How To Value a Startup?
WeWork’s shambolic IPO attempt has sparked a great many interesting reads: everything about the company has been covered, from the eccentric habits of founder and former CEO Adam Neumann, his real estate dealings, as well as the consequences for its main backer, Softbank, and the future of the company, which still needs money, even if the IPO failed.
Besides the mesmerizing unfolding and the schadenfreude, however, some questions that have been posed that have a lot of implications and weight are around the valuation: how could the valuation be so “wrong”? Why did this happen? What do the current high valuations mean for investors and startups?
While these are all incredibly interesting discussion points, a more fundamental question beckons, and one to which there is hardly a clear-cut answer: how does one value a startup or a scaleup? What is the correct startup valuation model? Particularly for one that does not make revenues yet and for which there is no clear timeline for doing so?
This is a question that plagues both founders—when they are raising funds for their company, and investors, who have an interest in valuations going in the right direction both at the time of their investment and their exit. However, arriving at a figure all parties can agree upon is not very straightforward; ultimately, valuation is more of an art than a science.
In this article, we are going to recap traditional valuation methods as well as some of the most commonly used methods for startups, and provide some useful guidelines and best practices.
Traditional Valuation Methods - Brief Recap
Depending on the purpose of the valuation exercise and the state the company is in, it can be valued as either a going concern, a company that will continue trading, or a gone concern, a business that is being wound down or liquidated. In the latter case, future profitability is irrelevant (for obvious reasons), and the valuation will focus on what is recoverable from the sale of the company’s assets. This is beyond the scope of this article. For a company that is expected to continue trading for the foreseeable future, there are effectively three main ways of valuation:
- Cost approach: This valuation technique is effectively a gone concern valuation. The valuer looks at the cost (thus the market value) of each asset of the company and ignores income. It can also be used to calculate the minimum value of the company, a sort of a valuation “floor.” For this reason, this technique is rarely used outside of real estate.
- Market approach: This is the quickest and most intuitive way of doing a valuation. It is basically a relative valuation: the idea is that similar companies should have a similar value. The practitioner thus identifies comparable companies by looking at either stock market data or transactions (private or public). Most commonly, these valuations are done by taking a significant financial metric (such as earnings or EBITDA) and then applying a relevant multiple to it. The multiple is usually derived from observing transactions in similar companies. The accuracy of a valuation of this type obviously depends on how many data points can be extrapolated and how many similar companies exist that have undergone transactions.
- Income approach: This is the most comprehensive method for valuing a company. Future cash flows are projected over a period of time such that they can still reasonably be estimated. The not-foreseeable future is estimated through a terminal value. The cash flows are then discounted to the present through the use of an appropriate rate. The result is the intrinsic value of the business—what it is worth as a standalone entity and based on its cash-generating potential. The main challenge here, of course, is accurately forecasting cash flows, ones that are created through reasonable and knowledgeable assumptions.
Business Valuation Methods
Valuation for Startups: A Philosophy
But what methods are most accurate to value a startup? The methods described above clearly pose some difficulties when looking at early-stage companies. For example, how could the cost approach be applied to a company that holds very few assets outside of intangible assets, such as the team’s qualifications and the validity of the idea? Or how can a revenue multiple be applied to a company that does not yet have revenues? For these reasons, over time, early-stage company valuation has emerged as a separate field in corporate finance.
There are also tensions between investors and entrepreneurs, as the former have all the incentives to keep valuations lower, while entrepreneurs want to see their efforts rewarded through an attractive valuation.
So how should one think of startup valuations? Ultimately, the “correct” valuation is the one that gives entrepreneurs the funds they require to reach the company milestones for the phase that they are in. It also gives them time to devote themselves to the business without constantly focusing on fundraising. At the same time, it does not give away such a portion of the company that could jeopardize their control over it through the dilution of subsequent rounds. The logic is mirrored for investors: they should aim to acquire a sufficient stake in the company that allows them to have some control, while still having alignment and “skin in the game” from entrepreneurs. It is also important that the valuation is not too optimistic in order to avoid a downround. For this reason, investors must be clear about: a) what needs to be achieved in terms of product and sales before the company needs a new capital injection; and b) why a more successful and knowledgeable investor is more useful to an entrepreneur than someone who will just contribute cash.
The structure of the investment also matters: venture investors commonly use “downside protection”—most often in the form of a convertible note or a liquidation preference. This is made necessary by the very risky nature of early-stage investing. Fred Wilson explains this very clearly through what he calls the 1/3 rule:
“1/3 of the deals really work out the way you thought they would and produce great gains. These gains are often in the 5-10x range. The entrepreneurs generally do very well on these deals.
1/3 of the deals end up going mostly sideways. They turn into businesses, but not businesses that can produce significant gains. The gains on these deals are in the range of 1-2x, and the venture capitalists get most to all of the money generated in these deals.
1/3 of the deals turn out badly. They are shut down or sold for less than the money invested. In these deals, the venture capitalists get all the money even though it isn’t much.
So if you take the 1/3 rule and add to it the typical structure of a venture capital deal, you’ll quickly see that the venture capitalist is not really negotiating a value at all. We are negotiating how much of the upside we are going to in the 1/3 of our deals that actually produce real gains. Our deal structure provides most of the downside protection that protects our capital.”
Ultimately, these three points are what matters when negotiating the terms of an early-stage investment:
- How much money does the company need to reach the milestones set before they next need to raise funds?
- What is the best capital structure to align the interests of entrepreneurs, investors, and ultimately employees?
- How much is the market willing to pay for a stake in a company like mine?
A fixation on the headline number of the valuation can be at times damaging for entrepreneurs.
Early-stage Company Valuation: Methodologies
Given these principles, what is then the best methodology to use when valuing an early-stage company? We look at three of the most common methods used by angel investors and VC.
Scorecard or Checklist Method
The scorecard method was described by Bill Payne and formalized in his manual on how to raise money from angel investors. The investor should first look at the average valuation for companies at a similar stage and in a similar industry to the one they are evaluating and find an average valuation. For companies seeking angel funding, this value has slowly been creeping up over time, with an estimated average value of $3.4 million in 2018.
Once the average has been established, the investor will then apply a multiplier, based on their assessment of the following qualitative factors and the weight they decide to apply to them within the set range.
- The strength of the Management Team (0–30%)
- Size of the Opportunity (0–25%)
- Product/Technology (0–15%)
- Competitive Environment (0–10%)
- Marketing/Sales Channels/Partnerships (0–10%)
- Need for Additional Investment (0–5%)
- Other (0–5%)
The multiplier will then be 1 for an average company, or lower/higher for a company that is worse/better than the average. Obviously, the results of such a valuation are very dependent on the personal opinion of the angel and on their expertise and experience. A very similar method is the checklist method, developed by Dave Berkus, which assigns fixed weights to each defined category.
DCF with Multiples
Much like a standard DCF, this is based on financial projections made by the startup management team. To calculate the terminal value, the last projected EBITDA (or similar figure) is then multiplied by the multiple extrapolated from a group of comparables. The cash flows are then discounted using a rate that represents the weighted cost of funds (debt and equity). There are two major challenges with such a method. First, the projections are guaranteed to be incorrect; second, it is extremely challenging to determine the appropriate discount rate to be applied. This web article offers some guidelines.
This is an industry-standard method that takes into account the required return rate of the fund and their investment horizon. Basically, it requires calculating post-money valuation (of the current round)—based on the anticipated exit amount and the target return of the fund—and then adjusting by ticket size and anticipated dilution. The main weakness of this method is that it focuses only on the assumptions of the venture investor, not on the company’s characteristics.
Milestones for Each Round
Finally, it is worth discussing the average valuations and milestones for each funding round. This article gives a comprehensive explanation of the different stages of funding for a company and the size of the respective valuation round. It is important to keep in mind that round sizes and valuations are much smaller outside of the US, and even in the US outside of Silicon Valley.
Initial stage: this is the realm of angel investors - the riskiest stage of any company. At this point, the company is really just an idea and a small, dedicated team.
- Friends and family: The startup is funded either by the founders themselves or through the help of funds and relatives. This provides the company with the first funds to work on the idea; invested amounts are usually less than $250k, valuation $1 million.
- Angel / Seed: The first external funding comes to the company, and will usually have a prototype at this stage - the company invests in team members and marketing. The investment received is usually around $500k/750k, for a valuation of ~$2/4 million.
- Seed: Not always a separate round. The first professional investors come on board, expecting a push on customer acquisition.
Growth stage: this is the typical venture capital playground. Companies are trying to find product/market fit and then scale.
- Series A funding: Typically, at this stage, the company has launched a product and is working on making it successful, with product and business model tweaks. Series A rounds may finance $2-$5 million.
- Series B funding: This round serves to further prove the model tested during the Series A - the funds raised will go to test the growth levers, improve the product, and professionalize the team. Series B will be around $5-$15 million.
- Series C + funding: At this stage, the company has clear product/market fit and is just investing to accelerate growth. It may or may not be generating revenues, though. Series C rounds will be of $15+ million and each subsequent round size will increase accordingly.
Ultimately, it is important to remember that for a startup, or an early-stage company, the valuation is not based so much on the current (or future, as the odds of the company making it are so low and hard to predict) as on intangible factors such as the strength of the idea, the capabilities of the team, and the industry it operates in. It is crucial for entrepreneurs not to get fixated on high startup valuations, which may be hard to sustain. The goal of a well executed funding round is that of giving the company sufficient runway to meet its milestones while ensuring that the incentives are aligned for all stakeholders.
Understanding the basics
This is an industry-standard method which takes into account the required return rate of the fund and their investment horizon. It requires calculating post-money valuation based on the anticipated exit amount, the target return of the fund, and then adjusting by ticket size and anticipated dilution.
The “correct” valuation for a startup gives the entrepreneur the funds they require to reach the company milestones for the phase that they are in, while at the same time not giving away such a portion of the company that could jeopardize their control over it through the dilution of subsequent rounds.
The difference before pre-money and post-money valuation is the dollar value of the investment.