The Definitive Guide To Startup Valuation
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
This is a comprehensive guide to the sometimes confusing world of startup valuation.
In this guide, you’ll learn the most common startup valuation methods and how to apply them to early-stage startup and late-stage startups.
You'll also learn when you need to value a business and when you're looking for pricing or equity allocation.
(including a step-by-step to help you find the right valuation approach for your case)
What does this guide include?
Startup valuation is the practice of estimating a company's value, either an early-stage company ranging between the pre-seed round to series A and B or late-stage typically from series C onwards.
In other words, startup valuation is estimating how much a startup is worth.
But what is a startup, and why do you need to know how much it's worth?
The definition of a startup is fragile and delicate. In general, a startup is a new business initiative started by a single founder or a few co-founders to develop a new idea, concept, or technology aimed to solve a specific problem.
Founders have a few alternatives to fund their startup's journey to growth and prosperity. Some of these require an estimation of the company's worth to be able to provide the funding:
Option #1: Bootstrapping:
This alternative is pretty straightforward, and the founders finance their new initiative in an old-school way by covering all expenses by taking money from their pockets.
The best part of this alternative is that founders keep all the shares of the company.
However, the worse part is that the founders also carry all the risks if the startup fails.
Option #2 Debt:
In this option, the founders fund the startup's expenses by loans. You can either take loans in the traditional way from banking institutions.
Or you can take on debt from private market investors that are willing to offer loans to startups. These private market investors could include private equity funds, family offices, angels, etc.
The downside of this alternative is that the company or founders will need to repay the debt with interest burdening additional business expenses.
However, the flip side is that founders take less cash out of their pockets than in the first option, but they transfer part of the risk of failing to the debt holders.
Option #3: Venture Capital Funds:
In this option, the founders sell shares of the company to external investors who believe that the value of the company's shares will appreciate over time.
The term “VC funds” is probably too generic since there are different investors in every startup life stage.
At the earliest days of the company, founders will approach friends, family, angel investors, and accelerators.
Slightly later, founders will seek investment from seed funds. Later, they will approach early-stage funds, late-stage funds, private equity funds, hedge funds, private offices, etc.
The type of investor may vary, but the concept is the same.
The great thing about this option and what made it so popular lately by entrepreneurs is that founders take out very little, if any, money from their pockets compared to options 1 & 2.
However, this option comes with a significant downside. By selling shares of the company to other shareholders, founders are diluted and remain with a smaller number of shares than options 1 & 2.
Here’s the deal:
while in the first alternative, founders don't need to know their company's value, they must know it in the second and third alternatives.
Finro Startup Valuation | Source: Hedgeye
In the second alternative, debt funding, valuation can play a central role in certain situations.
For example, it's common for debt in the early stages of the company's life to be converted into equity (e.g., convertible debt). In this case, the debtholder could take over a substantial part of the company if it fails to repay its debt.
The exact portion of the company that the debtholder could obtain in such an event depends on the conversion ratio between the amount lent and its equity value. In other words, how many shares in what price the debtholder will receive if the company will fail to pay. Therefore, in these types of deals, estimating its value is central to the investment decision.
In the third alternative valuation plays an imminent role in the decision-making process.
Venture capitalists will need to know the company's value to understand how many shares or what portion of the company they will obtain for the amount they intend to pour into the company. It will also help estimate the company's share price and the potential return on investment ('ROI').
Finro Startup Valuation | Source: Tom Fishburne, Marketoonist
The above examples are relevant to startups. However, valuation is required in almost every transaction in the private market since companies value is not publicly available.
But wait.
Before diving into the startup valuation world, let's make a quick detour to understand the difference between pre-money valuation and post-money valuation.
When estimating a company's value before raising external funds, its valuation is referred to as "pre-money valuation." In other words, this is the valuation before any new money is transferred to the company.
The post-money valuation will the pre-money valuation plus the money invested in the company.
Valuation approaches are different angles to look at the value of a company. These are the three most commonly used approaches:
1. The income approach evaluates the company based on the present value of its future financial performance. It is also referred to as the intrinsic value approach, as it reflects the company's core value when combined with other valuation approaches.
2. The market approach evaluates the company based on the prices investors were paying or currently paying for other companies in the same niche, sector, or market. This approach can consider information on privately-held companies, publicly traded companies, and previous transactions.
3. The asset approach evaluates the company as a sum of its components. These could be tangible or intangible assets. For example, Facebook can be valued as the sum of WhatsApp, Instagram, and Messenger, and Nike can be valued as the sum of its inventory and the value of its brand.
Each of the valuation approaches above has many different valuation methods that help calculate its value within its specific approach.
Even though dozens of valuation methods apply to many different situations that use different valuation approaches and other ideas, only a few apply to startups and, therefore, broadly used.
These are the leading startup valuation methods:
1. Multiples Method For Early-Stage Startups / Pre Revenues Startups
This is a market approach method that could be applied to early-stage and late-stage startups with slight variations.
The first variation is revenue multiple, applies to early-stage startups, startups with negative free cash flow, or negative earnings before interests, taxes, depreciation, and amortization (EBITDA).
To value an early-stage startup by using the multiples method, we need to perform extensive market research and gather enterprise to revenue multiples for private and public competitors:
Publicly traded companies: these could be direct competitors of the startup, market leaders, and startups with similar business models active in the same niche. This information is publicly available and can be easily obtained in Yahoo Finance, Morningstar, or Seeking Alpha.
Privately held companies, if the information is available. That is the same information as the publicly traded companies data above, but more relevant since they reflect real private market multiples. However, this could be harder to obtain.
Finro Startup Valuation | Source: Tom Fishburne, Marketoonist
2. Multiples Method For Late-Stage Startups
This is the second variation of the multiples method.
This variation typically applies to late-stage startups or mature companies with positive earnings before interests, taxes, depreciation, and amortization (EBITDA).
To value a startup by using these method variations, we need to perform extensive market research and gather enterprise to revenue or EBITDA (depend on the case) multiples for these three groups:
Comparables publicly traded companies: these could be direct competitors of the business, market leaders, and startups with similar business models active in the same niche. This information is publicly available and can be easily obtained in Yahoo Finance, Morningstar, or Seeking Alpha.
Privately held companies, if the information is available. That is the same information as the publicly traded companies data above, but more relevant since they reflect real private market multiples. However, this could be harder to obtain. It could be available either in media publications or in paid-private market platforms like Pitchbook or PrivCo.
Once we build a weighted average of the relevant ratio, we will multiply it by the representative year EBITDA, which is the average or median annual EBITDA of the company.
Finro Startup Valuation | Source: Dom Guzman, CrunchBase
3. Previous Transactions
This is another market-based valuation method with some similarities to the multiples method.
In this method, we use real-market data of prices buyers were willing to pay, and sellers were ready to get.
This information could be hard to obtain since the participants in some deals publish partial data and, in some cases, no financial data at all, except the deal announcement.
To evaluate a startup using previous transactions, we need to gather two data sets: deal sizes and annual revenues or EBITDA.
Deal sizes are usually published in the press release when the participants announce the deal. In most cases, the deal's announcement will not include the entire deal terms but only deal sizes. Therefore, annual revenues or EBITDA will be published separately from the deal announcement and possibly in previous or later media publications.
It could be tricky to obtain some of the previous transactions' information. In some cases, when the data is not available, it could be found in paid-private market platforms like Pitchbook or PrivCo.
4. Discounted Cash Flow (DCF)
The DCF has a bad reputation in the venture capital community. The underlying assumption in a DCF model is that the company has a positive free-cash-flow in the present or will have it in the foreseeable future. However, this does not apply to every case, especially for early-stage startups who can barely forecast their top-line revenues and have only a vague understanding of how their projected financials might look like in the future.
While the Discounted Cash Flow method doesn't apply to every case, it's a beneficial and powerful tool for late-stage startups valuation.
There are five steps for building a DCF model:
Step 1: building a financial forecast for the business we are going to evaluate. Start by going through our financial modeling content, available here, to understand better how to build a robust and useful projection.
Step 2: extracting the free-cash-flow (FCF) from the financial projection. There are a few ways to build the company's FCF. However, we prefer FCF = EBIT - Tax Expenses + Depreciation & Amortization - Changes in Working Capital - Capital Expenditure.
EBIT = Earnings before income and taxes from the financial projection. For simplicity, you can use the operating profit.
Tax Expenses = this is annual tax expenses the company will pay.
Depreciation & Amortization = The company's annual amount will depreciate for a fixed asset, tangible and intangible assets. Must be aligned with the local tax authorities' direction and IFRS standards.
Changes in Working Capital = Working capital is the difference between the current assets and the current liabilities. In most cases, current assets include cash and accounts receivable, and current assets include inventory and accounts payable. The change in working capital is the year-over-year change in the working capital.
Capital Expenditure = CapEx is the amount of money a business spends to buy or improve its fixed assets.
Finro Startup Valuation
Step 3: estimating the company's discount rate. This is the rate that we use to discount future cash flows to their present value. A company's discount rate is a weighted average of its cost of capital: equity and debt. This is the way we recommend to calculate the WACC for the DCF: (Rf + ERP*Beta)*Equity/(Equity + Debt) + Interest rate on debt * Debt / (Equity + Debt)
Rf = This is the risk-free rate in the location where the company does most of its business or raises funds. Usually, an interest rate on a government ten years bond is used here. Information in most countries is available for free on Investing.com.
ERP= This is the equity risk premium for every country, reflecting the risk of doing business in each country. This data is available for free on Aswath Damodaran's page.
Beta: this is the correlation of the company's stock price with the stock market. However, private companies that are traded have no beta, so we use an average of their publicly traded competitors or industry average betas for free on Aswath Damodaran's page.
Equity= Market value of the company's equity
Debt= Market value of the company's debt
The interest rate on debt = if the company has any interest-bearing debt or loan.
Step 4: estimating the terminal value. Since we cannot project cash flows forever, we use the terminal value as a proxy for the cash flows that the company will generate from the moment our projection ends until the end of the company's life. There are a few models and methods to estimate the company's terminal value. However, we prefer to use the stable growth model for simplicity, which assumes that the firm will grow at some stable rate until liquidation. So the terminal value is calculated this way: Terminal Value = Cash flow * (1 + future growth rate)/(WACC - Growth rate).
Step 5: putting it all together. We have a free-cash-flow projection for each of the next five years and an additional terminal value in the final step. We will now discount each year (and the terminal value) to the present using the discount rate we calculated above. The aggregated amount of present values is the company's valuation.
5. Other methods
In the venture capital and private equity industries that are additional methods for valuation that depend on the company's stage, niche, business model, and deal structure. These methods may include the Venture Capital Method, the Berkus Method, the Cost-Duplicate Method, Net Asset Value (NAV), and many more. We cannot cover these too, but we recommend further reading on the CFI website or Dave Berkus' website.
If you want to know how much a business is worth, you need to build valuation for the company. However, if you want to know how much a single share is worth and how a specific valuation flows through the pipes of different stock classes, investment terms, rights, and liquidity preferences. In that case, you need to use equity allocation methods.
There are three main equity allocation methods:
Current Value Method (CVM), also known as the 'Waterfall' model: This method assumes an immediate sale or liquidation of the company. It allocates the company's value to the different equity classes of stockholders.
Probability-Weighted Expected Return Method (PWERM), also known as the VC Method: This method combines CVM and future potential exit scenarios. Share value is based on the probability-weighted present value of expected future investment returns, which considers each of the possible future outcomes available to the enterprise as well as the rights of each share class.
Option Pricing Method (OPM): An allocation methodology that treats common stock and preferred stock as call options on the enterprise's equity value, basing exercise prices on the preferred stock's liquidation preferences.
Finro Startup Valuation: Startup Burn Rate
Once we establish a company's valuation, we need to use an equity allocation model to see the holding value for a specific shareholder or a single share price. In a perfect world, we could divide the valuation with the number of outstanding shares, and that would give us the share price that we could then multiply with the number of shares for each shareholder. However, every funding round is a different share class with a different liquidation preference, liquidity rights, conversion right, etc.
To bake these rights and terms into the analysis and see how the valuation we built flows through the cap table and how much every share is valued in each class, we need to use an equity allocation method.
The waterfall method is probably the most efficient and most commonly used equity allocation method. It shows how a company's specific valuation flows down its cap table through the different terms and rights, hence the name 'waterfall.'
However, To build a more robust waterfall model, in many cases, one or more valuations are used in a probability-weighted valuation to cover a broader spectrum of scenarios and how they are translated into a single share price.
Both asset pricing and valuation use the same terms, language, assumptions, and information. But they drive different results that reflect differently on the business. So, what's the difference between them?
When buying an asset, there's a significant difference between how much it is worth and how much you're willing to pay for it in light of current trends, your personal preference, your mood, or market sentiment. This is the difference between pricing and valuing an asset.
Valuation is a quantitative estimation of an asset's or firm's worth. This estimation can be made either on a standalone basis looking at asset's projected cash flows or relatively compared to other similar assets. Valuation is based on fundamental analysis of the asset and applying generally accepted calculation methods.
5 Essential Elements To Include In Every Startup Financial Model
The essential elements that your startup financial model should include to up-level the model from okay to excellent.
Pricing is estimating how much the buyer should pay for a particular asset. Pricing considers the momentum in the market towards the specific asset or asset class, the asset's liquidity, subjective added value to the buyer, estimates of the seller's expectations, and other behavioral factors of the seller, buyer, or market. So, which one should you use?
Asset valuation is used when buying or selling an asset or company (or part of them). Some of the pricing aspects are already embedded when you're choosing the asset to value. Once you know the asset's intrinsic value, you apply the additional subjective elements to determine how much you're willing to pay for it. In some cases, like stock trading, the pricing weight of the due diligence process is higher. In other instances, such as accounting or legal purposes, the weight of valuation is higher. However, in the end, both elements are applied in most cases to estimate an asset's worth to a buyer.
Once we have all the necessary data about the startup, its business model, competitors, niche, market, industry, and even the management team, we can find the right method for our case.
If the startup is at the pre-revenues stage or early-stage, where historical financials are limited to nonexistent, there is a significant weight to the founders' subjective expectations. Naturally, as founders, they will be optimistic and believe that their product will have a remarkable adoption rate and phenomenal clients and sales growth rates.
We use the founders' revenue and user base forecasts to mitigate this inherent optimism as the best-case scenario. Together with the founder, we develop specific assumptions that we could stress to show the worst-case scenario. In some cases, we even build more potential scenarios to show how financial performance fluctuates when the underlying assumptions change.
Each financial projection scenario will then be translated into a different business valuation using the Previous Transactions Method or Multiples Method For Early-Stage Startup.
If this a late-stage startup or mature company, it probably has a robust financial projection and a good understanding of its financial performance in the past and the future.
It should be relatively easier to build a few forecast scenarios to reflect different growth trends when specific attributes change between the scenarios.
In this case, to build a robust valuation for the startup, you should use a mix of a few methods:
Discounted Cash Flow (DCF): If the company has a positive free-cash-flow at present or soon.
Previous Transactions: if there are earlier deals in the niche/market/industry, that could help understand the businesses' real market value similar to the company evaluated.
Multiples Method For Late Stage Startup: if the company has a positive EBITDA in the present or the near future, this method could add a significant market value element.
Multiples Method For Early-Stage Startups: using the revenue multiple is also useful in later stages and can help mitigate any discrepancies in the other methods.
After you build a few valuations according to the number of scenarios you have, you can create a proforma cap table to reflect how the company's cap table will look like post-money. Once you have your proforma cap table, you can use one of the equity allocation methods to see the value of a single share in one of the classes.
Conclusion
This was my ultimate guide to startup valuation.
Now I'd like to hear from you.
What section was the most useful to you?
What topic do you feel we should cover in our next post?
Either way, let me know by leaving a comment below.
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