IES375

EN-5-E
Rev. 3/2012

Early-Stage Companies and Financing Valuations: The

Venture Capital Method

For investors focusing on start-ups and early-stage companies, one of the most challenging
tasks is determining how to price a financing – deciding how much equity (or ownership) the
investor must receive for the capital being invested. Likewise, for entrepreneurs the big
question is how much equity they will have to give up when raising new capital.

Deciding how much ownership is required involves determining what the value of the company
(or idea) is. Traditional methods of determining the value are not helpful here because start-ups
and most early-stage companies don’t have the financial results necessary to apply such
methods. There are few, if any, assets; minimal or no sales; no profits; and projections that are
often based on formulas and guesses rather than any actual performance history. In addition,
experienced early-stage investors know from experience that most new ventures will take
longer and need more capital than even the most conservative entrepreneur expects.

Thus, when addressing the valuation and ownership question, experienced investors use a
different approach known as “the venture capital method” of valuing early-stage companies.

Part 1: The Framework

The venture capital method is based on a framework that is described well in several
excellent technical notes.1 In it simplest form this framework uses a discounted cash flow or

1 See Sahlman, William A., and Scherlis, Daniel R., “A Method for Valuing High-Risk, Long-Term Investments,” 2009, Harvard
Business School, 9-288-006; Lerner, Josh, “A Note on Valuation in Private equity Settings,” 2011, Harvard Business School,
9-297-050, pp. 7-9; Chaplinsky, Susan, “Valuing the Early-Stage Company,” 2009, Darden Business Publishing, UVA-F-1471;
Hellman, Thomas, “A Note on Valuation of Venture Capital Deals,” 2001, Stanford Graduate School of Business, E-95.

This technical note was prepared by Professor Rob Johnson. April 2004. Revised in March 2012.

Copyright © 2004 IESE. To order copies contact IESE Publishing via www.iesep.com. Alternatively, write to [email protected],
send a fax to +34 932 534 343 or call +34 932 534 200.
No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any
form or by any means – electronic, mechanical, photocopying, recording, or otherwise – without the permission of IESE.

Last edited: 3/27/12

0-604-025 1
EN-5-E Early-Stage Companies and Financing Valuations: The Venture Capital Method

net present value approach to relate the future value of the company to the current
investment being made, as follows:

1. Determine the projected value of the company at a future date – the terminal value
(TV).

2. Discount this terminal value to the present, using the investor’s target IRR (usually a
very high rate, as discussed below) to get what is called the post-financing valuation
(Vpost). Since this post-financing valuation includes the new capital that is being
invested, one can calculate the implied value of the company before the financing –
the pre-financing valuation (Vpre) – by subtracting the amount of capital (C) being
invested from the post-financing valuation:

Vpost - C = Vpre

3. Calculate the percentage ownership required for the investor by dividing the amount
of capital being invested by the discounted terminal value2:

% ownership = C / Vpost

4. Adjust the percentage ownership above for the effects of adding a key employee share
option pool.

5. Adjust the percentage ownership to take into account anticipated future rounds of
funding.

The technical notes referred to above explain in detail how these calculations work, including
the more complex calculations involved in the last step above. They also offer cautions about
the application of this method.

Using the Framework

If there were only one single financing, then applying the venture capital method using this
framework would be straightforward, simply following steps 1-4 above.

On the surface, the basic numbers in steps 1-3 – determining a terminal value and
establishing a target rate of return – are challenging in themselves, but most professional
investors are capable of making educated decisions about these factors. Using an appropriate
method to determine the terminal value (usually applying a price earnings ratio to future
projected earnings) is relatively straightforward, and target return rates (IRRs, or discount
rates) are generally accepted at different levels for various stages in a company’s
development. While these rates may be difficult to defend in any kind of technical analysis
(they are usually very high and can range up to 80% or more, depending on the stage of
development of the company and the related perceived risks involved in the deal), they are
widely accepted in the venture capital community.

2 Alternatively, one can work forward, using the target IRR to determine the required future value of the investment and
dividing that by the terminal value (TV) to get the percentage ownership. Both approaches produce the same result.

2 IESE Business School-University of Navarra

 Early-Stage Companies and Financing Valuations: The Venture Capital Method EN-5-E

Also, in step 4, adjusting for the addition of a key employee share option pool is relatively
straightforward, as the investor usually has a reasonable idea of what size that pool should be.

Where the method becomes much more difficult to apply is when one has to choose specific
timings and also factor in future rounds of financing. Determining a terminal value (step 1)
involves choosing an exit date, yet any experienced early-stage investor knows that is it
extremely difficult to predict when a new company is going to achieve an exit. Basing a
valuation on a fixed exit date is likely to be misleading, as the timing could vary by any
number of years from deal to deal. That factor alone can make a big difference in the
outcome of the calculations.

The other problem is that very few start-ups or early-stage ventures make it with only a
single round of financing, and it is these subsequent rounds of financing which make it
extremely difficult to apply the framework and reach a conclusion that one can rely on. With
regard to future financing rounds (step 5), one may reasonably estimate the timing and even
the amount of the very next round of financing, but it is difficult to predict how that round
will be priced. One could just as easily have a “down round” as see a valuation increase, and
the effect on ownership can vary widely depending on this variable alone. Then factoring in
subsequent financing rounds involves even greater uncertainty, not only in terms of pricing
but also regarding the amount of capital to be raised and the timing of those rounds.

One can run all kinds of scenario analyses and even use Monte Carlo analyses to try to make
sense of the myriad of assumptions being made, but the range could be so wide as to make
the effort virtually fruitless. For this reason, most experienced investors don’t actually do
such calculations for early-stage investments. While they clearly understand this framework,
they apply the venture capital method in a different way.

How Venture Capitalists Apply the Method

Experienced early-stage investors usually apply the mathematics of the venture capital
method in the reverse order. First determine the value of the business (or, in the case of a
start-up, the idea) today, before the financing (Vpre). Then once we decide how much capital
the company actually needs in this financing round (C), adding these two amounts together
gives us the valuation of the business after the financing is completed (V post = Vpre + C). Here
we have used the pre-financing valuation (Vpre) and the amount of capital being raised (C) to
calculate the post-financing valuation (Vpost).

Consider a real example. Europa Venture Investors decided to invest ¤1,250,000 in Medistat
N.A., a pre-revenue healthcare services company founded twelve months earlier with ¤20,000
by two entrepreneurs. Europa had determined (for reasons we will see later) that the company
should be valued at ¤2,500,000 before the financing. Thus:

Pre-financing valuation (Vpre) = ¤2,500,000;

Post-financing valuation (Vpost) = Vpre + C = ¤2,500,000 + ¤1,250,000 = ¤3,750,000.

It is important to understand that both the pre-financing valuation and the post-financing
valuation are implied valuations resulting from a financing transaction. They represent the

IESE Business School-University of Navarra 3

EN-5-E Early-Stage Companies and Financing Valuations: The Venture Capital Method

values at which a particular investor is willing to invest in a privately- held (or unquoted)
company. Yet these valuations can help address other important financing questions.

The first question – how much equity does the investor require for his or her investment –
involves a simple calculation using the amounts above. The percentage equity required (%E)
is simply the ratio of the amount invested in this round to the valuation following
completion of the financing:

%E = C / Vpost

In the financing of Medistat, the equity required by Europa is calculated as:

%E = ¤1,250,000 / ¤3,750,000 = 33.3%.

Thus Europa would need to receive one-third of the ordinary (or common) shares of Medistat
in order to make their investment, leaving management with 66.7% of the equity.

The Starting Point: Pre-Financing Valuation (Vpre)

It sounds simple, and indeed the calculations are simple. However, you may already be
asking one critical question: How did Europa determine that Medistat should be valued at
¤2,500,000 prior to the financing? Indeed what is a company with no customers and no
revenues worth? What is a company whose product is still in development worth? What is a
new idea worth? This brings us to the art of venture capital.

Can the deal achieve my minimum return?

The first step an experienced early-stage investor takes in evaluating such a deal is to make a
judgment about whether the company has the potential for delivering the minimum return
that the investor requires. Despite all the emphasis placed on business plans with detailed and
substantiated financial projections (which are indeed very important to potential investors),
most experienced early-stage investors do not rely on sophisticated financial analyses of
business plan projections to answer this question. Contrary to what some people think, they
do not calculate detailed discounted cash-flow analyses of different scenarios to derive a
present value of the company. Why not? Because they know from experience that the one
certainty in a start-up or early-stage business is that the results are highly unlikely to
resemble the plan, and variations on the plan are purely guesswork in the early stages.
Discounted cash-flow analyses, as useful as they are in certain circumstances, depend on
reasonable levels of certainty, which simply are not characteristic of such situations.

Instead, what these investors do is a “back-of-the-envelope” calculation to see if it is feasible,

or likely, that the future value of the company will be high enough to deliver their minimum
required return. Since the uncertainties mentioned above and the uncertainty surrounding
the timing of future events make it difficult to project the expected IRR (internal rate of
return) for such deals, this minimum return is usually measured as a multiple of the capital
invested by the venture capitalist. In today’s environment, most start-up and early-stage
investors will tell you that they want deals that can deliver at least ten times their
investment. If they can see that this minimum return is possible, then they may be interested

4 IESE Business School-University of Navarra

 Early-Stage Companies and Financing Valuations: The Venture Capital Method EN-5-E

in pursuing the deal; if they decide that it is not possible, then they will simply cease
discussions with the company and move on to other opportunities.

In judging whether the minimum return is possible, there are a number of variables that the
investor must consider, but again it is not as simple as plugging numbers into a formula. The
eventual return to the investor will depend on not only the exit value of the company but
also the ownership stake that the investor has at that future date – and the investor’s
ownership percentage may (indeed probably will) change over time if, as is often the case,
the company requires additional round(s) of capital. However, projecting how much capital
will actually be required, when, and at what price can vary widely from initial expectations.
The experienced investor knows this and recognizes that judgment, rather than intricate
calculations, is what is required here. This judgment will be based on the investor’s
experience investing in similar deals, and ultimately the investor will have to take a view
about the likely ownership position he/she will eventually have in judging whether their
minimum return is possible.

In the case of Medistat, let’s assume that after investigating the business thoroughly Europa
believed that if things went well Medistat could ultimately be worth ¤100-million in a
reasonable (but unspecified) length of time. Using the ten-times guideline, Europa would
want an investment of ¤1,250,000 to be worth ¤12,500,000 at exit. One could then conclude
the following:

Investor’s exit amount / total exit value = required ownership, or

¤12,500,000 / ¤100,000,000 = 12.5%.

It appears that if Europa received 12.5% of the equity, that should justify making the
investment. One probably would go a step further, though, and adjust that percentage for
anticipated dilution from further round(s) of funding. For example, if Europa anticipated that
they would ultimately be diluted by 50% in subsequent round(s) of financing, then they
would require 25% of the equity rather than 12.5%.

Yet while these calculations are correct and would indeed be a starting point for thinking
through this issue, the actual thought process of an experienced early-stage investor
ultimately takes a different route, as seen in the next section.

The Pre-Financing Valuation (Vpre)

Having concluded that the minimum required return is possible, the investor then turns to
the question of what the real value of the company is today (Vpre). As mentioned above,
setting the value today is not usually the result of sophisticated financial analyses (although
you can be sure that they will have assessed the financial projections in great detail before
getting to this point).

Experienced start-up and early-stage investors have learned how to “put a value” on early-
stage businesses based on their experience with other such investments. From experience
venture capitalists learn how such ventures can perform and develop rules of thumb about
what constitutes a “reasonable” valuation for such deals. Following these rules of thumb has
produced, over time, the kinds of returns that such investors require; so they follow the

IESE Business School-University of Navarra 5

EN-5-E Early-Stage Companies and Financing Valuations: The Venture Capital Method

discipline of applying these valuations to other early-stage deals. Their final assessment of a
company’s value will be influenced not only by the numbers but also by a variety of other
factors – from the strength and completeness of the management team to their evaluation of
the competitive advantage of the product or service, and much more – but the range of
valuations among various deals will fall within a fairly narrow band.

Prior to the dotcom bubble, start-ups and pre-revenue companies were rarely valued above
$1-2 million. (As with all rules of thumb, there are exceptions, such as large bio-tech start-
ups, which have their own unique rules of thumb for valuations.) Following the craziness of
the dotcom bubble, when pre-financing valuations could get as high as $40 million or more,
today’s valuations are “back to normal”, with pre-financing valuations currently in the $1.0-
3.5 million range.

With Medistat we saw, at the beginning of this note, that Europa felt the proper pre-
financing valuation (Vpre) for the company was ¤2.5-million. We also saw that the amount of
equity required by Europa was:

%E = C / Vpost = ¤1,250,000 / (¤2,500,000 + ¤1,250,000) = 33.3%.

Note that this percentage is higher than either of the ones reached from the earlier
calculations based on exit valuation. What is the justification for this? Experienced investors
simply know from experience that their investment cannot value any company at this
particular stage above a certain level; otherwise, experience has shown them, on average
they are not likely to achieve their minimum return after all subsequent financings are
completed and an exit is eventually achieved. Indeed, using an exit value calculation as the
sole basis for determining the required ownership percentage can lead an inexperienced
investor to overpay for deals.

The Importance of the Post-Financing Valuation (Vpost)

So far we have focused on the pre-financing valuation – the starting valuation for pricing a
financing. The post-financing valuation is also important because it sets the “baseline” for
any future valuation. Keep in mind that the post-financing valuation is the value
immediately following completion of the financing; thus this valuation includes the capital
that has just been injected in the company. Now, the challenge for management is to use that
capital to build even greater value in the company. Likewise, from this point on the investor
will always be comparing any subsequent valuation of the company with this post-financing
valuation, as they too want to see an increase in value.

As time passes and additional capital is required, the same thought process that we saw
above applies in determining how to price subsequent financings. When an early-stage
company is seeking a second or third round of financing to develop the business further,
investors have to decide what the current valuation (Vpre) is for that company before
structuring the financing. Combining a) their knowledge of other recent private market
valuations and b) their “feel” of what valuation is appropriate based on prior experience in
similar deals, experienced investors have a sense of what valuation “sounds right” for a

6 IESE Business School-University of Navarra

 Early-Stage Companies and Financing Valuations: The Venture Capital Method EN-5-E

company, given its development up to that point. This then becomes the investor’s
benchmark for establishing the pre-financing valuation for the new round of financing.

It is also at this time that management’s results become glaringly obvious. If substantial
milestones have been met – if customers have started buying, if the “burn rate” is being
controlled effectively, and so on – then one can reasonably expect the pre-financing
valuation (Vpre) for this subsequent round to be higher than the post-financing valuation
(Vpost) of the prior round; i.e., value has been created. If, on the other hand, the company is
still struggling to achieve its milestones, then Vpre (valuation now) may be no higher than,
and indeed may be lower than, Vpost from the last round.

Consider Medistat again. Following its previous financing, the valuation of the company was
¤3,750,000. Fifteen months later the company had signed a few clients but was struggling to
deliver services on time, and it needed another ¤1,500,000 to achieve its plan. While
prospects for the business still looked promising, it was unclear that the company would
succeed. Thus the management team had a real selling job to do with new investors, and
indeed they may have had to work hard to convince their existing investors to put in more
money.

Under these circumstances “the new money calls the shots”. Using the same approach as
discussed above, a new investor may well conclude that the company is currently worth only
¤2.5 million. Under these circumstances, the new investor would require an ownership
position of:

%E = C / Vpost = ¤1,500,000 / (¤2,500,000 + ¤1,500,000) = 37.5%.

But what if Medistat had signed lots of customers and was already generating revenue from
them? What if it was clear that other prospective customers were very interested in using
Medistat’s services? Under these circumstances, there may be a number of investors who
would want to invest in the company. Then the company would have an opportunity t o
produce an increase in valuation. A new investor may determine that Medistat is about
to break out of the “early stages” and begin growing rapidly and thus agree that the
company is now worth, say, ¤6,000,000. Now the equity required by the new investor
would be:

%E = C / Vpost = ¤1,500,000 / (¤6,000,000 + ¤1,500,000) = 20%.

Obviously the dilution of management’s equity (as well as that of the existing investors) is
significantly less in this second scenario.

A Lesson
One can appreciate the importance of getting the pre-financing valuation “right” by
considering how subsequent rounds of financing might play out. Here the dotcom bubble
offers a lesson.

Approaching the end of the century, as it became clear that people were making serious
money from dotcom companies, many venture capitalists got caught up in the frenzy and
began offering higher and higher prices to get into deals, thus driving up the pre- and post-

IESE Business School-University of Navarra 7

EN-5-E Early-Stage Companies and Financing Valuations: The Venture Capital Method

financing valuations of deals. Some US early-stage venture capitalists have speculated that
the average pre-financing valuation in 2000 exceeded $40 million – orders of magnitude
above the $1-2 million level that had been the norm for years prior to then! As the dotcom
boom began to slow and investors started to be more cautious, companies began to realize
that they could not raise capital at increasingly higher prices, and suddenly financing prices
began to fall. Investors who had invested at values approaching the $40 million level soon
found that subsequent rounds were available only at far lower valuations (if at all) and ended
up being substantially diluted. Eventually capital injections simply ceased, and the busts
ensued.

During that boom, one UK venture capitalist who was very experienced with early-stage
investing (which was unusual in the UK) was heard to say that his team were still sticking to
their more traditional valuations when deciding on investments and that as a result they
were missing out on the froth. Subsequently, when a number of venture capitalists were
licking their wounds, that person’s funds were still delivering good returns to their fund
investors.

Likewise, getting the pre-financing valuation “right” implies that the post-financing
valuation will also be “right”. It is the post-financing valuation that the investor uses in
assessing the potential return from a given investment. Following the dotcom bust, for
example, many experienced investors concluded from what they were seeing in the M&A and
public markets that it was unrealistic to expect an exit value in excess of $200 million on
virtually any traditional deal. This, in turn, meant that an investor was not likely to achieve
the targeted ten-times return on capital if the post-financing valuation for their investment
was higher than $20 million. Thus some investors enforced a cap on financings, limiting
post-financing valuations to a level at or under $20 million.

Part 2: Complications

Debt Instruments
So far we have implicitly assumed that these early-stage companies are financed with all
equity. In such situations, it is easy to do all the calculations because there is no debt to
consider. What happens, though, when you introduce a preferred equity instrument, such as
preference shares (in Europe) or preferred shares (in the US), or debt? How does the venture
capital method deal with that? The answer is not so straightforward.

It is important to understand why such instruments are used in early-stage investments. Most
experienced early-stage investors structure their deals using preferred or debt instruments to
accomplish three important things for the investor. Most importantly, they ensure that the
management team makes money only after the investor has received his investment back
first, often with some minimum level of return from accrued interest on debt or accrued
dividends on preference (or preferred) shares. Management thus know that they must build
significant value before they will be able to make serious money from their shares.

8 IESE Business School-University of Navarra

 Early-Stage Companies and Financing Valuations: The Venture Capital Method EN-5-E

Second, if things do go well for the company and the value grows a lot, by receiving his
invested capital and accrued interest or dividends first upon an exit, the investor boosts
his overall return. Finally, in the event of liquidation, the investor ranks ahead of
management (and any other ordinary, or common, shareholders). While this last point is not
likely to mean much in a start-up or an early-stage company, as there is usually little to
salvage from such a company when it goes bust, it is still prudent for the investor to be in a
senior position.

What is important to understand is that the use of such instruments does not actually change
the risk of the deal; rather they are used to achieve other things. In this sense, then, the use
of a loan is not really a loan in the conventional sense. The investor has not used it because
he thinks it is truly a loan that will get repaid under “normal” circumstances. The investor
has used it (a) in order to secure an equity position in the company while (b) achieving the
other objectives discussed above. Thus one might call such a loan “equity in disguise”. The
same is true of preference (or preferred) shares.

Consider Medistat again. Recall that Europa had determined that they must receive 33.3% of
the equity of the company in order to make the investment of ¤1,250,000. In fact they
actually structured the deal with ¤1,249,000 in a subordinated loan and ¤1,000 in ordinary
shares. They then set the share price of the ordinary shares so that they received the required
33.3% equity stake. The company still received its ¤1,250,000 capital injection; management
still ended up with 66.7% of the equity; and Europa held both a loan and one-third of the
equity in Medistat.

Conventional finance rules tell us that the value of the company is equal to the value of the
equity plus the value of the debt. In this case such a calculation would result in a value of
the company following the financing as follows:

Founders' equity 20,0003

Investor's equit 1,000
Debt 1,249,000
Value following financing 1,270,000 (post-financing valuation)

However, this post-financing valuation is below the pre-financing valuation that the investor
established before doing the deal! That doesn’t make sense. The reason it doesn’t make sense
is because the loan is really “equity in disguise”. The investor made the investment solely to
get 33.3% of the equity (not because he thought this was a good company to make a loan
to). This will be discussed further in the next section.

The Share Price Trap

Some people approach valuation questions by using the ordinary (common) share price,
simply multiplying this price by the number of shares to get both pre- and post-financing

3 Technically, based on the investor’s price, the founders’ equity would be valued at only ¤2,000.

IESE Business School-University of Navarra 9

EN-5-E Early-Stage Companies and Financing Valuations: The Venture Capital Method

valuations. This works fine when a company is financed using all ordinary (or common)
shares; however, it will yield misleading results when other financing instruments are used in
combination with ordinary shares.

Consider Medistat’s financing history after a third and final round of financing at a time
when the company was approaching breakeven, with valuations shown in Table1:

Founding: ¤20,000 invested for 20,000 ordinary shares

Round 1: ¤1,249,000 invested in 7% subordinated loan and

¤1,000 for 10,000 ordinary shares

Round 2: ¤1,498,200 invested in 7% subordinated loan and

¤1,800 for 18,000 ordinary shares

Round 3: ¤1,200,000 for 1,200,000 redeemable preference shares

convertible into 7,500 ordinary shares

Table 1

Founding Round 1 Round 2 Round 3

Investment in loan 0 € 1,249,000 € 1,498,200 0

Investment in conv. pref. shares 0 0 0 € 1,200,000
Investment in ordinary shares 20,000 € 1,000 € 1,800 0
Total investment 20,000 € 1,250,000 € 1,500,000 € 1,200,000

Ordinary shares this round 20,000 10,000 18,000 7,500*

Total shares o utstanding 20,000 30,000 48,000 55,500
% of equity purchased (%E) 100% 33.3% 37.5% 13.5%

Price paid per ordinary share € 1.00 € 0.10 € 0.10 €160.00*

Post-financing valuation (Vpost) na € 3,750,000 € 4,000,000 € 8,888,888

Pre-financing valuation (Vpre) na € 2,500,000 € 2,500,000 € 7,688,888

Note that in this example the top five lines are given; the next three lines are simple calculations, leaving only the two valuation
calculations to be considered.
The calculation to get the post –financing valuation for round 1 is:
Vpost = C/%E = ¤1,250,000/0.333 = ¤3,750,000.
Since the post – financing valuation includes the capital that has just been invested, you simply subtract the capital just invested to get
the pre – financing valuation:
Vpre = Vpost – C = ¤3,750,000 – ¤1,250,000 = ¤2,500,000.
It is important to note that this table assumes that the preference shares in round 3 will be converted into ordinary shares – indeed
what is ultimately intended by this structure.

10 IESE Business School-University of Navarra

 Early-Stage Companies and Financing Valuations: The Venture Capital Method EN-5-E

Looking at the price paid per ordinary share, one would draw some very misleading
conclusions. From the share price, it would appear that something terrible happened from the
founding to the first round. Of course, when the first outside investor comes in, the financial
structure may be changed, as was the case here, and the share price ends up being
determined not directly by the value of the company, but by the need to structure the
financing to provide the investor with his required percentage ownership.

Round 2 shows no share price change from round 1, yet in reality the value actually declined
between the end of round 1 (Vpost of ¤3,750,000) and the beginning of round 2 (Vpre of
¤2,500,000). In other words, management was not able to build value with the money that
was invested in round 1. Then look at round 3. Here it appears from the ordinary share price
that the value has skyrocketed by 1,600 times! Indeed the valuation did increase since the
previous round, from ¤4,000,000 (Vpost) to 7,888,888 (Vpre) – nearly double, but nowhere near
what the ordinary share price suggests.

This point is further illustrated if you consider that round 2 could have been structured to
show an increase in the ordinary share price by putting less money in the loan and paying
more for the ordinary shares, as shown in Table 2.

Table 2

Founding Round 1 Round 2

Investment in loan 0 € 1,249,000 € 1,496,400

Investment in ordinary shares € 20,000 € 1,000 € 3,600
Total investment (C) € 20,000 € 1,250,000 € 1,500,000

Ordinary shares this round 20,000 10,000 18,000

Total shares outstanding 20,000 30,000 48,000
% of equity purchased (%E) 100% 33.30% 37.50%

Price paid per ordinary share € 1.00 € 0.10 € 0.20

Post-financing valuation (Vpost) na € 3,750,000 € 4,000,000

Pre-financing valuation (Vpre) na € 2,500,000 € 2,500,000

Here the investor has put twice as much money into the same number of ordinary shares,
resulting in a doubling of the ordinary share price. However, that share price increase does
not mean anything, because the valuation of the deal did not change: the investor still
invested ¤1,500,000 for 37.5% of the company. In other words, when combining debt
instruments or preference shares with ordinary (or common) shares in a round, the ordinary
share price can be arbitrary – it could have been priced however the parties agreed without
changing the underlying basis of the deal.

IESE Business School-University of Navarra 11

EN-5-E Early-Stage Companies and Financing Valuations: The Venture Capital Method

Note that in all of these calculations, we have included the entire amount invested,
irrespective of what instruments are used, since all of this capital is totally at risk in an
early-stage deal. Thus, as shown in Table 1 for round 1:

C = total capital invested in all instruments this round = ¤1,250,000.

Vpost = C / %E = ¤1,250,000 / 0.333 = ¤3,750,000 (the same post-financing

valuation reached at the start of this note).

It is critical to understand how financing instruments work and what the resulting financial
structure really means in terms of valuing a company. Remember that the only reason a
venture capitalist invests in an early-stage business is to get equity (ownership) in the
company; the use of other instruments (such as the loans here) is simply prudent deal
structuring. It is not the ordinary share price which tells the story, but the total amount
invested in return for a certain percentage of the company. Thus the pre- and post-financing
valuations must be calculated using the total amount invested by the outside investor and
the percentage of the equity purchased by that investor.

Share Options
What happens when the company has issued share options (stock options) to key employees?
How does the venture capital method deal with those? Here the answer is more
straightforward.

Any investor must assume that if things go well with the company, then all share options
will be exercised (just as Table 1 assumed that the preference shares would indeed be
converted into ordinary shares). That will in turn change the ownership percentage of all
other shareholders. Thus the investor must base all ownership calculations on fully-diluted
numbers (that is, assuming that all options are exercised).

Consider Medistat again. Suppose that as part of the first round of financing the company
put in place a share option plan with option shares equal to 10% of the total shares
outstanding. They then hired two key executives and awarded them options for six of those
ten percentage points. What happened when the next round of capital was raised?

The new investor would assume that the 6% were effectively already exercised and probably
would also decide that the additional 4% would eventually be awarded and exercised. Thus
in any ownership calculation, the total number of shares outstanding would include all of
these option shares. (An investor may also include an even higher number for options on the
assumption that they will ultimately be necessary to attract future key employees.)
The resulting table for round 1 would change in one of two ways, as shown in Table 3.

12 IESE Business School-University of Navarra

 Early-Stage Companies and Financing Valuations: The Venture Capital Method EN-5-E

Table 3

Alt. A Alt. B
Founding Round 1 Round 1

Investment in loan 0 €1,249,000 €1,249,000

Investment in conv. pref. shares 0 0 0
Investment in ordinary shares 20,000 1,000 €1,000
Total investment (C) 20,000 €1,250,000 €1,250,000

Ordinary shares this round 20,000 10,000 11,770

New share options 0 3,333 3,530
Total shares outstanding 20,000 33,333 35,300
% of equity purchased (%E) 100% 30.0% 33.3%

Price paid per ordinary share 1 0.1 €0.085

Post-financing valuation (Vpost) na €4,166,667 €3,750,000

Pre-financing valuation (Vpre) na €2,916,667 €2,500,000

Under alternative A, the 10% option pool is simply added on after the financing, resulting in
a lower percentage ownership for the investor and higher valuations. Under alternative B the
options are factored in to the calculations to keep the investor at 33.3% ownership, resulting
in the same valuations as in Table 1. Most venture capitalists are too experienced to allow
alternative A to occur without forethought, but the example illustrates the point: how one
treats options affects the valuation of the deal.

Valuations with Multiple Investors

Considering Table 2, one can look back at a prior round (round 1) and determine the
valuation for that round by first calculating the post-financing valuation and then
subtracting the capital invested to get the pre-financing valuation:

Vpost = C / %E = ¤1,250,000 / 0.333 = ¤3,750,000; then

Vpre = Vpost – C = ¤3,750,000 - ¤1,250,000 = ¤2,500,000.

Often new capital is invested by a syndicate of investors. In the above example the
¤1,250,000 could have been composed of ¤900,000 from investor A for 24.0% ownership and
¤350,000 from investor B for 9.33% ownership (total ownership still 33.3%). In such
situations the starting post-financing valuation can be calculated two different ways. You
can use the total amount raised by the outside investors as a group and the total percentage
acquired by that group (as shown above), or you can use the amount invested and percentage
acquired for any single outside investor (provided that all of the outside investors invested at
the same price, as they did in the example here); the result will be the same:

For investor A Vpost = C / %E = ¤900,000 / 0.240 = ¤3,750,000, and

for investor B Vpost = C / %E = ¤350,000 / 0.0933 = ¤3,750,000, the same as above.

IESE Business School-University of Navarra 13

EN-5-E Early-Stage Companies and Financing Valuations: The Venture Capital Method

To get the pre-financing valuation, however, you must subtract the total amount invested by
all of the outside investors:

Vpre = Vpost – C = ¤3,750,000 – (¤900,000 + ¤350,000) = ¤2,500,000.

Uses . . . and Limitations

As mentioned earlier, the venture capital method is a simplified method of dealing with
valuations and pricing issues in start-ups and early-stage companies. It is a widely-used
practice, and you will often hear venture capitalists refer to pre-financing and post-financing
valuations when discussing various deals.

Financial purists will rightly question the accuracy and rigor of such an approach. After all,
how does it account for accrued interest or dividends? How do you factor in probable future
rounds of capital when the timing and amounts are unknown? What about a special share
price deal that may be given to a special investor (such as an industry expert who is being
wooed to join the board of directors)? The answer is that the method cannot account for
every detail. It is in some ways a shorthand approach, and it is important to recognize it as
such. Nonetheless, the venture capital method is a proven approach that works in an
investment environment where financial projections cannot be relied upon, where time
horizons are purely guesses, and where entrepreneurial ingenuity can count for more than
analytical rigor.

Yet it is also important to recognize that there comes a time when this method is no longer
useful in assessing a company’s valuation. Once a company has broken through the early-
stage level and is producing meaningful financial results that lend themselves to traditional
financial analyses, the method no longer applies (and indeed can produce very misleading
valuations in such a case). This is the time when a loan may no longer be “equity in
disguise”, when rules of thumb are no longer so useful, when one has to return to traditional
valuation methods in order to assess a company’s value. Indeed another aspect of the art of
venture capital is knowing – or sensing – when that level of a company’s development has
been reached.

It is also important to note that the application of the venture capital method is not so
relevant for management buyouts and buy-ins of mature companies, where the risk dynamics
are different from early-stage deals. Some private equity investors may still talk about pre-
financing and post-financing valuations, but the way different financing instruments are
viewed is different in a company which has a history of sales and profitability, which in turn
affects how one calculates those valuations.

Some Cautions to Entrepreneurs

For entrepreneurs it is important to remember that financing valuations are ephemeral and
can change at any moment for a variety of reasons. One also has to be careful how one
applies the venture capital method. If you fail to understand the subtleties of financing

14 IESE Business School-University of Navarra

 Early-Stage Companies and Financing Valuations: The Venture Capital Method EN-5-E

instruments and financing structures, then you can end up reaching the wrong conclusions
about valuations.

Finally, a financing valuation is not the same as a “realization value”, the value one receives
upon an exit. An investor is valuing the company at a certain level now in anticipation that
the company will realize a much higher value for investors later, not because the investor
believes he or she can sell their shares today at the financing valuation. Consequently,
management would be well-advised to focus not on calculating the “value” of their (illiquid)
shares, but on working to build real value in the business.

IESE Business School-University of Navarra 15