Furnari Scher LLP | Business Law Update | Valuing Early Stage Companies

Business Law Update
August 2008

  What's Your Company Worth?
The art and science behind early-stage company valuation

by Stephen Furnari

This article was originally published on June 23, 2008 in:

David Lindsay, 38, is the CEO of Confluentia Group, a New York City startup business analysis consulting firm in the financial services sector. Like the CEOs of many other young companies, Lindsay wanted to grant stock options to Confluentia's employees performance incentives and to set a tone for the company's values. For Lindsay, the decision to grant options to employees was an easy one. However, making a decision about where to set the exercise price and how much of the company to give away was a different story.

"It was important to get that tension right between doing the right thing by employees and senior level staff--in terms of showing integrity, being fair, and encouraging an entrepreneurial mind-set--while also managing to maintain an appropriate level of control over the direction of the company and an equity stake that was in line with the risk I had taken," Lindsay says.

In October 2007, Lindsay found himself asking the all-too-common question that he couldn't easily answer: What's my company worth?

Determining the value of a growing company is a critical step. It will come into play not only when granting options to employees, but also when raising capital from investors, selling assets or buying out a partner.

Value your company too low, and you can give too much of it away. On the other hand, value your company too high, and you may turn investors away when you're raising future rounds of capital.

According to Carmel, Indiana independent valuation expert Michael Pellegrino, the process of determining a company's value is part art and part science.

"The science is in the mathematics: looking at cash flows, revenues and assets and crunching the numbers," Pellegrino says. "The art is in knowing how to apply those numbers in a way that is going to be appropriate and credible."

Valuing an early-stage business can be especially difficult. Early-stage businesses tend to be short on assets or steady cash flow, factors valuation analysts use to assess value. Without these, early-stage company values are based more in the art of valuation methodology rather than the science, and according to Pellegrino, this is where experience becomes critical.

"During the dotcom era, you really began to see that standard methods of valuation didn't apply to early-stage companies," he says. Investors came up with new methods for valuation that placed more emphasis on factors like customer acquisition cost or click-through rates.

But at the end of the day, many of those methodologies churned out estimates that were imprecise and/or inaccurate. Nevertheless, the calculus was significantly altered.

"Valuation methods for early-stage businesses can vary widely in philosophy, and determining an accurate number that can be relied on is sometimes a problem for management," Pellegrino says.

To complicate matters, valuation can be significantly influenced by other factors, such as company location or the interests of the parties performing the analysis. For example, according to Pellegrino, on the West Coast where there's a culture of "a prayer and the dream," valuations tend to be higher than on the East Coast, where there is more of a pragmatic investor culture.

The analyst matters, too. A valuation expert may place heavy emphasis on market adoption of a product or service, whereas a valuation performed by an institutional investor, like a venture capitalist, may be more heavily influenced by other factors such as exit strategy and ROI.

Tom Dickerson, a partner in the Greenwich, Connecticut-based VC firm Tullis Dickerson & Co. Inc., names two factors that drive valuation for his firm: how much money they need to put in to get to an exit and how much time it takes to get there. Dickerson, whose fund invests in the health-care sector, points to shifting exit valuations for biotechnology companies as an example.

"Two years ago, companies were IPOing at valuations of around $250 million. Now they are going out at $125 million," he says. According to Dickerson, this has created downward pressure on valuations in this sector since the VCs need to buy in at a lower valuation to maximize their ROI.

For entrepreneurs, getting valuation correct is critical when raising investment capital, particularly if a business plan calls for multiple rounds of financing. If you over-value your company in a friends and family round, you may turn off future investors completely. And those investors who will look at your deal may require a lower valuation. Earlier-stage investors will find it distasteful if investors in later rounds buy in for less money. In this situation, investors like Dickerson will almost always require existing stockholders to sign off on the deal, which can be a tricky task for management.

To complicate matters, management is obliged to make sure that a valuation is fair and in shareholders' best interests. However, while there is no golden standard for valuing an early-stage business, the good news is that, legally, management has broad latitude when it comes to which method to use. In the event of a dispute with shareholders about valuation, courts generally will not call into question management's decisions regarding valuation as long as the assessment was performed on an informed basis using valuation methods that are acceptable in the company's industry.

While not legally required, engaging the services of an independent valuation expert may be a good idea, particularly for entrepreneurs with no background in finance. The expert's report serves as evidence that management met its standard of care to shareholders.

Ultimately, Lindsay decided against utilizing the services of a valuation expert.

"Given that Confluentia was just at the inception stage, an expert was going to do a full analysis on a lot of theoretical items and unknown factors," Lindsay says. "I felt that an expert was just going to come up with a model that they could update in the future but would add little value to us at this stage."

At the time, Lindsay had just begun actively marketing his services but did not yet have contracts from which to base a revenue forecast. Additionally, Confluentia had the capacity to develop software products that could potentially be licensed to its clients.

"That's a huge X-factor that could have had a material impact on Confluentia's value but was hard to allocate a number to," Lindsay says.

Lindsay's in good company.

"In certain cases, early-stage companies have few resources, so the idea of adding another service provider into the mix is not something that many entrepreneurs are interested in doing," Pellegrino says. "Those are dollars that could be going toward product development."

Frustrated by the lack of tools that are available to help early-stage companies attain a realistic valuation, Lindsay relied on his own financial acumen. He reviewed several sources of relevant criteria, including the prices at which industry competitors had been sold as compared to their revenues. He also factored in projected revenues for Confluentia and his likely exit strategy.

After careful consideration, Lindsay came up with a valuation for Confluentia that he feels is a good starting place.

Lindsay plans to re-visit valuation when Confluentia hits certain revenue milestones and is actively pursuing a software concept, which he believes will be within the next 18 months.

To learn more about valuation, seeValuationInfo.com.

© 2008 Entrepreneur.com, Inc.


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