Introduction

Early Stage Valuation covers a broad range of valuation methods that reflect the variety of early stage enterprises (ESEs), from entities that may have just started operations to companies that have substantial revenue and have already gone through multiple rounds of venture capital financing. A recurring message throughout this book is that the approach to ESE valuation needs to follow the company's evolution and adapt to reflect the company's characteristics at each stage of development. The structure of this book consists of three parts:

Part One: Early Stage Valuation in Context lays the foundation for ESE valuation under the fair value standard and describes the main characteristics of ESEs, including their market and capital structure.

Chapter 1: Early Stage Enterprises and the Venture Capital Market introduces the definition of ESE and provides an overview of the capital markets in which ESEs operate. This chapter considers the objectives and target returns of venture capital investors and how they reconcile to the historical returns realized by ESE investments. We discuss how the venture capital market has evolved over the past decade. We identify recent trends in ESE exit strategies and valuation, considering data on M&A transactions, buyouts, and IPOs over the past decade.

Chapter 2: Fair Value Standard presents the fair value standard for financial reporting as defined in Financial Accounting Standards Board, Accounting Standards Codification 820, Fair Value Measurement (ASC 820) and International Accounting Standards Board, International Financial Reporting Standards 13, Fair Value Measurement (IFRS 13). We provide a historical overview on the development of the fair value concept, from the medieval debate on the "fair price" (justum praetium) in Franciscan and Scholastic theology through the writings of Alfred Marshall, the Railroad Rate regulation of the 1890s-1910s, and the interpretation of fair value in the wake of post-World War II economic liberalism.

We then examine the fair value definition for financial reporting under generally accepted accounting principles (GAAP) and illustrate the income, market, and asset-based valuation approaches under ASC 820/IFRS 13 as they apply to ESEs.

The last part of this chapter reviews some key reference material that we use in our analysis, with an emphasis on the most recent guidance on fair value implementation, including:

• American Institute of Certified Public Accountants Accounting and Valuation Guide on the Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the "AICPA PE/VC Valuation Guide")
• International Valuation Standards (IVS) 210, Intangible Assets and IVS 500, Financial Instruments, latest edition.
• International Private Equity and Venture Capital Valuation Guidelines: latest edition (the "IPEV Guidelines")
• Appraisal Foundation: VFR Valuation Advisory #4, Valuation of Contingent Consideration ("VFR #4")
• Alternative Investment Management Association: Guide to Sound Practices for the Valuation of Investments (2018).
• Financial Instruments Performance Framework (FIFP) for the Certified in the Valuation of Financial Instruments (CVFI) Credential
• Mandatory Performance Framework for the Certified in Entity and Intangible Valuations (CEIV) Credential and Application of the Mandatory Performance Framework for the CEIV Credential (collectively the MPF)

We also include some less recent sources that are also relevant for ESE valuation and that we have used in various chapters of this book. More references can be found in our selected Reference section at the end of the book.

Chapter 3: Capital Structure discusses the capital structure of ESEs, which are often complex structures with multiple classes and series of securities. We consider the most common features of common stock, preferred stock, options, and option-like instruments, debt and hybrid instruments such as simple agreements for future equity (SAFE) and keep it simple securities (KISS). We discuss economic rights of preferred stock, including liquidation, antidilution, participation, conversion, dividend and redemption rights, as well as noneconomic rights such as registration, voting, board composition, drag along, preemptive, first refusal, tag-along, management and information rights. We provide practical examples of antidilution provisions and various types of liquidation preferences and insights into how these rights may play out in valuation depending on the company's exit strategy.

Part Two: Enterprise Valuation illustrates the valuation of an ESE at the level of the overall enterprise. Most ESEs do not have debt in their capital structure or have debt with equity features (convertible debt). In this context, the enterprise value of the firm will coincide with its equity value.

Chapter 4: Seed Stage Valuation and the Venture Capital Method presents an overview of valuation of ESEs in their initial stages up to their Series A funding with venture capital financing.

We review the market for seed investing and the role that angel investors play in providing seed capital. We introduce the concepts of premoney and postmoney valuation and provide examples of how postmoney valuation is affected by a company's capital structure. We illustrate how an "up" round where the postmoney valuation of a company increases may actually be a "down" round from the perspective of an individual investor whose interest has been diluted by the addition of new investors into the company.

We walk through some of the scorecard methodologies that are used in the earliest stages of seed investing, including the Payne Scorecard, the Risk Factor Summation Model, the Berkus method, and the Modified Berkus method. Most of the chapter is dedicated to the Venture Capital (VC) method, which is a common approach to valuation for negotiating new stakes in portfolio company deals. One of the challenges of the VC method is how to reconcile the "Target Returns" that VC investors aspire to in entering into a new deal (typically 30% or above), with the "Required Returns" that investors expect to achieve based on the historical evidence of venture capital fund returns (typically in the 15-25% range). In this chapter we show some practical examples of how, given the (1) time horizon, (2) projected exit value for the deal, (3) expected risk of failure, and (4) the expected dilution percentage over the term to exit, an investor can determine the ownership percentage that needs to be negotiated in order to achieve its Required Return in a specific deal.

We conclude the chapter with an illustration of the First Chicago Method by applying a simple scenario analysis to the valuation of a company in the seed stage.

Chapter 5: The Backsolve Method is a common method under the market approach to estimate enterprise value based on the price of a recent transaction in the company's own securities. Chapter 5 walks through a case study in the implementation of the Backsolve method based on Case Study 10 of the AICPA PE/VC Valuation Guide. The chapter explores how to apply the Backsolve method in combination with an option pricing model (the "OPM Backsolve Method") to a company with a complex capital structure.

We discuss how secondary transactions can be factored into the reference price that is used as the starting point of the valuation. Finally, we illustrate how to estimate the volatility of the company's equity, which is a key input in the OPM model.

Chapter 6: Discounted Cash Flow Method is dedicated to the Discounted Cash Flow method (the DCF Method or DCF), which is a cornerstone of the income-based approach. Of all the valuation techniques discussed in this book, the DCF method is the one that has the greatest variety of applications and is also the most controversial in terms of its ESE implementation. A DCF model can provide an appropriate methodology for ESE valuation for companies that already have an established revenue stream, especially when recent transactions in the company's securities are not available or the transaction prices that are available are not indicative of fair value (for instance, a related party transaction at other-than-market terms).

It is common practice in a DCF model to use a single discount rate throughout the projection period. In this chapter, we present a dynamic DCF model that includes three stages of development: a high growth period with revenue growth and discount rates significantly above industry average (Years 1-5 in our example), a stable growth phase (Years 10-plus) where revenue growth rates are in line with the risk-free rate and the discount rate is in line with industry averages, and an intermediate declining growth stage where revenue growth and the discount rate gradually converge to their stable growth values.

In our model, the high-growth stage is based on management's projections of revenue and cash flow amounts. The stable growth stage reflects the company's capital structure, revenue growth rate, operating margin, tax rate, depreciation, and reinvestment rate based on the analyst's long-term "vision" of the company. The intermediate or declining growth stage is formula-driven.

Most of the ESE value depends on the terminal...