Valuations refer to the process of calculating the financial market value of a company and are typically calculated when a company chooses to raise a round of private equity funding. For public companies, the process is streamlined – multiplying the stock price by outstanding shares. But since private companies do not report financials as often as public companies, it is not as simple a process.
What is a Valuation?
Company valuations are used to estimate a business’s intrinsic value and are based off both qualitative and quantitative metrics. Revenue, profits, losses, company assets, and sales growth can all go into a company valuation in addition to qualitative metrics such as the team, market opportunities and competitive advantage, the size of the company, and other factors. There is not a one-size-fits-all solution for calculating private company valuations, but there are a few calculations that can assist such as the discounted cash flow (DCF) analysis, multiple analysis, and net book value method.
Why Value Private Companies?
Valuations can be important for both the business, and their potential investors. Companies can use valuations to track their progress and compare themselves to competitors and other startups. Investors can use valuations to help determine the value of their investment, and if making an investment in the startup is suitable for their personal portfolio. While not an exact science, valuing private companies is usually necessary for startups to calculate at some point or another.
There are two main types of valuations: pre-money valuation and post-money valuation. These valuations are as they sound; the company’s value before they raise capital, and after they raise capital. The main difference between these two types is the timing of the valuation, but they are both calculated in similar ways.
The pre-money valuation refers to the value of the company before external funding is raised. This value is used to help determine the price of each issued share, and gives investors an idea of the current position the business is in. The pre-money valuation usually changes before each round of financing, and can be a subjective figure based on metrics like revenue, expenses, the experience of the founders, and many others. When determining pre-money valuation, founders and entrepreneurs should be aware that their personal company valuation may not align with the potential investors’ valuation.
For companies that are pre-revenue, there are other methods to calculate valuation, because metrics like revenue cannot be factored in for pre-revenue companies. For these companies, the scorecard valuation method may be a better calculation, as it is calculated by comparing the pre-revenue company to another existing startup that operates within the same industry, region, or company stage. The scorecard valuation method primarily focuses on qualitative metrics like the size of market opportunity, the product or the technology, the strength of the founder and their team, and/or the competitive environment.
Alternatively, the post-money valuation is simple once the pre-money valuation has been calculated. Once the company has raised the additional funding, the post-money valuation is calculated by adding the amount of new money raised to the pre-money valuation. The ownership percentages of investors are calculated off the post-money valuation. However, if the post-money valuation has decreased from the previous funding round, it is known as a down round. This can be seen as a negative thing, but data from Pitchbook found that only 13% of US companies who raised a down round from 2008 to 2014 were unable to raise new funding or exit immediately after. Pitchbook also found that companies who raise down rounds are more likely to be acquired by a private equity firm.
Valuations are based off a combination of metrics, assumptions, estimates, and averages. There is not one set way to calculate valuations, but there are a few calculations that can provide insight as to what the company valuation could be. Valuations regularly change and can be impacted by additional funding rounds, public perception, the company’s reputation, industry demand, market size, and other factors. While valuations are subjective and based off best guesses and estimates, they can be a valuable tool for both businesses to track their progress, and investors to value their investment.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.