When it comes to valuation of private companies, the task becomes more daunting that that of public companies.
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For public companies, one can refer to the value of its shares and analyse its published financial statements. However, for private companies, much of that information is lacking.
Methods such as using comparables are possible, but some say they may not be applicable if this private company is truly unique. Other methods such as discounted cash flow valuation may not be accurate due to a lack of reliable financial data. At the core of the debate, what is apparent is that individuals perceive value based on subjectivity.
A widely-used method of valuing a private company is the venture capital method. This method takes a somewhat holistic approach, in that it looks at the overall value of the company, mainly based on the financing that the company has obtained. The entrepreneur should understand how this is done, so as to have a feel of what is likely to be offered to them.
The venture capital method is based on the discounted cash flow (DCF) method of valuation. At early stages of the venture, it is difficult to determine the value of the company at that point in time, therefore the DCF method comes in handy as it is built on projections, i.e. the expected financial performance of the firm in the near future.
Pre-financing valuation (also known as pre-money valuation) is the value of the company as agreed between the entrepreneur and the VC. Post-financing valuation is the amount of funds that are invested in the company.
Let's suppose a private company needs $500,000. It has done its projections for the next 5 years, after which it is projected to be in "stable growth stage". At that stage, the company expects to have annual earnings of $1million.
The venture capitalist (VC) estimates that the company should have a PE ratio of 10 after 5 years. The required rate of return of the VC is 40%.
Post-financing valuation = Present value of company
= (Earnings x PE ratio)/(1+ required return)number of years
= ($1million x 10)/(1+0.40)5
Pre-financing valuation = $1,859344 - $500,000 = $1,359,344
VC's stake = $500,000/$1,859344 = 27%
This is a simplified example to illustrate venture capital method of valuation. The PE ratios and required rate of return used in this type of valuation done by VCs usually depend on the experience of the VC. In my example above, although a PE ratio of 10 and a 40% required rate of return are commonly used figures, VCs will vary these according to the industry and also according their take on the projections.