How do valuations in start-ups and new-age companies work?
It is famously said that “Equity Valuation is a combination of science and art”. The immediate thought which came into my mind is yes, it might be 80% science and 20% of art. I did some research and have come to a generalization that the qualitative aspects which can be called as “art” or a measure/feel of “market opportunity” being addressed probably contributes 80% to the eventual outcome in early stage investing and that reduces down to 20% art for late stage investing or public markets. Let us deep dive in the world of start-up valuations and towards the end of it, I shall leave it on you to decide how much of an art it is!
The readings show that there are various methods being used to ascribe a value to equity investments in start-up or new age companies and that changes as they mature from idea to product-market fit to scale up and then to harvesting. Some of the methods used described below:
Venture capital method: This is one of the most common methods used by VCs to quantify the investment in early age start-ups (Pre-series A/Series A). The logic behind this method is that the VCs estimate the exit value of company 5–6 years down the line basis revenue/EBITDA multiples. They also estimate the ROI multiple which they expect to earn from this investment (5x/7x/10x). Now, once we have these two estimations, [post-money valuation = exit value/ROI multiple]. For a X amount of investment in the company, the VC would get a stake of [X/post-money valuation]. Of course, it does not take into account future dilution and thus it can also be built in the pre-money valuation. The Venture Capital method is by no means a comprehensive model for valuing early-stage companies. Nevertheless, because of its simplicity and straightforwardness, it is widely used as a rule of thumb and a starting point for more in-depth models. The exit multiples for the relevant sectors is probably being derived from similar scaled up companies and listed in US market.
Scorecard method: The Scorecard Method is another option for pre-revenue businesses. First, you find the average pre-money valuation of comparable companies. Then, you’ll consider how your business stacks up according to the following qualities.
- Strength of the team: 0–30%
- Size of the opportunity: 0–25%
- Product or service: 0–15%
- Competitive environment: 0–10%
- Marketing, sales channels, and partnerships: 0–10%
- Need for additional investment: 0–5%
You’ll then assign each quality a comparison percentage. Essentially, you can be on par (100%), below average (<100%), or above average (>100%) for each quality compared to your competitors. For example, you give your ecommerce team a 130% score because it’s complete, fully trained, and has experienced developers and marketers, some from rival businesses. You’d multiply 30% by 130% to get a factor of .39. Do this for each start-up quality and find the sum of all factors. Finally, multiply that sum by the average valuation in your business sector to get your pre-revenue valuation.
Multiples of key indicator: This is one the most popular start-up valuation techniques because it’s built on precedent. You’re answering the question, “How much were start-ups like mine acquired for?” As the name suggests, valuation is built on multiples of key indicators. These key indicators change depending on stage/sector of the company. Examples of indicators can be DAU for a social commerce/fintech, ARR for SaaS, EBITDA for late stage, GMV for B2B, Repeat orders for D2C/ecommerce. These are just a few samples of indicators and one can always combine them depending on one’s conviction. One such commonly used indicator is “Rule of 40”. It is typically used for the SaaS companies and states that the addition of the growth rate & profitability should be close to 40% for an optimal valuation. It solves for a typical dilemma faced by founders — to choose between chasing growth (burn for acquiring new customers) versus profit margins (by harvesting the existing). A mean valuation for a SaaS company would be a 6–10x ARR. If the sum of growth and profitability is over 40%, the company shall demand a premium as it has managed to score well in both the areas or particularly well in either one of them which compensates for the other.
Let us take another example of key indicator multiple, imagine that Docux, a fictional doctor social network, was acquired for $10 million. Its mobile app and website had 200,000 users. That’s roughly $50 per user. Your doctor network start-up has 70,000 users. That gives your business a valuation of about $3.5 million. The value can then be adjusted upwards/downwards depending on proprietary technology, growth, other factors. This method is usually used to form a base and estimate the range of value for the company. Traditional businesses too use this method to assess the replacement cost in current context and thus arrive at build vs buy decision.
Cost to duplicate approach: Let’s say we are evaluating Company X and they have been in operations for 2 years now. The team has built a product, have kicked off the sales and figuring out the best GTM for them. They are seeking $5 mn investment at a $20 mn pre money valuation. The rational question to ask yourselves is that — How much capital would it need to build a company similar to this up to this stage? For this we can add up the fair market value of your physical assets, include R&D costs, product prototype costs, patent costs, and more and we conclude that it is/is not a fair ask from the founders. This method is very subjective in nature and can ignore many intangible elements (goodwill, opportunity cost) of the start-up.
The Berkus method: Mostly used for valuing pre-revenue stage start-ups, the Berkus method assigns dollar amounts of up to $500K each for the five key success metrics. Although, this method has a very limited scope due to its over simplicity and generalization. It can be used along with the other methods to justify a typical scenario.
Discounted Cash Flow method: This is is usually used for late stage investing where there is a good visibility of revenues and profitability and the growth can fairly be anticipated on assumptions of garnering a rational market share of the opportunity. The future cashflows of the company are discounted at the return-on-investment rate and we can arrive at the present value. A variant of this method: First Chicago method is also used in some cases where valuations are done using assumptions for the best/base/worst case. Probabilities are then assigned towards each case and the final valuation is the probability-based sum of three scenarios.
Apart from these, there can be other methodologies used depending on the thesis and firm culture. Also, VC investing is a global phenomenon and is affected widely by global trends. For example, round dilution from VC dollars has been declining for the past decade. It started in more developed countries and the trend trickling down to developing countries. In the last 12 years, mean seed round dilution has dropped from 25% to 12.5%. Series A has dropped from 30% to 20%; Series B from 22.5% to 12%; and Series C from 18% to 12%. This phenomenon does not exactly have a science backing it but it more to do with matching the investor — founder expectations. The table below shows the mean dilution at each stage and how it has progressed over years
The point to be made here is that start-up valuation has subjectivity and is a relative matter which can be influenced by certain personal experiences or prejudices. What seems obvious to one person might not be so obvious to the other. Thus, the perceived valuations might have a wide spectrum unlike public company valuations where the spectrum is somewhat narrow driven largely by the governance premium being assigned to that specific company in that sector. Most of the VCs use a combination of multiple methods to conclude and quantify the opportunity, only that the intangible and qualitative factors have more role to play leaning the decision of investing more towards the gut feeling. This brings me to the point to leave it up to you to decide how much of an art it is!
Look forward to your feedback. Feel free to comment here or share your views to email@example.com