You have built your innovative startup, you have been bootstrapping for two years and now it’s time to get funding. You need to raise $150,000 in seed funding and after countless pitches & meetings, an angel agrees to fund you with the full amount for 30% equity. You are happy with the deal and come back to share the happy news with your family, but your mom says that your cousin raised a $ 400,000 seed for 25% equity, you wonder why! Your tech is so cool & innovative, you are a blockchain-based, AI-powered IOT product, while your cousin is building a mobile commerce app, so why did he get such a good deal?
Your startup pre-money valuation is $350,000, while your cousin’s startup is valued at $1,200,000, so why did the investors assign this value to your company?
It’s “valuation”! So let’s explore how you can value your company.
What Do You Need to Know About Valuation?
There are certain things you need to know about valuation in general, and valuation for startups in specific. I’m going to paraphrase Professor Aswath Damodaran words; Dean of Valuation for this part.
Valuation can be tricky, simple but not easy. It is neither science nor art. Not art because it’s based on data, requires discipline, and has certain rules and systems. Not science, because it is not objective even if it’s quantitative. In science when you have the inputs, you can know for sure what the output is, but in valuation, there are many subjective assumptions that would be differed by the person/entity doing the analysis (Biases)
If you’re trying to value your company, you will try to come up with the highest value possible, and you’d be blind to certain risks. However, if you are an angel investor, you’ll try to get the lowest valuation possible.
So before valuing any asset, you should be aware of the discipline and aware of the biases you have, are you going to overestimate or under-estimate the asset? Identify your biases and how it is going to direct your valuation before you start.
For more posts, go to our Blog section.
Models Used for Startups’ Valuations
Valuing startups is quite challenging, more challenging than valuing mature companies. As a startup, you don’t have enough financial data, you may even be pre-revenue and you can’t make high-quality financial projections. You are also facing many risks, like dealing with an existential crisis on a daily basis. This makes the valuation task quite hard, and that is why we use multiple models for startup valuations, here are the most common ones:
- Discounted cash Flow Method (DCF): this method assumes that the value of the company, is the sum of the present value of the upcoming cash flows generated over the next years.
- Venture Capital Method: used by VC firms usually when they evaluate startups.
- Multiples Method: this is more of a pricing method than a valuation method, which values your company based on the price of similar/comparable companies in your industry.
- Cost to Duplicate Method: which estimates what would be the cost of building an exact copy of this company.
- Berkus Method: developed by Dave Berkus for pre-revenue startups, which values startups based on 5 elements (idea, prototype, team, strategic partnerships, and product roll-up/sales), and assigns a value ($ ½ million max) to each item.
- ScoreCard Method (SCM): developed for pre-revenue startups. It values the startup based on 7 elements (idea, product, market, team, exit potential, traction, and competition) with relative weight for each element.
- Risk Factor Summation (RFS): similar to SCM & Berkus, designed for pre-revenue startups, but uses more elements in the criteria, exactly 12, including management risk, operation risk, tech risk, and funding risk.
- Option Pricing Method: this method is not specifically designed for startups as its name implies, it’s for pricing options (financial instrument), but it’s used to value companies that have some conditionality. For example, valuing a biotech startup working on Vaccine for Covid-19 would be very high if their vaccine was FDA approved, but it will be worth nothing if it wasn’t. (Tough challenge)
Let’s talk about the first three in details first, we might cover the other in another article.
To explain Discounted Cash Flow, you must first understand the concept of “Time Value of Money”.
If I gave you the choice of giving you $1000 now or $1000 next year, what would you choose? Of course, you will take it now! This is because $100 now is worth more than later, but if it was $1000 now, $1300 next year, or $1500 after two years, What would you choose?
Thumb rule: Never compare two money amounts in different time horizons! Get what the future value is worth now (its price).
You need to know how much the $1300 & $1500 are worth now; you need to discount the amount to the current time using the equation: PV = CF / (1+i)n where CF is the amount, i is the discount rate, and n is the number of time periods.
So if we assumed that the current market interest rate is 25%, then the $1300 next year is worth $1040, while the $1500 after two years is worth $960 now. So although the $1500 is the biggest value in absolute terms, its present value is the lowest, which means you should go for $1300.
That’s what DCF is all about, we get the sum of the present value of all projected cash flow over the next n-years, plus the terminal value which is the present value of the cash flows generated after year n, assuming you will maintain growth at a specific rate.
The DCF equation is the following:
- CFn = Last year’s projected cash flow.
- G = Growth rate (must be reasonable & a conservative estimate, as it is calculated for perpetuity).
WACC = The discount rate, which is called (Weighted Average Cost of Capital (WACC).
Let’s assume you are financed by both debt & equity, WACC takes the weighted average cost of debt & cost of equity. If your company is financed by equity funding only, then WACC is just the cost of equity.
- E = Equity financing amount.
- D = Debt financing amount.
- RE = Cost of Equity.
- RD = Cost of Debt (the specified interest rate).
- T = Tax rate.
The Cost of Debt is simple, it’s just the interest rate you agreed on. As for the Cost of Equity, it is a bit problematic because you don’t know actually how much the equity costs until exit.
Cost of Equity follows this equation:
- i = (FV/PV)1/n-1
- i = Cost of Equity.
- FV = Future Value.
- PV = Present Value.
You may notice that this equation is just a tweak of the DCF equation.
Let’s assume that your investor has funded you with $1,000,000 for 10% equity, if you sell the company after 5 years for $100 millions and his return was $10 million, then the cost of equity was pretty high (10 / 1)1/5-1=58.5% , on the other hand, if your company failed, then the cost of equity is basically zero.
To estimate the cost of equity, you have several methods: a) to estimate how much your exit will be (FV) & when will you exit (n), or you can use a more sophisticated model that helps companies grow, which is (Capital Asset Pricing Model – CAPM), or you can use one of two rules of thumb that you will find in the spreadsheet template.
Venture Capital Funding is usually an expensive product as the cost of equity is very high, this is because the cost of equity is highly correlated with the risk, and by investing in startups, they are taking a large set of risks. Debt financing is a much cheaper option but it’s very risky for you.
Many argue that DCF is not a suitable way to value an early-stage startup, as DCF requires startups to have 4-10 years of financial projections! 10 years? You don’t know if you’re going to survive the next three months.
For instance, Tesla was about to shut down in 2008 (3 days to bankruptcy) and Elon Musk himself couldn’t pay his rent back then, now its market value is +380 Billion dollars.
As Peter Thiel says in his book: “the value of a technology startup is shown over the long-term, 10-15 years after launching, maybe more. Uber & dropbox are 11 years old companies and their cash flows are still negative, does that mean that their value is negative?”
DCF works best with mature companies because they have tons of financial data they can use to build well-estimated projections & realistic assumptions. As a startup, you don’t have much data, that’s why we have different valuation models for startups.
But why is DCF so important? Remember the dot com bubble, when silicon valley entrepreneurs could get a million dollars for just having a website? Many companies had great ideas but couldn’t monetize and had to shut down after a few years. VCs don’t want to invest in these companies, you don’t want to build this kind of a company. DCF is simply correct finance; it is the best way to value a business based on the cash flow it generates.
As startups are very risky, some use a different version of DCF, which puts into account the probability to achieve the cash flow projections. So if you forecast achieving $100,000 next year but you’re 80% sure about it and the (WACC) is 25%, then the PV of Cash flow is 100,000/1.25 * 0.8 = $64,000. But note that this might be double accounting, as the risk is already set in the discount rate/wacc.
In the template, you’ll find a sheet (Adjusted DCF), which will give you a more sophisticated view of your company valuation, by valuing the company using risk-adjusted DCF, then making a scenario-analysis with three cases (worst, base, and best), and finally doing a simulation-analysis that takes uncertainty & randomness into consideration and runs 100 cases (you can add 5000 if you want) and gives you a probabilistic view of your company valuation given the assumptions you made at first.
2. Multiples Method
Multiples are pretty straight forward, but it is not a valuation method, it’s more of a pricing method.
So What Is the Difference Between Value & Price?
Value, in general, is what something is worth, this might be a very abstract concept philosophically, but in finance, the intrinsic value of any asset is based on the cash flow it generates. Price, on the other hand, is what we pay for, it’s based on supply and demand rules.
Back to the multiples, a multiple is a metric that measures the financial health of a company, it’s usually divided into two metrics. Like the P/E ratio, which is the share price/earnings per share, that measures how much the investors are willing to pay for the earning per share.
Companies like Apple, Netflix, Amazon, and Tesla have very high P/E ratios, and investors are willing to buy these expensive overvalued stocks because of their high growth potential. Warren Buffett strategy is to invest in undervalued stocks, companies that have solid earnings and growth, and high value, but yet have a low price.
For you as an entrepreneur, you use the multiples of companies that are very similar to yours and multiply their P/E ratio with your last year earning, or multiply their P/S ratio (Price to Sales) with your last year’s sales, and you’ll get an estimate of your share price. For example, if you are a fin-tech payment company, P/E ratio is around 28-35 and you have annual earnings of $50,000, then your valuation is between $1,400,000 – $1,750,000.
A major bias here is picking the good companies, the Amazon & Tesla of your industry, so a good strategy is to have a larger sample of comparable companies, while also avoiding outliers.
3. Venture Capital Method
This method is also called IRR Method (Internal Rate of Return), and it’s widely used in the Private Equity & Venture Capital world. Remember the cost of equity we mentioned in DCF? The investor has funded you with $1 million for 10% equity, his return after five years was $10 million, and the cost of equity was very high at 58.5%. This percentage is VC IRR.
VCs take a lot of risks, and as we know 9 out of 10 startups fail, that’s why the VCs require high IRR and are considered as an expensive solution. They need to cover up the 9 losses they had and make good returns, through the 1 successful company.
While I don’t have data, I believe, most VCs required IRR is around 40% to 50% for early-stage startups and quite lower for later-stage startups.
The VC method uses both DCF & Multiples Method, the process goes like this:
- They will look up for comparable companies and see the average P/E ratio.
- Look up to your firm and forecast the net earning you will have at the exit year (VC expects startups to exit after 3-7 years).
- Estimate your company valuation at exit year using the multiple method.
- Calculate the future value of their investment (how much will their capital be worth during exit year).
- Calculate how much equity they should have for the capital they will invest.
The equations used are:
Let’s assume that the VC asked for the IRR to be 45%, then you are asking for $500,000. According to your strategy, you’ll exit after 5 years, with $1,000,000 in net income. Your industry has an average P/E ratio of 20.
- Your terminal value is $20,000,000.
- The investment FV equals $3,204,877.
- VC equity should be 16.02%.
- Post-money valuation is $3,125,000 (investment value/ investor equity%)
- Pre-money valuation is $2625000 (post-money valuation – investment value)
Back to you & your cousin’s story, he got a much better deal because there are many variables. Your innovative blockchain IOT product is much riskier in terms of technology risk & market risk than a mobile commerce app, even if you are going to generate the same cash flow over the next 5 years. His startup is more valued than yours because it’s less risky.
Another reason might be that the VC you went to, had a higher required IRR, because they are more established, more helpful, and resourceful or just more greedy.
But to save you all the trouble & time, we’ve built a valuation model for you made up of the three methods we’ve discussed: DCF, VC method, multiples, plus the more sophisticated DCF that takes uncertainty into consideration
Please, don’t forget to call me before your acquisition. Have a great deal!
- Quantitative Modeling For Analysts, Wharton Online – Coursera Spec.
- Private Equity & Venture Capital, Bocconi University – Coursera Course.
- Financial Analysis & Valuation For Startups, Yonsei University – Coursera Spec.
- Investment Valuations, Aswath Damodaran, 3rd edition.
- Valuation For MBAs Class, Session 1 to 4, Aswath Damodaran.
- Venture Capital Method, Harvard Business school
- Valuation video & template, Mohamed Hossam Khedr.
- Chapter 3 (WACC), Kaplan Financial Knowledge Bank
- Valuation vs Pricing in Startups & Early Stage Companies, Adam Patterson (LinkedIn)
- Value your company with option pricing theory, alphagamma.eu
- Real options model tech startup valuation, https://www.altar.io
- WACC risk matrix, Nordic Valuation
- Corporate Finance Institute: IRR, CAPM, WACC, Cost of Equity