How do I do a valuation on my software company launched in March 2010 without revenues, or hard-to-project revenues? Do I base it on C/F?
Answers
This is a great question. Valuations of early stage enterprises are, in many ways, more complicated than valuations of later stage enterprises; certainly they are more speculative! The most compelling evidence for an early stage company valuation is the price paid recently by an outside investor for a security in the company (generally a class of preferred stock) in an arms-length transaction. This value can be used to “backsolve” the enterprise value of the company which, in turn, enables the valuation of the common stock. The modeling for this exercise is done using an option pricing methodology and requires assembling a peer group of public companies to estimate stock price volatility. This method is very commonly used in 409A valuations and has acceptance for financial reporting as well.
In the absence of a recent transaction such as the one described in the previous paragraph (or to support the value arrived at using a recent transaction), a discounted cash flow analysis is the second most compelling valuation evidence for an early stage enterprise. The company’s forecast (we generally see 3 years) is used to build an expected cash flow model which is then discounted back to the valuation date using a weighted-average cost of capital (sometimes based on venture capital rates). The terminal value of such model is generally based on a market multiple (revenue or EBITDA multiplier) applied to the fundamental in the terminal year. This terminal value is also discounted back to the valuation date and is added to the discounted cash flows of the forecast years. Generally the terminal year value portion of this multi-stage model is many times higher than the value of the forecast year cash flows. We generally reconcile this value with a the company’s book value plus aggregate R&D spending to see if the implied intangible asset value appears rational (probably fairly low in a pre-revenue company).
I hope this helps.
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Michael has provided a great overview of the most widely used 409A valuation methodology used for determining an implied enterprise value and an implied value for the common shares of a company based upon a recent arms-length financing transaction. The Option Pricing Model (OPM) is a quick, easy and accepted methodology, especially given the tremendous uncertainty for a very early stage company.
However, like most one-size-fits-all solutions, there are short-comings to the OPM. It has been documented in many articles published over the past 18 months that the OPM tends to overvalue the common share price. There are two widely-circulated articles that have received substantial response and rebuttal(http://www.svb.com/pdfs/BlackScholes0110.pdf and http://www.pluris.com/files/PDFs/A_Matter_of_Liquidity_2_14_11.pdf?utm_source=Boomerang&utm_medium=Email&utm_term=%93A+Matter+of+Liquidity+%96+Why+the+Black%2DScholes+Model+Over%2DValues+Conversion+Options%[email protected]&utm_campaign=How+Badly+Does+Black%2DScholes+Over%2DValue+Derivatives%3F). Understanding that you probably do not have the time to pour over these articles, the over-simplified summary is that the OPM is based on a Black-Scholes calcuation that has a probability distribution that may not appropriately mimic the chances of success and failure of an individual start-up company.
If you are looking to value your company for a 409A exercise based on a recent transaction, it is best to consult with a valuations firm that can take into account all of the facts and circumstances regarding your company and the transaction to determine an appropriate, defensible, and AICPA Guideline approved value. There are multiple approved methodologies and allocation methods and selecting the right one for your company is best done at an individual company level.
On the other hand, if you are looking to value your company as you are trying to figure out what it may be worth as you are seeking financing, the OPM will not work for you, as described above, as it requires a recent arms-length financing transaction. Again, Michael described for you an accepted practice supported by substantial financial literature in prescribing a discounted cash flow (DCF) analysis. However, this also has limitations as it is best applied to later stage companies than recently founded start-ups.
There is another widely-accepted methodology called the Probability-Weighted Expected Return Method (PWERM), which is another way of saying look at the potential exit timing, size and probability, take into account the required funding to achieve those potential exits, and allocate that value based on projected ownership at the time of exit. Clearly, this has a lot of variables that need to be determined, verified and supported, but there is substantial research out there on early stage companies that can provide appropriate ranges. This also tends to mirror the way that investors look at an investment, which allows you to see how the other half of your potential transaction is thinking.
Hopefully this provides some additional clarity regarding some potential approaches, depending upon your situation.
I would recommend getting a 3rd party and not do this on your own. This is an easy one to answer - just say no to doin it yourself. You want to have a valuation for granting options that is completely defensible to the IRS and do not want to allow employees to take any risks. And you do not want the company to have any risks with employees coming back and complaining about the valuation and IRS penalties.
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Valuation can be important for the employee stock option plan. Check out this quick video on 409A. It's entertaining: http://www.xtranormal.com/watch/7471325/option-pricing-made-easy
Good comments, DCF is useful for companies with an operating history and positive cash flows, early-stage pre-revenue companies that are not near a financing marker or valid market proxy as such are much more difficult to value.
I do disagree with excluding firms that offshore (contrary to the above), so long as the firm used utilizes professionals with similar credentials (CFA, CVA, etc.), the report is ASA-BV and USPAP compliant, and the firm will be familiar with the AICPA practice aid, why not leverage the price / quality arbitrage?