The Investor's Approach to Valuation of Early-Stage Technology Companies

• Author: John Hague & Roger Wilson
• Pages: 777-799

777

Chapter 28

The Investor’s Approach to Valuation of

Early-Stage Technology Companies

john hague & roger wilson

Practice Tip

“Enterpr ise value and investor expectations of these values are a function of the stage

of devel opment of the organization and it s products versu s the risk tolerance of the

f‌inancier. Matching investor expe ctations of those of the entrepreneur is the art of the

early stage f‌inan cier.”

Harold Bridge, CA

A. INTRODUCT ION

Financing rapidly growing early-stage technology companies can be very

challenging. The process typically involves a series of f‌inancings over a per-

iod of years as t he business grows and matures. Each separate f‌inancing

has its own character istics inc luding t he availability of information upon

which to base an investment decision, the amount of capital required a nd

the pur pose for the f‌i nancing, the anticipated time to the next f‌inancing,

and the t ype and number of investors involved as well as t heir investment

criteria and ret urn expectations. Underlying all f‌inancings is a view of the

value of the business. This chapter describes how investors approach valua-

tion as a part of considering investments in early-stage technology compan-

ies. We will comment on a number of topics including:

the differing investor and entrepreneur perspectives on valuation;•

commonly used approaches to valuation;•

778 john hague & roger wilson

the venture capital investor approach to valuation;•

other factors affecting valuation and deal structur ing;•

valuations at different stages of development;•

f‌inancing strategies for successive rounds of f‌inancing; and •

building value over time. •

We have included a case study of a technology company, Wishful Think

Inc., to illustrate how in practice the entrepreneur and investor perspectives

come together in a valuation discussion leading to an investment proposal

from the investor to the entrepreneur.

B. INVESTOR AND ENTREPRENEUR PERSPECTIVES

Investors and entrepreneurs bring quite different perspectives to valuation.

The entrepreneur generally seeks to balance the need for expensive venture

capital today with the belief that his business wi ll undoubtedly increase in

value over time. The entrepreneur will try to m inimize the amount of cap-

ital raised in the early stages of the development of the business when its

value is lowest, preferring to limit the dilution of his ownership by securing

capital in stages as the business grows.

The investor wants to ensure that the company has suff‌icient capital to

move successfully to the next stage of development under circumstances

less positive than those anticipated by the entrepreneur, the company’s cap-

ital requirements are provided for over a reasonable period of time, and

his investment earns an appropriate return for the signi f‌icant risks associ-

ated with t he investment. Unlike the entrepreneur, who may not have any

experience with f‌inancing and valuations, the investor is likely to bring a

wealth of related experience and access to information with respect to simi-

lar investments that will di rect his approach.

Because the entrepreneur often has a considerably more optimistic view

of the company’s prospects than does the investor, there are conf‌licting

views on how much capital the business requires, how quickly cash wil l be

used, when capital will be required, what type of capital is necessary, and

what the cost of that capital should be.

Underlying every venture capital f‌inancing is a mutually accepted valua-

tion of the company by the investor and entrepreneur. T he valuation must

ref‌lect both the venture investor’s determination of the risks and rewards of

the investment as well as the entrepreneur’s view of the acceptable amount

of ownership t hat will be given to the investor in exc hange for the capital

obtained at that point in t ime as well as the impact of the f‌inancing on the

company’s ability to raise money in the future.