Startup Valuation is the art of figuring out how much a company should be worth. The emphasize lies on “should”. The actual price of any asset is of course how much a real buyer is willing to pay for something! So, unless anybody has actually paid a price for at least one share in your business, everything is speculation which is why smart founders are keen on cash wealth, not just paper (equity) wealth.
Nevertheless, any sale is also a negotiation. Without an analysis you won’t have a starting point and at least leave “some” value on the table. In this section we apply the main valuation methods you might have heard about in business school and bring them to the real world of startups with examples.
One way to get to this, is predicting future cash flows and basing your valuation on these numbers. Another way is to admit to the fact that early stage startups have huge cash flow uncertainty and use more qualitative approaches (e.g. Scorecard and Checklist Method). Finally the venture capital method also takes a mathematical approach, but works backwards by looking at the return requirements for a certain risk levels and expected time until exit. Below we introduce each method.
Cash Flow Methods
There two main ways how to value companies based on cash flows: Making a detailed financial model and discounting all the cash flows (DCF), or applying a Multiple against one of your current or future metrics.
Discounted Cash Flow (DCF) Method
Here one tries to analyze how much earnings potential a company has, how likely it is that these earnings come true and then discounts these cash flows by their expected return percentage. Hence the name: Discounted Cash Flow analysis, or DCF for short.
As most startups have to come up with at least a basic financial model at some point, discounting these predicted cash flows is pretty common among founders and investors. There is one major draw back however: The DCF approach is very sensitive to future cash flow growth. That means if you start with a small initial market and try to be conservative, the results from a DCF valuation will look like sh$$!! So you kind of have to model multiple markets or multiple revenue streams to get to high enough cash flows. Also 5 year models will likely give much better valuations than 3 year models, independent of your actual business model. And of course the longer the time horizon, and the more assumptions you make about markets, the less certain your results will be. Learn more about the DCF method here.
The best thing about the Multiple method is, that its easy. And is easy is easy to understand. For example if you are building the next Facebook and have some revenues, then you can divide Facebooks Equity value by its Share price and multiply that by your revenues. Boom!! You got yourself an equity value for your own company. Problem is of course, you might not have revenues yet, or they are not steady enough. In your desparation you might end up making up your own esoteric multiples, like multiples on Facebook likes or Users etc. These of course are pretty far away from anything that directly drives cash. Also you hopefully build a startup in a niche that hasn’t been served before, which means hopefully there is no perfect competitor. In that case even finding a comparable company for your multiple will be tough. Learn more about the Multiple method here.
There are two main qualitative methods: The checklist and the scorecard approach. These care more about the likelihood of success, rather then predicting it. While startups beyond Seed stage will have a tough time getting away with not having a formal financial model, these methods give you additional points to argue for your dream valuation when your company is not old enough to have created a lot of financial facts.
One caveat is that they originated in Silicon Valley and despite their appeal are not broadly applied in other markets. That said, in non US startup markets there still is an appreciation for qualitative valuation factors. This usually means that a negotiated market price ends up being settled around US$1m-US$3m for 10%-30% of the outstanding equity no matter what any quantitative valuation method says.
The scorecard method also takes account of the difficulties in valuing a very early stage startup. Simply put, it compares a Startup to market prices of similar startups in the same (geographical) market. To add accuracy adjustments are made qualitatively via a scorecard. Hence the name.
The scorecard is divided in 6 categories against which a startup is measured. It is given a percentage score, comparing to the “average” Startup. Each category also has a specific weight. This weighted average percentage is then multiplied by the “average valuation” of a startup in the respective market at the same funding stage.
The Checklist Method by Dave Berkus, considers what we all kind of know intuitively: In the very early days all predictions are nonsense, but by looking at the people and the opportunity you still can get a feel for the potential. So the checklist method looks at:
- Quality of the idea
- Whether there is a Prototype
- Quality of the team
- Existence of strategic relationships
- Whether product rollout has happened
Each of these points add up to US$500k in valuation up to a total of US$2.5m. Obviously this method only makes sense for Seed/Angel Rounds. Learn more about the the Checklist method here.
Venture Capital Method
The Venture Capital method views valuation from the investor’s side. It accounts for the fact that VC investors simply need a certain (very high) return to make their business feasible. So why not directly start there!?
A VC needs to be able to deliver a very attractive return on investment. They invest in high risk, illiquid (not traded on open markets) assets. Since they likely won’t be able to exit their investments before a couple of years (3-7 years), there needs to be a huge expected valuation gain to get anywhere near 100% IRRs.
This method starts with the expected exit price. Then this price is reduce by which stages of development still need to be reached to achieve an exit. It is different from a DCF approach in that one does not try to figure out specific cash flows or risk factors for discounting. Instead a qualitative exit price is “determined” and then “reduced” through negotiation. It is frankly quite arbitrary, but give s credit to the investor’s needs for returns. To be fair it is quite time saving and without reaching required investor returns, VCs have to make take it or leave it deals anyways.
Pros and Cons
As such, both methods have distinctly differing approaches and both have their advantages and disadvantages. The huge advantage of comparables is that it’s a very easy approach: If you are a car company, you simply find another car company that is listed on a stock exchange, download the financial report and compare your company across a couple of Income Statement metrics. The downside of this approach was indirectly highlighted by my example: Comparables work best with large, publicly traded companies, with a clearly defined business focus, as its very difficult to get accurate data about startups: Either they are a brand-new business and there are no similar companies OR the only competitors are of a similar development stage and either don’t yet provide information at all or any that is reliable. So in essence it remains a validation method, which is useful to derive and double check your overall valuation, but its results can vary grossly.
The DCF in contrast is based on a detailed financial model which in turn requires detailed assumptions on all kinds of aspects of the business, especially its revenues and expenses. If the inputs would be perfect, the resulting output of this method would also be perfect, but of course it never is. The reason why a well-developed financial model can be so useful is because it allows you to plug in the most recent metrics and then analyze “What-if” we can sustain or even improve these current metrics? What will this do to our profitability and valuation? So as mentioned before it becomes a very powerful tool to analyze whether you are on the right track and whether your business makes sense at all.
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