Can ECV method be used to value pre-revenue companies?

Typically, a pre-revenue company is valued using a combination of financial and non-financial methods viz.:

  • Venture Capital (financial)
  • Dave Berkus (non-financial)
  • Scorecard (non-financial)
  • Risk Factor Summation (non-financial) etc…

From the above methods, it seems that the valuation process is more about rationalizing subjective decisions to be taken due to unavailability of financial data.

While we understand that Expected Commercial Value (ECV) is one of the preferred financial methods to value innovations and prioritize R&D projects in an established organization, the question is:

Can it be adapted to objectively evaluate risk of investment in a pre-revenue company which is working on a novel idea?

Based on the experience of this author in successfully raising seed capital in 2 out of 3 ventures in India and also, as a member of jury in reviewing proposals from first generation entrepreneurs for seed capital funding, it could make sense to use ECV to mitigate this risk as suggested below:

  • First, get the Net Present Value (NPV) as estimated from the existing Venture Capital method. This value is the Post-Money Valuation derived from Terminal or Harvest value of the pre-revenue company.
  • Next calculate ECV using the formula ECV = {(NPV * Pcs) – $C] * Pts -$D} with the following assumptions:
    • The capital is structured in two rounds or stages as shown in the below sketch.
    • Remaining Development Costs (remainder of the money spent in building prototypes, that include procuring machinery, hiring space/ personnel etc…) = Rs.0/-.
    • Launch Costs (costs involved in market research, promotion, setting up distribution channels etc…) = Rs.0/-.
      • Note: The value is assumed to be zero because, loading these costs into the formula further reduces the ECV value, which may be good for an R&D project as it reflects the cash outflow to commercialize the project. But, in our case, a fine balancing has to be done by the investors in being supportive to the capital requirements of the Entrepreneur, while simultaneously mitigating the risk involved in addressing them.
    • Probability of Technical success (Pts) and Commercial success (Pcs) are calculated as suggested in the below table.
    • The above probabilities are calculated separately for each round. Obviously in Round 1 these values will be less compared to Round 2.
    • The metrics or criteria being used to calculate the above probabilities could themselves evolve over a period of time, especially with the evolving startup eco-system in India. These evolved metrics or criteria could possibly help the VC/ AI firms in India to systematically evaluate the funding proposals from pre-revenue companies, instead of the highly subjective evaluation being done at the time of this writing.
    • If ECV > Investment required, the venture seems to be less risky.
    • If ECV < Investment required, the venture seems to be more risky.

ModECV

 

 

 

 

 

Probability of Commercial Success
Element Rating Scale Rating
0 4 7 10
Customer benefits New Product offers no unique benefits New Product offers some benefits, but not important to customer New Product offers unique features and benefits New Product offers positive, unique benefits and features
Customer value for money New Product is same as competitors; poor value for money for the customer New Product provides better value for money for the customer New Product has good value for money for the customer New Product has clearly an excellent value for money for the customer
Market size Very small Small Moderate Very large
Market growth No growth or negative market growth Slow market growth Better market growth Very fast market growth
Payback period > 5 years 4 years 2 years < 1 year
Overall Rating:

 

Probability of Technical Success
Element Rating Scale Rating
0 4 7 10
Technical complexity of the product or service being developed Many hurdles; undefined product Some hurdles; defined product A challenge, but, do-able Straight forward
Demonstrated Technical feasibility Have not been able to demonstrate feasibility Some demonstration; limited Almost demonstrated; will be able to early in development Technical feasibility demonstrated clearly
Technological synergies Partners have little or no experience in this technology; require hiring/ acquiring new skills/ technology Some experience and expertise in this technology; require acquiring some new technologies Experience in this area; somewhat leverages partners existing technological knowledge and experience Partners are highly experienced in this technology
Overall Rating: