You’ve probably heard, read or asked the question “How do I value a startup?” more times than you’ve promised yourself that Monday will be the start to a new healthy regime. It’s one of the most frequently asked questions and regrettably it has no definitive answer.
The art of valuing an early stage company is just that, it’s art. A blended contextual montage of science, market sentiment and gut feeling. Value is an elusive concept at the best of times. Nothing more than its perceived worth.
So for a startup team with no previous track record and zero financial history, how does one go about setting a valuation when it comes to hooking investors and raising money?
Aint No Party Like A Variable Party
To your delight, there is an undefinable list of factors that will affect the outcome of a startup’s valuation; track record of the founders, attractiveness of the market (growth, recent exits), stage of growth of the business, location, traction, gut feeling, supply of money, and the list goes on.
As there is no cookie cutter solution for any business (except for cookie cutting) the same goes for valuation. This is why companies such as Urban Compass (founding team has an excellent track record with numerous exits) can raise an $8 million seed round before the product stage, Clinkle (founders have minimal experience but market is spicy and the idea is potentially groundbreaking) can raise $25 million also before beta launch and why mystery startup X raises a €1 million seed round while generating significant revenues each month (let’s say the team has a limited track record and more niche market). It doesn’t take an Einstein IQ to see the huge disparity in the valuations.
Whilst this theoretical introduction gives you no gritty details on how to value an early stage startup, I’ll try to give you some pointers on what I’ve experienced in the past and look at some of the more common practices used. This is a complicated topic and it’s imperative to understand that every investor/VC has their own metrics, methods and algorithms for analyzing startups. The following might and might not apply to them…
Multiples, Traction & Quantitative Fun
In an ideal world, your business will be generating revenues and the trajectory of your growth will be something reminiscent of a space shuttle on takeoff. Showing investors that your business model is gaining traction is a big plus and should increase your chances of raising money and achieving a higher valuation, depending of course that the other principal variables are factored in.
Having quantitative data to go on, albeit limited, enables a startup to base its valuation on real numbers. Using multiples as a way to determine the value of an early stage business with revenues is fairly common (in conjunction however with market forces and other influences), and with less than a year of financial results it can be calculated using the following formula:
Run rate – “How the financial performance of a company would look if you were to extrapolate current results out over a certain period of time.” Investopedia
Multiple – multiples of anywhere from 8 above are traditionally used but again, it depends on a variety of dynamics that we discussed above (some startups have seen as much as a 60x multiple on the run rate).
January revenues = €10k
Run rate = €10k x 12 (1 year) = €120k
Valuation = €120k x 10 (multiple) = €1.2 million
For businesses that have more than a years financial history, different metrics can be used against the multiple such as EBITDA, EBIT, NOPAT while these tend to be more geared towards later stage companies.
Markets & Comparable Methods – VC style
With nothing to go on but an idea, a team and possibly a product, the value of a business is based largely on what the market says its worth. If you are operating in a hot sector which is experiencing unparalleled growth and has seen numerous sizeable exits, that puts you at advantage (as long as the market isn’t saturated) yet while an idea that could potentially change the world in a sector that has never been touched before can put you at disadvantage. Investors need something to base their potential return on so if you’re delving into an industry that hasn’t been explored then you are either way ahead of your time or are doing something wrong. Forward thinking VC’s exist but investors need to mitigate their risk in order to increase the probability of a successful return.
One of the most popular methods that VC’s use to determine an entry and exit value for startups with limited financial history is the market and transaction comparables method. As Carlos Eduardo explains in his excellent piece on how VCs value early stage startups:
“comparables tell an investor how other companies in the market are being valued on some basis (be it as a multiple of Revenues or EBITDA, for example, but can be other things like user base, etc) which in turn can be applied to your company as a proxy for your value today”
“comparables, particularly transaction comparables are favored for early stage startups as they are better indicators of what the market is willing to pay for the startups ‘most like’ the one an investor is considering.”
Carlos describes in more detail the two methods that VC’s utilize; the top-down and bottom-up approach.
As the name suggests, the top-down methods refers to investors gauging the potential exit size of your business within its industry and working their way down to determine the pre-money valuation. Having an idea of the exit price, whether by using quantitative methods or by comparing to recent exits of companies within your sector, enables investors to evaluate the return on their investment based on what they will put in.
Using the formula below, investors can calculate, based on the multiple they are looking for (usually 10x but will vary depending on investment round), the post and hence pre money valuation. As Carlos quite rightly points out, the cases are rare when a follow up to a seed investment isn’t needed so investors also have to count that in (the further dilutions). Equipped with this information and how much equity the founders and other investors will be will be prepared to take, they will determine a set of valuations based on the returns they require.
Post-money Valuation = Terminal Value ÷ Anticipated ROI
Quite simply, the bottom-up method takes the average valuation for other startups at your stage relative to your sector/industry and bases the value on that.
Valuing a startup is a complex process based on contextual factors affected heavily by market forces and how similar companies within your sector are currently being valued or their recent exits. Even with some traction to go on, the market still plays a substantial role in shaping the final valuation. Everything down to the amount of investors bidding on your company (if you’re that lucky) will play a role in the end valuation. It’s important from an entrepreneur’s perspective to not overvalue your startup on misconceived assumptions, as the investors will take this as a sign that you don’t understand your market and believe me, they have more experience doing this than you do. A word to the wise, don’t fight over the valuation. It won’t get you anywhere, and the idea is to start your new ‘relationship on the right foot.