Valuation of Seed, Start-up, and Early-Stage Investments
Valuation experts typically agree that performing a business valuation is not an exact science. This becomes even more evident when valuing start-ups, as the valuation exercise becomes more of an art form.
By their very nature, start-ups have limited financial metrics that could be relied upon in arriving at business value. Typically, they have negative cash flows, limited or no historical financial data, unreliable forecasts, and a target market that has yet to be developed.
However, in situations where the investee had a recent transaction, the price of the recent transaction could be used to determine the fair value (FV) of the investment.
Recent transaction
The price of a recent transaction in an investee company’s equity can be used to calibrate inputs across various valuation methodologies. At each Valuation Date, an assessment must be made to determine whether there were any significant changes or events following the transaction that would require an adjustment in the investee’s fair value.
Adjustments to the recent investment price
When considering the price as indicated by a recent transaction as an input, the context of the transaction must be considered. Specifically, the following may suggest that the price did not entirely reflect fair value at the time of the investment:
- Different rights, privileges, and preferences associated with new and existing investments.
- Strategic motivations driving a new investor’s participation.
- Excessive dilution of existing investors resulting from new investor(s).
- Market conditions prevailing when the price was agreed upon by parties, regardless of the timing of the close.
- The transaction potentially being deemed a forced sale or a ‘rescue package’.
During periods of market distress, recent transaction prices that were negotiated before may no longer provide an indication of fair value.
Complex Capital Structures
Early-stage companies often raise capital through a combination of different classes of equity, each with different rights, privileges, and preferences. Most commonly, companies issue preferred stock through multiple rounds of financing, each at a higher price per share and liquidation preference.
The “headline” value, which considers the fully diluted value of all shares multiplied by the price paid per share in a recent financing round, overlooks the different rights and preferences of the other share classes. Additional analysis must be made to determine the fair value between the different financing events.
Various valuation techniques can be useful in estimating fair value:
- Scenario-based methods, forward-looking approaches considering one or more possible future scenarios (Simple Scenario, Relative Value Scenario, or Probability-Weighted Expected Return Method (PWERM)).
- The option pricing method (OPM) is a forward-looking approach that allocates the current equity value to different classes of equity, considering a continuous distribution of outcomes. The OPM method is most suitable for situations with longer holding periods before a liquidity event (sale or IPO).
- The current value method (CVM), which allocates the equity value to various equity interests as if the business were to be sold on the Valuation Date. This methodology is most suitable in situations where the investor has significant influence over the investee and a liquidity event is anticipated in the near term.
- The hybrid method, a blend of scenario-based methods and OPM.
When applying valuation techniques, it’s important to ensure that any allocation reflects market participant expectations for each share class and appropriately considers the risks and returns.
Conclusion
The price paid for a recent transaction is not a default in determining the fair value of an investee. In certain circumstances, adjustments to the recent investment price must be made to arrive at a fair value, specifically when the shares have different rights and restrictions. This involves informed judgment by the valuation expert to arrive at a reasonable and well-supported conclusion.
Given the complexity of valuing a seed, start-up, or early-stage company, it is often necessary to identify a professional who can guide you in determining the fair value of an investee company. If you would like to discuss your specific situation, please contact one of our Chartered Business Valuators.
