A man with more experience and knowledge of valuation than your humble author, Mr. Joe Bartlett, provided the commentary that inspired this post.

How do you value something that has no historical and only has speculative future cash flows? A seed or early-stage company? A spin-out or licensing of a technology? The hard answer is that you can’t with current valuation techniques.  Discounted cash flow is inadequate (I hear the cringe of finance academics every where) because the cash flows you model are speculative, making your valuation speculative. Industry performance benchmarks are also inadequate, because the metrics you’ll be analyzing and applying valuation multiples to are also speculative, causing the same problem as before.  Comparable analysis would be an efficient and accurate way to facilitate the valuation, but the companies receiving investment and their investors are not likely to disclose the terms of those transactions.  How do you solve this problem?

My suggestion is that you use an approach that embraces the speculative nature of the opportunity and provides a reality check for what any valuation means in a future liquidation event.  Let me explain using an overly simplified but easy(ish) example:

Let’s say we have a technology company named WhizBang , Inc. that needs to raise $500K to bring their product to market. They have a successful beta test with a handful of customers, an experienced team, and the technology appears defensible (to the extent that IP can ever be defended). The company projects revenue at $1M in year one, $3M in year two, $9M in year three, and $25M in year four.  They anticipate being acquired in year four at 2x revenue (or $50M).  What is a valuation of that company?

Instead of trying to understand the intrinsic value of the company, focus on the investor’s potential return. Let’s assume the company is selling common stock with no dividend and liquidation preference (not realistic, but keeps the math easy!) at a $5M pre-money valuation (also not realistic).  Pre-money means the value of the company before the investment, and post-$ means the pre-money value plus the investment.  In this case, the pre-money is $5M and the post-money is $5.5M.  If you invest $500K on a $5M pre-money value, you’ve purchased a 10% position in the company ($500K / $5M = 10%).

Lets assume that the company only raises this initial $500K round (again, overly simplified to keep the math simple).  Lets also assume that we have research and agree with the company’s expectation that they’ll be acquired at 2x revenue for $50M.  If the investor owns 10% of the company, the investor has rights to 10% of the acquisition price or $10M.  That is a net ROI of 9x and a XIRR of 72%.  Not too bad!  Research from the Pepperdine University Private Capital Markets program says most venture investors have a target IRR of 38%-42%, so we definitely cleared that hurdle.

Let’s say the investor digs into the business model and get some expert opinion on the sales forecasts that say the $25M sales goal will take eight years instead of four and that the acquisition multiple will be 1.5x revenue ($27.5M) instead of 2x.  How does that play out?

The investor’s ownership translates into 10% of the $37.5M liquidation vent, or $3.75M.  That is a net ROI of 6.5x and a XIRR of 28%.  Ruh, roh.  That investment greatly under-performed.

The scenarios above are overly simplified for ease of understanding, and a real situation would most likely include some combination of follow-on rounds of fundraising, anti-dilution, dividends, liquidation, preference, etc… and that’s just terminology and variables for the transaction.  The two largest risks of failure–market and execution–are independent to the transition itself.

When you think about the value of your pre-revenue or even pre-profits company, try to put yourself in the investors position.  Imagine you own a football franchise and you’ve been given the opportunity to put a contract on a middle school student that’s top tier in his peer group. He comes from athletic parents, he’s in a sports program that has quality equipment and coaching, and the student is in exceptional health for a middle school student.  Would you pay that student $1M now with the expectation that they’ll make you $10M in eight years when they’ve completed high school and college?

Something to think about.