Valuating a startup might be one of the trickiest thing to do and yet it is needed in any financing event. Here are a few different methods that we use at Creandum:
Multiple comparables
The most common method for evaluating startups is probably to find comparable companies and look at how they are/were valued. Usually the valuation multiples are expressed in terms of P/S (price-to-sales ratio) or P/E (price-to-earnings). There are several varations of for example P/E where one could look at P/EBT, P/EBIT or P/EBITDA.
Some issues/challenges:
- Difficult to find relevant comparables. Maybe the data points are old (multiples can fluctuate a lot) or maybe the business model or sector is different. For example, recurrent revenues are typically worth more than one-off revenues.
- Comparing your startup with listed companies introduce a discrepancy due to the lack of liquidity of non-listed shares (you can’t sell them at any time). We typically factor in a 25-35% discount towards listed companies’ multiples.
- When using M&A multiples, there may be a strategic component specific to the case which may not apply to your startup (or the other way around).
Established valuation methods
There are several established ways of determining the value of a company. The most common one is probably DCF (Discounted Cash Flow).
Some issues/challenges:
- The DCF method (and similar ones) presumes that it is possible to accurately predict the future cash flow and is reliant on finding a steady state not too far away in the future. This is rarely the case with startups. So, this method should be used with caution and always in combination with other methods.
Target ownership (or the cap table approach)
Many VCs are looking at getting a certain target ownership in the companies that they invest in. At Creandum, we typically like to have an 20-30% initial ownership to make it worthwhile spending time and money while still making sure founders have enough ownership to cope with additional dilution in the future. Combining the target ownership (=dilution of founders) with money raised actually indirectly gives the company valuation.
This method is quite wide spread in very early cases. For example, Y-Combinator and similar seed investors are using it heavily.
Some issues/challenges:
- This method does not really account for any aspects of how attractive your startup is, how fast it will grow, how much anyone will be willing to pay for the company etc. Still, it is an important component to make sure that the ownership structure (=cap table) is attractive also after an investment so it makes sense to use it together with other methods.
- Money raised becomes an important valuation factor. The more money raised, the higher the valuation could have to end up at to get a balanced ownership structure. Naturally, capital requirement per se does not say anything about the value of your company.
Counting backwards
A VC wants to make a good investment. Knowing the VC, you probably also know roughly what they expect in terms of returns. At Creandum, we are looking at 10x our investment in seed & early-stage cases and maybe 3-5x in more mature cases. Depending on the likely time horizon to exit, it is possible to define what kind of exit value is likely to achieve. For example, if you project a revenue of $100M in 5 years and a P/S of 2 at the time of exit means that the company will be worth $200M at exit. So to give the investor a 10x return multiple in 5 years, the current value of the company would be $20M.
Some issues/challenges:
- The return multiples that VCs are looking for do not really reflect your specific startup. The VCs have learned (the hard way) what multiples they need for good exits to balance the bad ones. And of course, your startup will be great so in that sense you’re paying the price of other failures.
- The investor typically is looking at getting on average 10x on the money invested. So if you need more money to get to the exit in 5 years, this may be factored in to a lower valuation of the startup today.
Important aspects
As you may gathered, there is no right way to value a startup and we are typically using a combination of most or all of the above methods.
A few things to remember:
- Liquidity: an equivalent listed company is (and should be) valued higher than a non-listed company.
- Absolute returns are usually more important than IRR for a VC meaning that it is better to get big exits even though it takes more time.
- While there are many ways to try to pin down the right valuation, the value really is determined by what the buyer and seller can agree upon. More competition among investors usually means higher valuation.
- Getting a high valuation early on may feel great but it can turn out to be very challenging when things are not going as planned. Also, new investors coming in at a high valuation will peg their expected exit according to the multiple on invested capital which in turn may force the founders to be locked in longer to get that big exit.
- The valuation is only part of the deal, other terms may be at least as important.
It would be interesting to hear what others think about this interesting but difficult subject!
