These External Factors That Can Risk Your Startup Valuation
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
Raising funds for your startup is equally exciting and terrifying.
It's exciting because it can help your dreams or plans come true, but it's terrifying because the entire process can be overwhelming.
Determining the value of the startup is one of the essential milestones of raising funds.
However, regardless of the valuation methods used, a startup valuation is estimated based on many internal and external factors.
While founders have some control over the internal factors they bring into the valuation, they have no impact on the external factors.
To reduce tension level during the fundraising process, founders of both late-stage and early-stage startups should be familiar with the factors they cannot control.
The central factor that founders can't control is the risk for potentials investors.
Every valuation method, including the DCF and comparables valuation, reflects the high-risk, high-reward future potential investment profile.
In tech startups' case, the reward is reflected in the high-growth financial projection, and the risk is reflected in the discount rate and comparables multiples.
The risk is a component of the valuation is set by market conditions and out of the founders' hands.
In this post, we'll highlight the external factors in each valuation method that have a substantial impact on the startup valuation but are totally out of the management team's control:
There are several ways to value a startup, but no matter which startup valuation method you're using, the comparables valuation is an essential part of the valuation.
The comparables valuation method is excellent for valuing almost every startup.
The core of the comparables valuation (also called the multiples method) applies multiples of comparable companies on the relevant part of your startup's financial forecast.
Pre-revenues and early-stage startups can apply similar companies' revenues multiples on their revenue forecast and receive a pretty good estimate of their startup's pre-money valuation.
More mature startups can apply their comps' EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiples on their own EBITDA forecast to estimate their value. They can calculate only that or together with the revenue multiple for a more robust result.
Each startup builds its own financial model based on its best estimates of how it will evolve and what actions they need to take.
This part of the valuation is entirely at the hands of the founders.
However, the multiples side of the calculation is totally out of the hands of the founders.
Here's An Example
Let's say you have a fantastic idea for a new social media platform that will revolutionize our life.
Since it's early stage (usually includes seed rounds, Series A and B) and pre-revenue, potential investors will probably use a comparables valuation and revenues multiple to value this idea.
There are generally four groups of comparable data points that we typically use: public companies, private companies, indexes, and previous transactions.
In the public companies group, we'll have the revenue multiple of Facebook, Google, and Snapchat. You can even add Amazon (owner of Twitch) and Microsoft (owner of LinkedIn) - but they should get a lower weight in the overall calculation.
In the private companies group, we'll have TikTok or ByteDance (TikTok's parent company), Discord, Vimeo, and any other privately-held social media platform that you have its revenue multiple.
Further reading: our tutorial for gathering the information and calculating the multiples is available here
In the indexes section, we can either use the Cloud and SaaS index multiple or use a revenue multiple of n ETF tracking social media companies.
In the last section of previous transactions, we'll include the revenue multiple of the Microsoft/Linkedin deal, Amazon/Twitch deal, Houseparty/Epic deal, Musical.ly/ByteDance deal, and any other deal info we can obtain.
All these four sections bring different perspectives to the calculation. However, they also bring external factors that are out of our hands.
A founder has no control over whether Facebook is trading in 5x, 10x, or 25x revenues multiple - but it has a significant impact on valuation.
In the same way, you have no control over the price Epic agreed to pay for Houseparty or Amazon for Twitch.
These external multiples can either strengthen the valuation a founder believes to deserve or harm it, but it's out of the founders' control either way.
The discounted cash flow or DCF is notorious among venture capitalists or angel investors.
While the DCF is a traditionally standard tool to assess a value of a company, it requires an extremely robust and meaningful financial forecast.
The main reason for that is the underlying assumption of the DCF model that the company has a positive free cash flow in the present or will have one soon. Naturally, that fits specific types of companies, usually in the late-stage, pre-IPO, or mature businesses.
Further reading: A Quick And Dirty Guide For A Discounted Cash Flow Valuation
We're not recommending estimating a startup valuation solely based on a single method, so in late-stage startups, we definitely recommend adding a DCF calculation to the mix.
The DCF gives much more weight to internal factors over external factors than the comparables valuation.
However, the discount rate used to discount future cash flows includes several tricky external factors that can impact your valuation.
The discount rate, which is formally known as the company's weighted average cost of capital (WACC), uses the current market value of the company's debt and equity and includes these external factors:
1. The risk-free rate of the country where the business is incorporated or does most of its business.
2. The Equity risk premium (also referred to as ERP) reflects the risk of doing business in a particular country.
3. Beta: the correlation between public companies' stock and the market.
4. Debt's interest rate or yield to maturity on existing debt.
5. Tax rate, where the company is incorporated.
All these factors are crucial when estimating the discount rate but are totally out of the founders' control.
These two qualitative valuation methods were developed for angel investors to estimate early-stage startups, and they are entirely subjective.
In both Payne Scorecard and Berkus Model, the potential investor grades different aspects of a startup company to estimate its value.
Let's take the Berkus Model as an example.
The potential investor needs to grade these aspects of the firm:
If Exists: Add to Company Value up to:
1. Sound Idea (basic value, product risk) $1/2 million
2. Prototype (reducing technology risk) $1/2 million
3. Quality Management Team (reducing execution risk) $1/2 million
4. Strategic relationships (reducing market risk and competition risk) $1/2 million
5. Product Rollout or Sales (reducing financial or production risk) $1/2 million
While founders might have a partial impact on the investors' opinion in some of these areas, these are purely subjective grades.
Closing a deal to invest in a startup is like every other transaction.
It starts with calculations and spreadsheets and ends up negotiating terms between two people.
There might be some more critical terms to the founders, and they will be willing to compromise in other places to maintain those terms.
Founders might want to compromise on the option pool or valuation size but insist on a specific liquidation preference, for example.
These negotiation dynamics are not entirely at the hands of the founders.
Assuming that founders don't want to break the deal, they will have to negotiate with investors on the terms.
In this situation, founders will have to compromise on some aspects of the deal, valuation included.
Got any tips of your own? I'd love to hear them. Add your tips to the comments below.