Valuing Early Stage and Venture Backed Companies

CHAPTER 7

Advanced Valuation Topics for Early Stage Companies

As discussed in Chapter 3, the current value method is acceptable only in limited circumstances as a preferred value allocation method for early stage companies. The probability-weighted expected returns method (PWERM), on the other hand, is virtually always an acceptable value allocation method if it is appropriately applied. Due to the apparent subjectivity of some of the PWERM’s key inputs, however, it is often considered less preferable than the option-pricing method (OPM). There are facts and circumstances of specific early stage companies that argue for the PWERM over the OPM—that is, when the relevance of the PWERM outweighs its perceived subjectivity. To properly address the choice between these two allocation methods, one should focus on situations in which the OPM is less likely to provide reliable results:

• Future financing rounds are expected to occur prior to an exit event.

• Major nonfinancial milestones have not yet been resolved.

• Significant spikes in value are possible (e.g., phase success in the biotech field).

• An IPO or sale is imminent.

• The time period to exit or liquidity is lengthy.

Some add that another flaw of the OPM is that there are many-stepped paths to liquidity that flow one from another and result in different times to liquidity (e.g., “We will try to sell in 18 months if things look tough, but if we get the big sales we are hoping for we will try to IPO in two years”). However, this ...