Venture Capital: Tying Risk to Valuation
Risk is an inherent element in early-stage companies. The word risk itself suggests danger, possible failure, and a whole package of bad feelings. In the world of venture capital, risk means something a little bit different: risks are the milestones that your business must accomplish before your company can reach its goals.
These potentially beneficial steps along the way are referred to as risks because they’ve not yet been accomplished. If the company doesn’t achieve them or doesn’t achieve them in a reasonable time frame, it stands to fail at accomplishing its final goals.
Several valuation methods use risk as the primary driver for early-stage valuation — an approach that makes sense because early-stage valuation is driven primarily by uncertainty and risk. Later-stage valuations can be done relatively easily using revenue, profit, and asset methodologies, but early-stage valuations have more to do with whether the investor thinks you can actually do what you say you’re going to do and whether the market will accept it.
Understanding how risk impacts value helps you make your best presentation and lets you negotiate the valuation for your company more effectively. Having a clear and transparent methodology that makes all risks clear also helps to dispel any vague concerns that the investors may have about your company.
It is always better to be able to have conversations in which the risks are clear and you can discuss the pros and cons openly rather than trying to counter concerns that investors may have with little more than a hunch.
The important thing to remember about the valuation methods that quantify risk is that the inputs are essentially all subjective. Although you may come out with a number, that number is only as good as the inputs you have started with.
The benefit of using these or other risk based valuation methods is that the risks and your attitudes toward them are transparent. You and the VC may not agree on the impacts of all of the risks, but at least they’re on the table and can be discussed rationally.
Using the risk factor valuation method
In the risk factor valuation method, you list all the major risks for a company and assign a value to them. To find this value, start with the average valuation for venture businesses in your area. Nationwide last year, the average valuation was about $2.5 million, skewed mostly by values on the coasts. The numbers in the Midwest may be more like $1.5 to $2 million.
Do some research to learn what your local basis is. For this example, assume a $2 million average valuation in your area.
Take the average valuation amount and apply risk values either positively or negatively. (This task is similar to what you’d do to adjust the Blue Book value of a used car, based on the mileage, special options, overall condition, and so on).
For each category, add up to three points for high value or deduct up to three points for extraordinary risk. Each point is worth $100,000. After you enter all the numbers, you can calculate your valuation.
Here’s an example: Assume that you are an early-stage company called Game-ibuy.com. You have a unique e-commerce site that gamifies the shopping experience where customers can compete with each other for bargains. Your company will make money using an affiliate model where you collect 20 percent of all the transactions completed on your site. You’re looking for $500,000 to finish the technical work on your site and get it ready to launch.
At launch, you’ll raise a Series A round for another $3 million which will fund your national launch and bring you to cash flow positive. You have a team of four, comprised of two developers, a CEO, and a CMO (Marketing) who has worked in retail but has limited online experience.
All have experience in start-ups, and the CEO has had a successful venture-backed exit in the past. The CEO has started conversations with Amazon who has expressed interest in the company’s technology, if they can get it to work.
For the purposes of this example, create a worksheet listing these risks in the left-hand column. Then fill in the necessary detail: Describe your company’s status in that category and then apply the risk factor. This table shows an example valuation worksheet.
|Business stage||Early stage — typical.||0|
|Competition||Others in development, lots of affiliate shopping sites.||–1|
|Economic risk||No unusual risk.||0|
|Exit risk||Have had conversations and interest was expressed early on. Past exit experience also helps.||+3|
|Funding risk||One more round.||–1|
|Legislative/regulatory/political||Internet tax applies to all competitors equally.||0|
|Litigation||No special risk.||0|
|Management||Small team, experienced, venture backed exit.||+3|
|Reputation risk||No unusual risk.||0|
|Sales and marketing||Increasing cost to gain online market share, lots of competition with similar offerings, lack of online marketing experience.||–3|
|Social risk||Possible fallout from all these affiliate sites. Gamification is a huge trend that may not last.||–1|
|Technological risk||Application not yet complete. There are unique challenges to building the gamification components.||–2|
Now do the calculation. Determine the value of all your positive and negative ratings to get your net adjustment. Subtract the net adjustment from the starting average to get your valuation prior to investment. This table shows the calculation based on the information in the risk factor valuation.
|Starting average regional valuation||$2 million|
|Value of all positive ratings||+6 x $100,000 = +$600,000|
|Value of all negative ratings||–8 x $100,000 = –$800,000|
|Net adjustment to value||$600,000 – $800,000 = –$200,000|
|Pre-money valuation (starting average minus total adjustments)||$2,000,000 – $200,000 = $1,800,000|