The Art of Valuing Startups
Early Stage Companies: Get in on Hockey Stick Growth
With half as many public companies to invest in as just 40 years ago investors are looking for opportunities. The private company market is booming. In fact, one of the reasons for the dearth of public companies is fast growing startups are choosing to stay private and merge or be acquired rather than going through the IPO process.
Startups are high risk/high gain with risk and return diminishing as companies mature. Early stage investments the more mature the company becomes. The phases are: friends and family, angel, seed, Series A, B, C, D and above. Institutional investing begins at seed stage although there are individual investors at seed as well.
Venture capital funds make money for their limited partners by selecting good companies at fair prices and by managing risk through portfolio construction. Determining valuation is one key to managing risk.
Early-stage funding ecosystems are well established. Startup companies present to investors through pitch demo days, investor conferences, and participation in accelerators as well as networking outreach to investors directly. Since 2010 the number of new business applications has nearly doubled from 2.5M a year to a high of 4.35M in 2020.
Experienced seed and Series A investors use well tested models to establish valuations as part of their due diligence processes and to establish terms of investing. In addition to traditional valuation methods like discounted cash flow and revenue and earnings ratios, a broader range of methods can be used for pre-earnings companies. The Scorecard Method provides a framework to value elements of a company that predict success; the Venture Capital Method supports an assessment method tailored to various investor target investment theses.
An objective assessment of potential looks at the elements of a company: problem and solution, product, size of market, quality of team, growth strategy, technology, financial projections, and investment offering. Then investors apply valuation models that allow comparisons among possible investments.
1) THE COMPARABLES METHOD
The comparable method of startup valuation is probably the simplest: find a comparable company to the one you’re trying to value, and use its valuation as a stand-in for the new startup.
In the same way that two houses might have their size, layout and outside space compared, two startups might have their MAU, churn rates and MRR growth compared to create a stand-in valuation.
2) THE SCORECARD METHOD
The scorecard method is a variation on the comparison method detailed above. It’s commonly used by angel investors to compare a new investment opportunity to an “average” startup in a given region and industry,
An angel would create a list of desirable characteristics, outlining the factors they believes impact startup success (things like founder experience, sales & marketing expertise, and industry competition).
These factors are then subjectively weighted according to their perceived impact on success:
If a particular criterion is determined to be average, it scores 100%; better than average and it’ll score over 100%; worse than average, less than 100%. These scores are then added together for a final scorecard valuation.
3) THE VENTURE CAPITAL METHOD
The Venture Capital method allows investors to work backwards from an intended return, and calculate the value and equity requirements of a particular deal.
Imagine an investor that’s looking to invest in your startup, with the intention of an exit in three years. The first step is to establish a terminal valuation and work backwards on growth assumptions and likely dilution to establish a current valuation.
Most investors have an expected return (their Internal Rate of Return, or IRR) they need their portfolio companies to generate: in this instance, let’s assume the startup needs to grow by 30%, year-on-year.
4) DISCOUNTED CASH FLOW
The Discounted Cashflow Method values a startup by predicting its future cashflow, and then discounting it to reflect:
· A. the time value of money (typically the risk-free interest the investment could yield over the same time period)
· B. the risk of that cashflow failing to materialize.
5) REVENUE MULTIPLES
Revenue multiples are another form of comparative valuation, using data from public companies to draw comparisons to earlier-stage startups.
Investors begin valuation by looking at public companies similar (in terms of industry vertical, revenue growth rate, etc.) to their target startup. As these comparison companies are publicly traded, it’s possible to find out two important pieces of information:
1. The company’s Enterprise Value, an approximation of the cost of buying it.
2. The company’s earnings.
It’s relatively simple to work out a target startup’s earnings, but it’s much harder to calculate its potential sales value. Instead, we can look to comparable businesses to find the relationship between their earnings and their valuation, and extrapolate that relationship to our own startup.
There are several ways of doing this, each with their own pros and cons:
Case Studies from our Files
Revenue Multiples Method
A client came to us with a solution similar to that offered by a publicly trading company in an industry in which this public company was dominant but not the dominant player. The publicly trading company was still growing at 60% per year so provided good comparisons to the kind of growth phase our our client.
Our client has current revenue and was raising funds to add a product to their product line that would solve an operations problem shared by companies in a $4T global market sector.
We use a combination of the Scorecard Method of evaluating the team and company elements as well as the Revenue Multiples method. The industry comparable gave us a 13.5x revenues (on current client revenue of $2.4M). Using the Scorecard method we put a premium valuation on the company due to the size of market and experience of team.
October 2018 ARR $2.4M
Revenue multiple 13.5x
Premium for 100% growth v. 60% in comparable 18.9x
= $45.36M Valuation
Client came to us with a very experienced team and a big idea in a difficult market sector; company product was on prototype stage that was not functional enough to generate. There was one large competitor in the sector and this team had been customer of the competitor and there were significant problems, acknowledged by all. These problems could be eliminated through use of blockchain. They had an LOI with a single partner which would bring 600,000 registered users when signed.
There is only one comparable in the market that is a $1B revenue company with 3 million active users but that had not taken investments so there is no valuation placed on the company. We applied the Scorecard method to find a positioning within a range of valuations based on the quality of team and idea. We would apply this premium once we added the registered users to the platform, giving a basis for applying the Venture Capital Method.
+30% 0%-30% Strength of the Entrepreneur and the Management Team
Experience, Vision for CEO Role, How Complete is Team
+10% 0%-25% Size of the Opportunity
Total Revenues of Target Market, Potential for Market Share of Company
+15% 0% - 15% Strength of Product and Intellectual Property
How Defined is Product, What is User Acceptance, What Barriers to Entry
-10% 0% - 10% Competitive Environment
Strength of Competitors, Competitive Products
-10% 0%-10% Marketing/Sales/Partners
0% 0% - 5% Need for Additional Rounds
0% 0% -5% Other
While valuation methods follow similar methods to those used to value public companies, you’ll note that in the discussion here of these methods the question of what the company is worth is only part of the assessment. The most important question is whether the business model is sound and whether the team can execute on the plan. As the company matures these questions are less important but in investing rounds up to Series C these are the paramount questions.
The valuation methods seek to quantify the risks and opportunities in business model and team as much as multiples of underlying financials. In the early stages miscalculating business model and team lead to 100% loss! Those are also fundamental drivers of the 10x return that early stage investors seek.
For more information: https://medium.com/the-saas-growth-blog/startup-valuation-methods-explained-982cddd6a1e9