What is the valuation?

Determining the valuation for an early-stage company might appear to be black magic for those who are not involved on a day-to-day basis in the process. Early-stage investors have the experience and knowledge of the market to make proper valuations of start-up companies.

Investors have been in a sector through up and down cycles. They also know the top price (in a competitive situation) that they will pay for an investment in order to realize a return when they sell their holdings, based on the projected amount of money required to build value in the company. You may also find that other investors will independently arrive at a similar valuation range. Ultimately, an investor wants to earn a good return (multiple) on their investment.

Why can early-stage companies command such a high valuation?

Some early-stage companies might have a high valuation when you look at their relatively small asset and revenue base because they have the potential to grow very quickly or there are high margins in their business. Fast growth occurs when a new product or service addresses customer needs that have historically not been met or poorly addressed. Technology companies often have high gross margins because they frequently incur low fixed costs and have low cost of goods, sometimes resulting in margins in excess of 70%. This advantage is in stark contrast to businesses in other sectors that work against comparatively low gross margins. Combined with low capital intensity—which means that a relatively low capital base is required to grow the business—the result is the potential for an extremely high return on investment. Large companies will buy small companies because they are typically better at innovation and they want to capture stand-alone economic benefits, distribution synergies and economies, or strategic value.

Google’s acquisition of YouTube is a recent example of an extremely successful venture capital investment. Sequoia Capital, the main investor in YouTube, invested $11.5 million into the company over two rounds of financing. YouTube was subsequently acquired by Google in the fall of 2006 for $1.65 billion. Sequoia owned an estimated 30% of the company, resulting in an exit value of approximately $495 million or 43 times their initial investment in less than two years. The exit valuation for YouTube was not based on any established corporate finance methodology. Google saw strategic value in the acquisition and was willing to pay for it. From a fund perspective, YouTube was the largest exit in the fund and made up for the lesser performing investments. For an early-stage deal, investors, founders and other shareholders will only make a lot of money if the deal is hugely successful. If the valuation was low or high at the time of the early-stage investment, it will not make a significant difference on the exit proceeds.

Investors may also try to acquire a company for a very low valuation. If you have ever watched Dragon’s Den, the investors often offer relatively low valuations. This will provide them with a larger share of the total ownership post-financing.

Try not to focus solely on the actual dollar figure of the valuation. There are other elements of the total offering that could make a lower dollar figure more attractive.