How does one value a start-up 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.
The traditional Business Valuation Methods are
Source: Corporate Finance Institute
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.
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 down round. 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.
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.
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 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.
Source: Corporate Finance Institute
Ultimately, it is important to remember that for a start-up, 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 start-up 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.