December 11, 2018

Series A Stage Pre-Money Valuation - Approaches

Rick Norland

Rick Norland
Owner/Thorington Corporation

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a.    Cash Out Approach

The Cash Out Approach focuses on the long-term potential of an opportunity and essentially says, assuming all goes well, what do I have to invest at now to meet my return expectations.  Its primary focus is on future potential.  As a valuation method, therefore, it is most appropriate for earlier stage companies that still have considerable uncertainty.  The process also requires the company to have significant potential growth and be in a market with many comparable liquidity comparables.

This approach starts with the future value of the company based on some expected liquidity event, say five years in the future.  This value is then discounted back to a present value, with consideration for risk and future dilutions.  A discount rate of 75% per annum would be normal.  The resulting present value becomes the post-money valuation at this stage.  Reducing this figure by the total investment currently sought yields the Series A pre-money valuation.

As an example, assume the company is expected to be worth US$150 million at a liquidity event in five years.  The present value of that, assuming a 75% annual discount rate, is about US$9 million[1].  Assuming the company is currently looking for US$3.5 million, the Series A pre-money valuation would be US$5.5 million.

b.    First Chicago Method

The First Chicago Method is a common approach among venture capital investors.  The process essentially requires the venture capital investor to predict the company’s current value under a range of scenarios and then applies a probability to each scenario to arrive at a weighted average pre-money valuation.  An example is shown in Table 1 below.

Table 1: Example Using First Chicago Method
Scenario                                  Value (USD)      Probability             Weighted
Business a success                   US$15 million         30%                 US$4.5 million
Business a moderate success    US$10 million          30%                US$3.0 million
Business survives                     US$5 million           30%                US$1.5 million
Business fails                           Nil                         10%                 Nil
Total                                                                                           US$9.0 million

c.    Comparable Transactions

This methodology is also quite common.  As a required element, this approach requires the company to be in a market with many recent transactions (financings and/or acquisitions).  The results of the comparable transactions will be modified to be more “comparable” to the investee company.  For example, the comparable may be adjusted to reflect differences in addressable market size or revenue potential.  Other unique risks related to stage of maturity (e.g. status of IP development) or specific attributes (e.g. strong Founding team) will be factored in to the adjustments.  To minimize the number of “discounts” for uncertainty, this approach is best suited to more mature Series A Stage companies.

[1] US$150 million / (1+.75)^5 = US$9.1 million

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