Thursday, September 13, 2012

Forward Revenue Multiples in Venture Capital Valuations

I am frequently asked by founders during my talks and conference participations how do I value a startup.
The first method is really an art more than a science. We know what market pre-money valuations are currently prevailing. 

But more importantly, we figure out that pre-money number from a founder's ownership for the series A, but also subsequent rounds of B and C. The rule of thumb is that if a startup is raising $1.5M then the pre-money is going to be around $1.2M to $1.5M, netting the founders a 50% ownership stake on a post-money basis. The goal is for the founders, if they execute well is for them to reach an enhanced valuation by the B and C rounds, and be diluted to 25% post B-round and to 10-15% post-C when the startup would have reached run-rate revenues to be able to value it for an M&A transaction through some of the more classical methods below.

Forward revenue multiples are beneficial methods for founders and for venture capitalists. There are two basic revenue multiples that every single investor needs to be made conscious of. The 1st, and most well-known, is Price to Sales or just P/S. The next and the more solid metric of the two is the Enterprise Value to Sales or EV/S (Equity + Debt - Cash; and in most VC cases Equity-Cash, since there is rarely any debt).

Enterprise Value to Sales Ratio (EV/S)

Venture capitalists use estimations like the EV/S multiple to find a business's value. It is measured by adding its market capitalization to its debt, minority interest and preferred equity then subtracting its liquid assets. The result is a multiple that gives valuable understanding for investors. For instance, a corporation with a revenue multiple of 1.9x effectively means that other investors might be willing to pay $1.90 for every $1 of revenue produced by the corporation.

Pre-Money Valuation

Investors and the businesses might have significantly diverse views of the business’s value. Investors like low figures, so they can get a good deal. Alternatively, businesses want them excessive, so they can get additional investment money. Pre-money assessment is the agreed-upon price before any dollar is invested. Furthermore, potential buyers may possibly use a multiple of the current revenue to value the company, if the company is presently making revenue.

Post-Money Valuation

Revenue multiples can have far-reaching repercussions. Poor multiples will turn-off numerous investors. Powerful multiples enable the company to keep more equity of the business, soon after the investment is created. Venture capital equity is determined by using the capital investment figure “I” and dividing it by the pre-money value “V” and then added in to the capital investment “I” (I/V+I). Thus, a strong multiple will maximize the pre-money valuation amount.

Future Value

Start-up businesses rely intensely on forecasts. Most start-up businesses, by description, are not proven and commonly have poor sales revenue. Estimations like, revenue multiples guide to project possible larger income in upcoming days -- generally about three to five years -- to convince venture capitalists for a good investment.
A revenue multiple may be more beneficial at times comparatively to the commonly used price-to-earnings ratio, in stock assessment. Specific restrictions exist when utilizing the P/E ratio, which could make the P/E ratio less purposeful. On the other hand, revenue multiples are much more appropriate even in some unique business and earnings scenarios for venture capitalists.