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By Andres Navia
My team at Poseidon proposed that I write a post on our most frequently used valuation methodology at our firm and I would like to start this post by thanking them for doing that. I think that our valuation methodology is really straightforward, manageable, and should be great for founders to read about.
Note to founders: When fundraising, it’s important to consider the different ways that investors are contemplating their potential participation in your company. This may dictate whether you feel that you should raise venture capital (VC) from a fund, or rather focus on raising financing from family, friends, and potentially, angel investors. As investors, we would rather demystify the objectives of a VC investor and have clear alignment with founders from inception.
Our valuation methodology is uncomplicated because it’s really just a net present value calculation with the following three main assumptions:
For example, suppose that Newco is raising a $10 million Series A financing round. Simplistically (and maybe, grandiosely), Newco is targeting to exit in Year 4 via M&A at a 2x Enterprise Value (EV)/Revenue exit multiple with $650 million in revenues in Year 4.
This assumption implies several other assumptions that are important for our valuation:
The expected holding period is going to be used by Poseidon to determine our target return. The exit strategy implies that there will likely be a control premium and an illiquidity discount applied to Newco’s equity value at the time of exit by the acquirer. The target exit multiple implies that Newco is targeting to get acquired for 2x revenues at the time of exit (i.e., in Year 4). The target exit revenues imply that Newco is targeting to generate $650 million in revenues in Year 4 at the time of exit. [1]
Poseidon is going to use its target Internal Rate of Return (IRR) and the expected holding period to determine the target return for this investment. The expected holding period for this investment is 4 years and suppose that Poseidon’s target IRR is 30%. In this valuation methodology the only positive cash flow occurs at the time of exit where we estimate Newco’s equity value at exit. This means that after receiving the $10 million investment, the post money valuation of Newco is simply Newco’s equity value at exit in 4 years adjusted for any future dilution from subsequent rounds of financing and discounted by Poseidon’s target return for this investment.
In VC, the equity value at exit estimate is typically based on some kind of success scenario. But since there’s considerable risk involved in a typical Poseidon investment, which is in line with VC, Poseidon applies a higher discount rate to compensate for the risk. Founders can be overconfident and have a strong tendency to overstate the prospects of their firm. This is natural, and frankly, expected, since they should have the most conviction in their firm. But this means that the equity value at exit estimate isn’t really the implied equity value at exit. The equity value at exit estimate is actually the expected implied equity value at exit in case of success.
If Poseidon was certain that Newco will succeed, then Poseidon’s target return for this investment would be:
(1 + 30% Poseidon target IRR) ^ 4 year expected holding period = 3x target return
But suppose that Poseidon actually thinks that Newco could falter (in fact, most do somewhere along the way), and that the probability of that happening is 25% each year. This means that Newco’s yearly probability of success is 75%, and its exit probability is:
75% yearly probability of success ^ 4 year expected holding period = 32% exit probability
This also means that the expected implied equity value of Newco at exit in case of success is the implied equity value of Newco at exit in Year 4 multiplied by Newco’s exit probability of 32%. Since the post money valuation of Newco is the expected implied equity value of the company in 4 years at the time of exit in case of success adjusted for any future dilution from subsequent rounds of financing and discounted by Poseidon’s target return, another way for Poseidon to account for this risk around the implied equity value of Newco at the time of exit is to simply calculate the expected target return for this investment:
3x target return if Poseidon was certain that Newco will succeed / 32% exit probability = 9x expected target return for this investment
A 30% target IRR combined with a yearly probability of success of 75% has the combined effect of a 9x expected target return or a 73% expected target IRR for this investment:
9x expected target return for this investment ^ (1 / 4 year expected holding period) — 1 = 73% expected target IRR
Newco is targeting to exit in Year 4 via M&A at a 2x EV/Revenue exit multiple with $650 million in revenues in Year 4. In other words, Newco is targeting to get acquired at 2x $650 million in revenues or an implied enterprise value of $1.3 billion:
$650 million in revenues at exit * 2 EV/Revenue exit multiple = $1.3 billion implied enterprise value
Enterprise value is described in detail in many places, so I will only summarize the concept here:
Assuming that Newco will raise little to no debt, and that startups don’t have any excess cash, Newco’s implied equity value will be equal to its implied enterprise value of $1.3 billion.
Now, since Newco’s exit strategy is via M&A instead of doing an initial public offering, Newco’s implied equity value should be adjusted for control and illiquidity. When an acquirer acquires a target, it is acquiring a control position as opposed to a minority position. Since the acquirer will now have control of the target, its position is more marketable, and more valuable than a minority position and therefore warrants a control premium. But, since Newco is also a private company and is not freely traded (i.e., illiquid), Newco’s implied equity value will also likely be adjusted for illiquidity by the acquirer at the time of acquisition (i.e., at the time of exit).
EV/Revenue multiples are typically derived from trading comparables. Trading comparables trade on a minority or non-controlling and marketable or liquid basis. Think about owning public company stocks. The value of your stock represents a minority position that is liquid and can be freely traded. So, when you value a firm using EV/Revenue multiples from trading comparables, the implied equity value is on a minority or non-controlling and marketable or liquid basis. To adjust Newco’s implied equity value for control and illiquidity, we first need to adjust for control.
Control premiums in the market typically range from 10 to 30%. Newco will want a higher control premium, and the acquirer will want a lower control premium. To be conservative, Poseidon will use a lower control premium to adjust Newco’s implied equity value. Suppose that Poseidon assumes that the control premium will be 10%. Newco’s implied equity value adjusted for control is:
Newco’s implied equity value of $1.3 billion * (1 + 10% control premium) = $1.4 billion implied equity value adjusted for control
Now, to adjust Newco’s implied equity value for illiquidity, we need to adjust Newco’s implied equity value adjusted for control, for illiquidity. Illiquidity discounts in the market typically range from 20 to 40%. Similarly, the acquirer will want a higher illiquidity discount, and Newco will want a lower illiquidity discount. And again, to be conservative, Poseidon will use a higher illiquidity discount to adjust Newco’s implied equity value.
Suppose that Poseidon assumes that the illiquidity discount will be 40%. Newco’s implied equity value adjusted for control and illiquidity is:
Newco’s implied equity value adjusted for control of $1.4 billion * (1–40% illiquidity discount) = $858 million implied equity value adjusted for control and illiquidity
This means that Newco’s implied equity value at exit in 4 years will be $858 million.
Companies typically raise multiple rounds of financing. Since Newco is raising a $10 million Series A financing round, it’s very likely that it will raise several more rounds of financing. Poseidon will therefore assume that their Series A ownership will be diluted in future rounds. This is a difficult problem to solve since it requires that we make assumptions about the terms of these future rounds of financing. While these assumptions may be difficult to make, future dilution is one of the most important components in VC valuation.
Newco is raising a $10 million Series A financing round. Series A investors typically require ownership percentages between 10–30% in order to get their expected target return (note: this can be a little different in cannabis because cannabis firms that are raising a Series A financing can sometimes be generating tens to hundreds of millions in revenue). Suppose that Newco expects that it will need to raise more capital by selling additional shares. Later stage investors typically require lower ownership percentages to get their expected target return since their expected holding period is shorter. Assume that Newco will raise a Series B and sell 20% of the firm at the end of Year 1. This round of financing will dilute (i.e., reduce) the existing owners of the firm, including Poseidon, by 20 %. The expected retention percentage for the existing owners of the firm, including Poseidon, after the Series B financing will be:
100% ownership * (100% ownership — 20% Series B estimated proposed ownership) = 80% expected retention percentage
Now suppose that Newco will then raise a Series C and sell 15% of the firm at the end of Year 2. It will then raise a Series D and also sell 15% of the firm at the end of Year 3, and then it will raise a Series E and sell 10% of the firm at the end of Year 4 right before exit. These subsequent rounds of financing will also dilute Poseidon’s ownership at the time of exit. The expected retention percentage for Poseidon at the time of exit is:
100% ownership * (100% ownership — 20% Series B estimated proposed ownership) * (100% ownership — 15% Series C estimated proposed ownership) * (100% ownership — 15% Series D estimated proposed ownership) * (100% ownership — 10% Series E estimated proposed ownership) = 52% expected retention percentage
Note: According to Sand Hill Econometrics, the average retention percentage for Series A financing rounds in companies that are successful is 50%.
Suppose that Poseidon’s expected retention percentage for this investment is 50%. The post money valuation of Newco is Newco’s implied equity value at exit adjusted for future dilution and discounted by Poseidon’s expected target return for this investment. Newco’s implied equity value at exit is $858 million, and Poseidon’s expected target return for this investment is 9x. This means that Newco’s implied post money valuation is:
($858 million implied equity value at exit * 50% expected retention percentage) / 9x expected target return for this investment = $48 million implied post money valuation
Since Newco is raising a $10 million Series A financing round and Newco’s implied post money valuation is $48 million, Newco’s implied pre money valuation is:
$48 million implied post money valuation — $10 million Series A financing round = $38 million implied pre money valuation
To try to compensate for any additional risk that Poseidon may not have accounted for, Poseidon is going to consider the $48 million implied post money valuation or the $38 million implied pre money valuation as the maximum valuation that they will be willing to invest at.
A term sheet will typically be offered between the preliminary and the final due diligence stages and this is when negotiations usually begin. This is intentional because it sets the zone of possible agreement early on and indicates the possibility of reaching an agreement before investing more time and resources into an investment opportunity. The Poseidon Method is an important tool for both parties to master since it provides the quantitative basis for the negotiation, but the actual deal will also be driven by the bargaining dynamics between Newco and Poseidon.
Thank you for taking the time to read this post on The Poseidon Method. I hope that it’s helpful, and please feel free to send me any feedback at anavia@poseidon.partners.
Notes
[1] Premiums and discounts are part of M&A. M&A is part of Corporate Finance. Premiums and discounts are described in detail in many places, so I will only summarize the concepts here. A control premium is an amount that a buyer is sometimes willing to pay over the current market price of a publicly traded company or the implied price of a private company in order to acquire a controlling share in that company. An illiquidity discount reflects the reduction in value from the implied price of a private company since it is not marketable and cannot be freely traded (i.e., illiquid).
Thanks to my team at Poseidon, Emily Paxhia, Morgan Paxhia, and Michael Boniello, for reading drafts of this.