will assist new venture management in negotiating and justifying investment requirements, ownership stake, and the preferred shareholder terms. 

Entrepreneurs also need to remain mindful of the local market for investor resources and its influence on valuation. Local capital market influence can work to the benefit of the new venture firm in offering local expertise and networking opportunities. Likewise, geographic location, limited funding supply, and lack of experienced industry professionals and knowledge can all work to the detriment of a new venture’s success.

Valuation Models

In general, academic valuation models have significant benefit for the entrepreneur in building awareness of a realistic business valuation to offer potential investors, who many times ask the valuation question as an “acid test” of a promising business opportunity. As Peter Kolchinsky notes, “[If the entrepreneur’s valuation is extremely high] the investor may see the entrepreneur as naïve or delusional and not bother to engage in negotiations. Time is on the investor’s side; eventually, an entrepreneur with unreasonable expectations will discover that investors are not interested and will lower valuation until it falls into investor’s negotiating range.”¹  

Some of the common valuation models for determining a startup’s terminal value and associated valuation are listed in the table below along with their strengths and weaknesses for valuing new venture firms: 

Table 1: Valuation Models² 

Options analysis remains one the most promising and least understood valuation methods. Its applicability to early stage ventures would appear to offer the investor some flexibility in conserving capital and in valuing an opportunity based on an array of strategic options to more efficiently manage investment portfolios. Many experts attribute the low utilization rate of options analysis (considered to be less than 10% of all firms worldwide) to a lack of understanding of its practical application, a shortage of software tools for employing options analysis (coincidentally, DCF and NPV were not popular until desktop spreadsheet software became available), and finally to the complexity of implementing real options analysis. Consider the case of Airbus which implemented real options to value contract “sweeteners,” like asset value guarantees, financial support, and performance guarantees in the sale of its airplanes. Similar to venture capital term sheets, neither Airbus nor its customer knew how to value seemingly complex contractual concepts with discounted cash flow. More importantly, Airbus did not understand the cost of these contractual terms. In the end, Options analysis helped the firm justify some of its contractual services costs and ensure profitable business negotiations.³ For investors and entrepreneurs alike, Decision Tree Analysis combined with Monte Carlo Analysis could be the future for analyzing opportunities and avoiding unnecessary risk. 

In interviews with SmartForest Ventures, Cascadia Partners, and Capybara Ventures the preferred method for valuing a new venture investment opportunity was the Venture Capital Method (See diagrams in the appendix). Generally, none of firms interviewed subscribed to a particular method for arriving at a terminal value, but preferred instead to look at the more qualitative aspects of the opportunity given that most were very early stage opportunities and lacked verifiable quantitative data. In determining a terminal value all of the investment professionals interviewed employed a comparables approach through subscription services such as VentureOne, PWC Money Tree, and VentureWire.^{4 5 6 7}  

Mr. Embree noted in his presentation at Angel Oregon 2005 that early stage VC’s don’t use discounted cash flow, net present value, or Black-Scholes (options analysis). Comparables of what other investors are paying for similar investments, competition for investment dollars in the local market, and the appeal of a particular technology or market segment are more appropriate.⁸ 

The key criteria in determining the appeal of a new investment (and therefore its pre-money valuation) mentioned by each venture professional was the quality and direct market experience of the management team. Mr. Embree stated that, “patents are virtually worthless…[when considering new opportunities].” Instead he preferred to focus on the strength and experience of the management team versus the intellectual property of the firm, even though both aspects are important to the success of a new venture. Mr. Rosenfeld also mentioned, “[Capybara Ventures] is looking for relevant direct experience in [the new venture’s] target market.” Ms. Kenny also offered her key criteria for determining the valuation of a potential investment: 

1. Total estimated investment over the life of the opportunity. Certain industries are favored and given higher valuations (consider a software firm with low capital equipment expenditures and expected industry returns versus a manufacturing company).
2. Liquidity and exit path. Time to exit and the expected return are key. Before the downturn in venture investments in technology companies (often referred to as pre-bubble) the typically time to exit for seed and early stage investors was 5 to 8 years. Post-bubble the time to exit extends 8 to 10 years from the initial investment.
3. Management team and their relevant experience in the market they are pursuing. At least one member needs to have very “deep” industry experience from a business management perspective.
4. Other terms and liquidation preferences, all of which fall under the terms in a term sheet and sometimes referred to as “preferred terms.”
5. Competition among investors for financing the opportunity. If several investors are evaluating the same opportunity, the valuations and preferred terms negotiated with the startup firm tend to make the opportunity less attractive. This is a one reason why entrepreneurs need to consider the other benefits of doing business with one investor over another as the guidance and experience of the venture capital professional can extend beyond just the capital inputs.⁹

In determining the ownership percentage to investors and ultimately the pre-money valuation of a startup is dependent on how compelling the startup’s story is with relation to the market, competitive advantage, the technology behind the startup, financial requirements, future financing requirements (dilutes initial shareholder ownership), and the experience of the management team. Current rules of thumb regarding ownership 33-50% will go to investors of a seed round, while 25-60% will go to investors of the 1^st and 2^nd rounds. Each of the investment firms interviewed felt it was critically important to offer management and employees an ownership stake ranging between 15% and 30% of the business.¹⁰ 

Dana Callow of Millenia Partners wrote, “The valuation of a company at a discreet point in time is subject to a certain range of interpretation. Most seasoned venture investors will value a company within 10-15% range of each other if they have exhausted all quantitative and qualitative data available.”¹¹ This highlights another important consideration between entrepreneurs and investors - venture capital investors and their representative firms have personalities that correlate with particular industries, geographies, growth goals, and access to other professional services like lawyers and investment bankers. Building value is the common goal between investor and entrepreneur. The goodness of fit between the two parties can have a positive impact on the success of a startup business. 

Considering that most venture capital investor funds are funding several ventures at one time (many of which will fail), the lack of liquidity of startup investments, the ample supply of opportunities to consider (deal flow), and the additional business consulting or mentoring they provide entrepreneurs; venture capital investors seek to earn a relatively high rate of return on their investments. Also, considering many entrepreneurs are overly-optimistic in their target financial projections, venture investors feel justified in discounting terminal values at 50% or higher depending on the startup’s position in the funding cycle.¹²  

It is evident from discussions with venture professionals that the pre-money valuations for early-stage startup firms is in the single digits. They are typically valued well below $5 million pre-money. The risk is considerable for firms at this stage and investors are less optimistic about the exit horizon for these firms and the potential for additional capital infusions to maintain them until another financing round can occur or the initial business concept is proven to be unworkable. Therefore, very early-stage venture investors seek a return of nearly 100% on money invested in these ventures. 

Some typical investor returns and probabilities are noted in the table below: 

  Table 2: New venture risk and return 

The typical exit strategy for nearly all new venture opportunities according to Jeff Karan of Woodside Capital Partners is mergers and acquisitions (M&A). Historically, 90% of all startups realize liquidity through M&A, while 10% pursue an initial public offering (IPO). At the moment, nearly 100% of startup firms liquidate through M&A considering the state of the public markets and the return of the historical IPO standards, such as:

• A revenue run rate of $40 to $60 million and over $15 million of that per quarter
• At least 3 quarters of profitability
• Growth rates in excess of 20% to 25%
• Valuations based on multiples of revenues and earnings¹⁹

A final consideration for entrepreneurs is the deal structure including the terms or “preferences” that investors require for the valuation and capital they are offering.²⁰ The simpler and less complex deal structures are associated with lower valuations. Complexity is directly related to the concepts discussed previously including:²¹

• Startup’s history and achievement of milestones to date
• The experience of the management team
• Total estimated investment until exit
• The time to exit or investment horizon
• Options available for liquidity
• Competition among investors for the opportunity, including local capital constraints

The preferences in the term sheet are designed to protect the investors and offset risk. Investors expect that the startup is creating shareholder value and that investors participate in the potential “upside” of a successful venture beyond just the initial investment through warrants and conversion rights. Investors also want to ensure some level of control over the startup through board membership (voting and veto rights), approval of dilutive issues (stock issuance or M&A activity), and inspection of information.  

For the investor the preferences can increase the return on an investment significantly. For the entrepreneur the preferences can make impact management decision making and change the balance of a valuation in favor of the investor. The preferences need to be reviewed and negotiated carefully to ensure both sides share in the growth of startup.

Conclusion

With the possible exception of real options theory, the academic valuation models reviewed in this paper favor established businesses with positive cash flow, stable capital structures, and consistent performance. Coincidentally, these are not characteristics of early stage startup firms.  

The contemporary approach to valuing startups includes the use of recent venture funding comparables, the Venture Capital Method, and a lot of confidence. Without quantitative evidence to support a startup’s valuation, entrepreneurs and investors practice a tactful art. Negotiating talent and an awareness of the valuation process are the only practical tools an entrepreneur has to find balanced funding and practical advice for the new venture. Ideally, the fit between the venture investment team and the entrepreneur will promote an alignment towards creating value and wealth for the team.

Appendix

Diagram 1: Sample valuation sheet using VCM (courtesy of Cascadia Partners) 

Diagram 2: Another VCM model (courtesy of SmartForest Ventures)

References

Callow Jr., Dana A. “Understanding Valuation: A Venture Investor’s Perspective.”

Millenia Partners website: http://www.milleniapartners.com/documents/WhitePaper/ WhitePaperAttachment6.pdf (22 January 2005).  

Embree, Wayne and Brent Bullock. Angel Oregon 2005 – Negotiations, Valuation and the Term   

Sheet (Presentation Slides). Cascadia Partners and Perkins Coie LLP. 

Evers, William D. Handbook Series for Start-ups and Emerging Companies: “How To” for

Early Stage Structuring – A Guide for Entrepreneurs. Published by Foley & Lardner, San

Francisco, 2002). 

Feld, Brad. To Participate or Not (Participating Preferences), 24 August 2004. Feld Thoughts

website: <http://www.feld.com/blog/archives/2004/08/to_participate.html> (27 February

2005). 

Fenigstein, Tzur. Issues Arising in the Valuation of Hi-Tech Companies. Published by

PriceWaterHouseCoopers LLP, 2003. 

Hanley, Mike. “Reality Bites.” CFO Europe.com website (July/August 2001),

<http://www.cfoeurope.com/displaystory.cfm/1736887/1_print> (22 January 2005). 

Higgins, Robert C. Analysis for Financial Management, 7^th edition (New York: McGraw-Hill,

2004). 

Kenny, Clare. Valuation: The Art of the Deal (Presentation Slides). Smartforest Ventures. 

Kolchinsky, Peter. “Director’s Note: Setting a Valuation.” Evelexa BioResources website (23

January 2002), <http://www.evelexa.com/archives/012302.cfm> (22 January 2005). 

Lerner, Josh and John Willinge. A Note on Valuation in Private Equity Settings. (Boston:

Harvard Business School Publishing Article 9-297-050, 1996). 

Loessberg, Shari. Early Stage Capital: Term Sheets 101. Fall 2003. MIT Entrepreneurship

Center. <http://ocw.mit.edu/NR/rdonlyres/Sloan-School-of-Management/15-    391Fall2003/C3BB0FC9-C820-438E-B1E2-1F6C9A316A62/0/lec2_term_sheets.pdf> (20 February 2005). 

Luehrman, Timothy. Capital Projects as Real Options: An Introduction. (Boston: Harvard

Business School Publishing Article 9-295-074, 1994). 

Nassar, Anthony. “Featured Interview – A Well Traveled Path to Liquidity.” (11 February 2004).

<http://www.venturemomentum.com/ezine/feb2004issue.htm>  (27 February 2005). 

Reinsberg, Indra and Dwight Crane. Note on Valuing Private Businesses. (Boston: Harvard

Business School Publishing Article 9-201-060, 2001).

¹ Peter Kolchinsky, “Director’s Note: Setting a Valuation,” http://www.evelexa.com/archives/012302.cfm (23 January 2005).

² Josh Lerner and John Willinge, A Note on Valuation in Private Equity Settings, Harvard Business School Publishing, Article 9-297-050, 13.

³ Mike Hanley, “Reality Bites,” www.cfoeurope.com/displaystory.cfm/1736887/1_print (July/August 2001).

⁴ Wayne Embree, Managing Partner – Cascadia Ventures, personal interview conducted on March 8, 2005.

⁵ Eric Rosenfeld, Managing Partner – Capybara Ventures, personal interview conducted on March 10, 2005.

⁶ Clare Kenny, CFO Smarforest Ventures, personal interview conducted on March 14, 2005.

⁷ My personal thanks to each of the investment professionals that met with me to discuss venture financing.

⁸ Wayne Embree, Angel Oregon 2005 Presentation on Negotiations, Valuation, and the Term Sheet.

⁹ Clare Kenny, personal interview conducted on March 14, 2005.

¹⁰ Wayne Embree, Angel Oregon 2005 Presentation on Negotiations, Valuation, and the Term Sheet.

¹¹ A. Dana Callow, Jr. and Michael Larsen, “Understanding Valuation: A Venture Investor’s Perspective,” Millenia Partners website (see References), P 5.

¹² Robert C. Higgins, Analysis for Financial Management – 7^th Edition (New York: McGraw-Hill, 2004).

¹³ Clare Kenny, personal interview conducted on March 14, 2005. Special thanks to Clare for sharing her presentation “Valuation: The Art of the Deal” and insights on the venture investing where the IRR and probabilities were gathered from Vinod Khosla, Kleiner Perkins 2002.

¹⁴ Clare Keny, personal interview

¹⁵ A. Dana Callow, Jr. and Michael Larsen, P 1-4.

¹⁶ A. Dana Callow, Jr. and Michael Larsen, P 1-4.

¹⁷ A. Dana Callow, Jr. and Michael Larsen, P 1-4.

¹⁸ A. Dana Callow, Jr. and Michael Larsen, P 1-4.

¹⁹ Anthony Nassar, “Featured Interview – A Well Traveled Path to Liquidity (Jeff Karan, Managing Partner of Woodside Capital Partners),” http://www.venturemomentum.com/ezine/feb2004issue.htm.

²⁰ A complete discussion of all term sheet terms and preferences is beyond the scope of this paper. The reader is encouraged to read the Angel Oregon 2005 Resource Guide which includes an annotated term sheet from Perkins Coie LLP.

²¹ Wayne Embree, Angel Oregon 2005 Presentation on Negotiations, Valuation, and the Term Sheet.