Private companies wrestle with new valuation climate

Investors warn entrepreneurs that the stock market decline and poor prospects of launching an IPO is depressing the valuations of privately held companies.

Dawn Kawamoto Former Staff writer, CNET News
Dawn Kawamoto covered enterprise security and financial news relating to technology for CNET News.
Dawn Kawamoto
3 min read
Investors have pushed down the stock prices of many Internet companies to levels that resemble the sizes of drill bits; that pessimism is starting to bore into the value of even privately held companies.

Venture and angel investors speaking at the VentureOne Premiere conference this week in San Jose, Calif., warned entrepreneurs that the stock market decline and poor prospects of launching an IPO in this environment are depressing the valuations of their privately held companies.

For executives, the issue of valuation is of paramount concern. For example, a CEO looking for additional funding might approach some venture capital investors, offering to sell a 5 percent stake for $10 million--which would value the entire company at $200 million.

But if the investors look at the recent stock prices for comparable companies--a standard practice--they might conclude that a more realistic value is, say, $80 million. As a result, the investors might be willing to pay only $4 million for that 5 percent stake.

Almost without exception, "the same company valued in June is worth less than it would have been in February," said Scott Sandell, a partner with New Enterprise Associates in Menlo Park, Calif.

The reason for this across-the-board discounting is the dismal performance of many publicly traded Net companies, which are used as benchmarks for similar, privately held firms. In addition, the number of initial public offerings has slowed to a trickle since August, after enjoying a brief growth spurt in early summer.

"Valuations are the dog that's wagged by the tail of the IPO market," said Ian Sobieski, managing director of Band of Angels.

According to VentureOne, during the first nine months this year, the median pre-IPO valuation for a company was $367 million, up a mere 16 percent from last year. By comparison, during the go-go period of 1999, the median valuation had nearly doubled from the previous year.

With current market conditions continuing to push these valuations sharply lower, entrepreneurs were advised to raise as much as possible as early as possible, venture advisers said.

"Fuel up the tanks, and fill them up now, because you don't know what's coming in another six months to a year," Sandell warned.

To avoid the disappointment at having a potential investor scoff at a valuation, entrepreneurs can take several steps toward deriving a realistic valuation.

One measure includes taking the so-called forward revenue multiple--the price of the shares compared with annual revenue projections--of publicly traded competitors and discounting that according to the round of funding they are seeking, Sandell said.

For example, companies seeking seed or early rounds may be discounted by 90 percent, first rounds by 80 percent, and mezzanine rounds by 50 percent, Sandell said.

Entrepreneurs should also consider their current and future opportunities in helping to determine a valuation, Benjamin said.

These opportunities depend on a company's innovation, such as new products and services, flexibility in dealing with changing market climates, and execution.

Despite these differing calculations, entrepreneurs often will find that venture firms are fairly conservative when it comes to valuing their company.

"This is really a marketplace," Sandell said. "The VCs and angels compare what other similar companies are receiving that they've seen throughout the year. They often have similar valuations because these people are looking at the same data set."