Gone are the days when the number of million dollar startups was pretty easy to count. With the boost in infrastructure, ideas and creative people, there are several startups reaching to that milestone daily. With the growing number of startups, the need and demand for the valuation of the startup is also growing day by day.
Valuing a startup is more of an art than a science. The art of valuing a company is somewhat similar to the domain of an artist. It is not something that could be taken light. It becomes the core when the entrepreneurs looks out to raise money and investors need to know the value of their investments to generate liquidity.
Without previous years financial data to rely on, startups and their investors have had to rely on more creative methods to substitute for the input data. In short, the process takes back to quantifying a bit of basic finance: ‘risk versus reward. In startup terminology it is called, ‘traction versus market size.’ The article looks into various steps an entrepreneur should take to get a reasonable valuation for your early-stage startup.
1.Perform a Self-Assessment:
– List out your assets:
One of the foremost thing while valuing a company is to bring in the company’s balance sheet. List out everything the company owns deducting the liabilities. The list of assets can include proprietary software, product, cash flow, patents, customers/users, partnerships, tangible assets like properties etc, Other assets can also be included and need not be limited to the above mentioned items alone. It may not be possible to calculate the real market value of the all the assets but the list of assets will help in looking at comparable valuations of other, same field startups.
– Revenue Calculation:
Revenues are core for the startups and it makes the company easier to value. For most of the startups, at the initial days the revenue works as the market validation. The money made during the initial days is not sufficient to sustain the growth the company needs to get a position in the market in the short-run. So for the startups, it is important to also look at the key progress indicators (KPIs) to help in valuation. The common KPIs are user growth rate, customer success rate, referral rate, daily usage statistics.
It is important to choose a model to calculate the valuation of the company considering the revenue generating stage of the startup. During the pre-revenue stage, one could adopt
* Berkus method
* Risk Factor Summation method
* Scorecard method.
If the startup has steady cash flow and is making sustainable revenues, the entrepreneur can make use of the methods that will look more like the models the investors use to calculate the valuation of the mature companies. It would at the great advantage for the company if the entrepreneur is able to show the investors they have a steady revenue stream that reduces the financial risk and also posing as ‘big-win’ for the investors. Investors generally look for the startups that are capable of giving at least 10 to 20 times return on investment opportunity on the minimum.
The steps taken to calculate a baseline valuation figure are mentioned below:
1.Calculate revenue run rate – 12 times the recent month’s sales.
2.Historical growth curve would help in calculating monthly or weekly revenue growth rate. If the revenue correlates to user growth, then the figure can be used.
3.Calcualte the adjusted RRR using the growth rate as the base
4.The adjusted RRR is then multiplied by a factor of ten to put ‘in the ballpark’ of a rational valuation figure.
The first time founders should have a clear understanding of the differences between the pre-money valuations and the post-money valuations also their implications. Pre-money valuation of the company is nothing but the valuation of the company at the present moment before receiving investment proceeds. When the discussion and negotiation about the valuation starts, it means they are dealing with the pre-money valuation. The post-money valuation is a calculation and not a negotiation.
Pre-money valuation + investment proceeds = post-money valuation.
Post-money valuation is considered important for two main reasons:
1. It sets the slab for the value of the company after receiving the funding. This impacts prices of the stocks and the value of the shares held.
2.Also, post-money valuation acts as a standard to calculate the future pre-money valuations. If the company is healthy and growing, the next round of funding should see a nice cushion between the prior post-money and the new pre-money. If the business is not doing good, the company may go through a flat or down round, which would not make investors happy.
Apart from getting to understand the pre-money valuation and post money valuation, it is also important for a startup entrepreneur to have a clear picture of the ownership targets. Most of the investors who are ready to invest in a startup at its early stage generally aim to own a particular percentage of the company with their investment. For instance, an investors may look out to own 20% or 30% of a company with their seed round investment and have an investment range of $250 to $500 thousand per deal. With the help of these parameters, one can apply the reverse factor theory and calculate the valuations investors typically fund.
Startup Valuation at Different Stages:
Now, having looked a bit at how the valuation is being done and how the amount is being calculated on general. Further to it, it is important to know how the investors value the company depending on whichever stage the company is at that point of time. Startup’s stage of development is a key driver in determining valuation. Knowing how the valuation differs at different stages and how it affects the funding from the investors, would be very important for an entrepreneur to make plans about the future of the company and how to allocate resources.
Stage1 – Early Stage:
Early stage is the stage when the startup has not taken a full shape or has not taken off already. It is the stage when the entrepreneur conceives the idea for the product or service and works to position it in the market. It is one of the difficult stages to value the startup as the company has not done anything so far or has it made any money. At this stage the funding is usually by the entrepreneur himself or may be for the people around like family or friends. If the idea of the startup looks feasible and if there is the future to it, then people would invest money in the company to kick-start the business concept into a working company. The valuation of the startup at this stage is based on the idea or the concept and the workability of it.
Stage2 – Seed Stage:
In seed stage, the company gets to test the market and experiment with its business idea. In this stage, the issue of valuation gets even bigger as the normal metrics of valuation like earnings and revenue are non-existent. Entrepreneurs often value their startup at what they believe it will become but the investors value the company at its current worth. For instance, an entrepreneur made an offering of $1 million in securities representing 25% of the startup’s post-transaction, the offering would value their company, before any considerable development at $3 million.
Valuation of the business at seed stage in venture capital transactions determines a current value of a future business. The commonly used calculation method is discounted cash flow (DCF) which discounts future earning and residual business value upon the company’s exit to a present value, on the basis of the percent that accounts for the interest rate the investors could get in risk free situation plus a risk premium for the endeavor. As the uncertainty involved is quite high and the high percentage of the failed business, the risk premium for a startup in generally very high. The risk is generally from the fact that the company does not have any solid evidence regarding its feasibility or workability and potential of the founders are not proven. At this stage if the entrepreneur approaches an investor without any employees or management or with substantial infrastructure, the premium may be even higher.
At this stage, the entrepreneurs generally look for angel investors for the funding. But not all angel investors will take discounted cash flow to calculate the valuation of the business Some angels are looking to grow their investment with a certain number of times in a certain number of years which is not very different from a DCF analysis minus the formulaic approach. There are some real angels who would invest simply because they like the idea of business. however, most of them would want to know the risk factors, profitability, valuation of the company before they fund the startup.
Stage3 – Market Expansion:
The growth or the expansion stage is the stage where the startup has established product and market fit and ten times better than the competitors. In this stage, the startup begins to scale customers and revenues. It would show considerable growth in the revenue with or without earning profit. A startup would be in this phase if manages to survive in the market for three or more years. At this stage, the company looks out for funding for major expansion like physical plant expansion, product improvement and marketing.
At this stage, as the company is successful in meeting development milestones, investors will be willing to put assign a higher value. Venture capital investors (VCs) focus on high-growth businesses and therefore are attracted to this phase of company development. VCs look for the companies that can scale to $25 million to $100 million in revenue within three to five years. At the expansion stage, capital is often injected through a series of financing rounds, called the Series A, Series B and Series C.
The main metric of the series A, B and C is growth. Growth means traction and also mean revenue. For a revenue to grow the user base should grow too. Investors at the stage of the company calculate the valuation of the company using the multiple method which is also called the comparable method. This valuation method is based on the theory that similar assets sell at similar prices. This assumes that a ratio comparing value to some firm-specific variables that include operating margins, cash flow etc. is the same for similar companies.
Multiples approach is commonly used for the equity valuation of the company. It is one of the quickest way to value a company and are useful in comparing similar companies. Multiples are calculated as a ratio of capital investment to a financial metric attributable to providers of that capital. The process of valuing a company under multiples consists of
– classifying comparable assets and obtaining market value for these assets.
– converting the market values of the assets into standardized values relative to a key statistic, as the absolute actual price cannot be compared. This process creates valuation multiples.
– implying the valuation multiple to the key statistic of the asset being valued, controlling for any differences between asset and the peer group that might affect the multiple.
Before we move on to the next stage, there is something else that needs to be known. While valuing a company, apart from the ones that help in calculating the valuation, there are some factors that influence valuation. One such factor is option pool. Option pool is nothing but the stock set aside for future employees. This is mainly because the investor and the entrepreneur to want to ensure some amount is set aside to attract talent to the startup. The option pool generally ranges from 10% to 20%. The valuation of the company would lower when the option pool is bigger. This is because option pool is value of the future employees, something that is not in the hands yet. It is set up in such a way that they are not granted to anyone yet. As they are taken from the company, the value of the option pool is generally reduced from the valuation.
Stage 4 – Mature or Exit Stage:
Stage four is the stage where the company has stabilized itself strong in the market. At the mature stage, characterized by a strong market position, continued sales growth and a profitable bottom-line, companies still need ongoing financing to take advantage of new opportunities. In this phase, equity offerings become easier to accomplish because of the track record to which management can show. New treasury issues can be negotiated on an on-going basis with investors or underwriters in harmony with the existing financial market conditions.
Some venture capitalists or other investors focus on later-stage investing when they have financing to grow beyond critical mass and to attract public financing through a stock offering. When a company opens to sell its shares to the general public for the first time through the facilities of a public stock exchange and an underwriting group, it is called as an IPO – Initial Public Offering. The process includes preparing the prospectus and engagement of brokers to sell the issue to the public. The prices of the shares are determines by the underwriter with his judgement or polling the potential buyers of the shares or comparing the prices of the similar companies and set a fair price. IPOs are generally done when companies need serious growth or expansion capital. However, there are junior stock exchanges like Canada’s TSX Venture Exchange that allows business organizations to do IPOs at much earlier stage of development like at the seed stage itself. These junior stock exchanges IPO really just take the place of a good Angel or Venture Capitalist giving companies who find it difficult to find such large investors a substitute in the form of numerous smaller investors.
Some venture capital funds specialize in acquisition, turn-around or recapitalization of public and private companies that they deem to represent favorable investment opportunities. Also, a mature stage venture would invest to help companies acquire another company as a way to achieve scale or to provide liquidity and an exit for the company’s founders and early investors.
The companies start thinking about their exit strategies at this stage. The exit is not for the founders or the owners or the business itself but is for the money. The company brings in money and the investors get money out. This is the reason the investor would look for exit strategy whether they are angel investors or venture capitalist.
Director of Babson College’s Summer Venture Program Steven Gold said, “Exit strategies are all laughable. The most common exit for young entrepreneurs is no exit at all, but rather failure or bankruptcy or liquidation. Given that’s the most high-probability exit scenario, it’s what they should focus on avoiding. The second most likely scenario is to continue to run the business. The third most likely exit is an acquisition. Going on to an IPO is one-in-a-million shot for today’s typical entrepreneur.”
Investors exits happen in two ways – the startup get acquired by a bigger company, for enough money to give the investors a return or the startup grows and prospers enough to eventually register for selling shares of stock to the buying public over a public stock market like that of Facebook in 2012 and Twitter in 2013.
– Traditional Exit Strategy:
In the traditional exit strategy or investor-oriented exit strategy, the investor expects the startups to cover the exit strategy when they sit for pitches from startups. It means discussing about the similar companies in similar markets have been able to exit via selling out to a larger company, in their business plan. The sophisticated plans and pitches will hold details on recent exits and offer information about the company’s valuation when they exited. The common phrase in that context is “5X” for an exit value of five times revenues, or “10X” or whatever.
– Modern Exit Strategy:
In this kind of exit, the startup founders or the entrepreneurs themselves sell their company and convert their ownership in a business into money. It is common among entrepreneurs who get older and want to put an end to their career. But these days, it is becoming common among the younger entrepreneurs too who works to start a business, grow it fast and make it attractive to a purchaser and sell. Whatsapp is a good example that sold it off to Facebook.
The interesting story about the tech startup exits these days is not the small number of really big company acquisitions, it’s the big number of smaller acquisitions. For the typical entrepreneur and angel investors, these smaller transactions are very good means to make several million dollar capital gain. Venture capitalists and other investors have a good sense of a company’s exit value. The value can be based either on recent merger and acquisition transactions in the sector or the valuation of similar public companies. Most early-stage investors looks for 10 to 20 times the return on their investment within two to five years. For example, assuming an exit valuation of $100 million and the VC owns 20% of the company at the time of exit. The VC would earn $20 million on their investment at exit. If the VC owned 20% for a $1 million investment, then the post-money valuation of the company at the time of the initial investment was $5 million. The investors us the post-money valuation to estimate the price an investment must command when they exit or sell the company.
The most common method is comparative ratios which includes price-earnings ratio and enterprise-value-to-sales ratio. There are other methods too which are replacement cost and discounted cash flow.
To Maximize Your Valuation:
– Let the investor know the reason behind the huge potential exit value for the company
– Maximize the potential exit valuation by removing any doubt or obstacle that the investor perceives as limiting the upside valuation.
– Research on the valuations of other companies at slightly later stages. Spot and understand the possible gaps and mistakes.
– Find an investor competitor to get a higher valuation for the company.
Investors’ Perspective of Valuation:
Now that having looked into the details of valuation of startup in the different stage, it is also important to know the investor’s perspective of valuation. Knowing how an investor look at valuation will help an entrepreneur in reducing the disparity between the expectations and reality.
– The first thing an investor thinks about before investing or valuing the company is the exit – what would be the worth, how much can this company sell for in some years later. They think about selling because IPOs are very rare and it is not possible to predict which companies will be able to do it.
– Second, they would think about the total money it would take to grow the company to the point that someone will buy it for $1 billion. For instance, Instagram received a total of 56 million in funding. This will help in figuring out how much the investor will make in the end. $1 billion – $56 = 940 million. This the value the company has created in the mean time. In case of debts, if any, it would be deducted accordingly.
– Next, the investor will calculate what is the percentage of the stake he/she owns in the company. The investor that funded the startup at early days does not want to get diluted too much by the VCs who will come in later and buy 33% of the company. That the ultimate matter. Generally the angels get diluted to a lesser percent as the years roll by and the new investors enter the company. For instance, let’s take Instagram itself. The investor invests at seed stage around 20% and over time it gets diluted to 4%. 4% of $940 million in $37.6 million. $37.6 million is the most this investor can make from the startup. If the company has raised $3 million in the exchange of 4% – that would be 10 times the money invested. But it has to be noted that only 1/3rd of the companies make such money.
In this post, an infographic has been shared below which will give you a fair idea of how to calculate startup valuation. Do have a look
I hope the information in the infographic was helpful. Do let us know if you have any thoughts.