Valuation is often described as an art and a science. As someone with a strong financial quantitative background (I am a Chartered Accountant by trade), I see it as much more science than art. Every valuation involves a degree of imprecision and greater degree of negotiation, but, there is a process of calculating a ballpark that is reasonable for both parties.
Investors are concerned with the amount of equity they receive to the extent it determines their rate of return at exit. By gauging an investor’s expected rate of return, an entrepreneur can reverse-engineer the equity position required to achieve that number.
As an example, suppose a life sciences start-up requires $5 million to be tranched over five years. $1 million will be received at the beginning of year from angel investors. $3 million will be received in equal amounts at the beginning of years two, three and four from a venture capitalist. The remaining $1 million will be received at the beginning of year five from a private equity company specializing in providing bridge financing to later-stage ventures. At the end of year five, the company is anticipating an exit via acquisition for proceeds of $30 million. As an entrepreneur, how much equity would you be prepared to give up?
The first step is to calculate the future value of each tranche of investment based on the expected rate of return. Venture capitalists typically aim for returns north of 25%. In this case, we will apply a hurdle of 10% for the first tranche, 5% for the second, and 0% for the third. As the first investors, we will assume that the angel investors require a return of 40%, and as mezzanine providers, private equity firms demand a 15% return. Based on this, the future values are as follows:
Angel investors: FV = $1 mil x (1 + 40%)^5= $5.38 mil
Venture capitalists: FV = $1 mil x (1 + 35%)^4+ $1 mil x (1 + 30%)^3+ $1 mil x (1 + 25%)^2= $7.08 mil
Private equity: FV = $1 mil x (1 + 15%) = $1.15 mil
The total is $13.61 mil, which equates to 45.37% ownership for the investors. Pro-rata, this is 17.93% for the angels, 23.60% for the venture capitalists (11.07%, 7.32% and 5.21% for first, second and third tranche respectively) and 3.83% for the private equity firm.
As quick-and-easy as this approach is, its application requires that the entrepreneur be confident of three key assumptions:
(i) Expected return for investors
Personally, I believe applying a 40% return to angels and 15% to late-stage investors is fair. In terms of estimating the expected return for venture capitalists, much depends on the status of the firm and its fund. For example, a firm that struggled to raise its last fund might require a higher return in order to justify the investment of the limited partners. However, a firm with a fund nearing the end of its investment cycle with unallocated capital might be willing to accept a lower rate of return, particularly if the other portfolio companies are doing well and achieving their milestones.
(ii) Timing and amount of financings
Issuing equity is not only a matter of economics, but also control. By underestimating the amount or frequency of financings required to achieve an exit, the venture may eventually issue enough equity that control passes from the co-founders to the investors. So, preparing a well researched and detailed budget is a critical input in the valuation process. For a venture engaged in basic R&D or preparing for clinical trials, this is certainly easier said than done.
(iii) Timing and amount of exit
With this example, postponing the exit by one year would require the company to concede additional equity of 15.11%. Similarly, a drop in the exit value in the fifth year from $30 mil to $25 mil would require an increase of ownership of 9.07%. So, being able to predict the timing and amount of the exit is critical. In life sciences sector, exits can often be estimated using comparables based on the indication, market size and stage of the company (i.e. pre-clinical, clinical, commercial). However, again, this can be easier said than done.
As most are aware, early-stage investments normally take the form of convertible debentures. In this case, ownership is calculated using a conversion price based on the principal plus accrued interest. Referring to the previous example, suppose the convertible debentures earn 12% interest per year compounded annually, which equates to a $1.76 investment at the conclusion of year five. Assuming 25 million shares are outstanding, the angels would be entitled to 4.48 million shares. This implies a conversion price of $0.39 per share. The same math can be applied to the determine the conversion price for the other investments.
In summary, this approach is far from foolproof. However, as a first step, I believe it can be valuable in establishing a ballpark valuation that is fair for both the entrepreneur and investor.
