Can you explain to me how it is possible to value a company that has not realized any revenues and earnings?
Depending on the stage of the private company, there are a few ways we could perform the valuation analysis:
1 – Early stage companies / OPM Backsolve:
Depending on how recently the prior round of financing was completed, one could calibrate back to the latest round of financing and backsolve for the implied value of the entire company (and other equity classes) by applying an OPM (option pricing model) framework. The rationale of using an OPM framework here is that each class of equity security within a private company behaves like an option on the company’s equity value, given a certain assumed time to a liquidity event. This is because the equity securities within a private company typically don’t have a way to monetize the shares until a sale/IPO/liquidation event. And when such an event takes place, each class of equity security will receive the distribution of the proceeds from the Company in accordance with their liquidation preferences and/or rights.
As a quick example, let’s assume a private company recently received a second round of funding via the issuance of the Class B Preferred Shares after the company was initially funded by the Class A Preferred shares 1.5 years ago. The total funding received via the B round financing was $1mm. Now, this B round financing could actually imply a certain value of the company’s total equity value because we are asking the following question: “What does the total equity value of the company need to be in order for the Series B investors to invest at the given per-share price, accounting for all liquidation preferences and seniorities for the other classes in the company’s capital structure. As an example, let’s assume that upon a liquidity event where proceeds will be distributed, the B class holders will be paid first for their original investment amount (i.e., liquidation preference) before the A class holders will get their original investment amount paid back. For simplicity, let’s assume these preferred shares are not entitled to any dividends (but please note that preferred shares typically are entitled cumulative dividends). After both B and A have been paid back with their liquidation preference, then the B, A, and common holders will share any additional proceeds on a pro-rata basis in accordance with their number of shares. For the OPM to work, we will need to assume a certain volatility level, risk free rate, and time to liquidity event (i.e., 3 years). Please see the attached screenshot for how the OPM backsolve is set up. We can see that when the total equity value of the company is $1.801mm, the value of the Preferred B shares is $1mm, consistent with their investment amount. The breakpoints are set with respect to where each equity class’ share of proceeds allocation changes. The option values are derived using the normal Black Scholes formula and the tranche values represent the incremental option value at each break point.
2 – Comparable companies / “creative multiples
For tech start up companies, we could also search for a group of comparable companies and/or prior comparable transactions and invent some “innovative” multiples such as EV / Unique Visitors and EV /Pageviews rather than using the more conventional EV / Revenue or EV / EBITDA given that the premise here is that the company has not yet realized any revenues.
3 – “Back to the future” DCF
We could also apply a DCF analysis if it is expected that the company will soon be able to realize some revenues and as such it is not unreasonable to forecast some financials a few years out when will likely start generating revenues and profits.