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How does an early-stage investor value a startup?

18.01.2012

How does an early-stage investor value a startup?
by Carlos Eduardo Espinal (@cee)

One of the most frequently asked questions at any startup event or investor panel, is “how do investors value a startup?”. The unfortunate answer to the question is: it depends.

Startup valuation, as frustrating as this may be for anyone looking for a definitive answer, is, in fact, a relative science, and not an exact one.

For those of you that want to cut to the summary of this post (which is somewhat self-evident when you read it) here it is:

The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.

Whilst this statement may capture the bulk of how most early stage startups are valued, I appreciate that it lacks the specificity the reader would like to hear, and thus I will try and explore the details of valuation methods in the remainder of my post with the hopes of shedding some light on how you can try and value your startup.

As any newly minted MBA will tell you, there are many valuation tools & methods out there. They range in purpose for anything from the smallest of firms, all the way to large public companies, and they vary in the amount of assumptions you need to make about a company’s future relative to its past performance in order to get a ‘meaningful’ value for the company. For example, older and public companies are ‘easier’ to value, because there is historical data about them to ‘extrapolate’ their performance into the future. So knowing which ones are the best to use and for what circumstances (and their pitfalls) is just as important as knowing how to use them in the first place.

Some of the valuation methods you may have have heard about include (links temporarily down due to Wikipedia’s position on SOPA and PIPA):

While going into the details of how these methods work is outside of the scope of my post, I’ve added some links that hopefully explain what they are. Rather, let’s start tackling the issue of valuation by investigating what an investor is looking for when valuing a company, and then see which methods provide the best proxy for current value when they make their choices.

A startup company’s value, as I mentioned earlier, is largely dictated by the market forces in the industry in which it operates. Specifically, the current value is dictated by the market forces in play TODAY and TODAY’S perception of what the future will bring.

Effectively this means, on the downside, that if your company is operating in a space where the market for your industry is depressed and the outlook for the future isn’t any good either (regardless of what you are doing), then clearly what an investor is willing to pay for the company’s equity is going to be substantially reduced in spite of whatever successes the company is currently having (or will have) UNLESS the investor is either privy to information about a potential market shift in the future, or is just willing to take the risk that the company will be able to shift the market. I will explore the latter point on what can influence you attaining a better (or worse) valuation in greater detail later. Obviously if your company is in a hot market, the inverse will be the case.

Therefore, when an early stage investor is trying to determine whether to make an investment in a company (and as a result what the appropriate valuation should be), what he basically does is gauge what the likely exit size will be for a company of your type and within the industry in which it plays, and then judges how much equity his fund should have in the company to reach his return on investment goal, relative to the amount of money he put into the company throughout the company’s lifetime.

This may sound quite hard to do, when you don’t know how long it will take the company to exit, how many rounds of cash it will need, and how much equity the founders will let you have in order to meet your goals. However, through the variety of deals that investors hear about and see in seed, series A and onwards, they have a mental picture of what constitutes and ‘average’ size round, and ‘average’ price, and the ‘average’ amount of money your company will do relative to other in the space in which it plays. Effectively, VCs, in addition to having a pulse of what is going on in the market, have financial models which, like any other financial analyst trying to predict the future within the context of a portfolio, have margins of error but also assumptions of what will likely happen to any company they are considering for investment. Based on these assumptions, investors will decide how much equity they effectively need now, knowing that they may have to invest along the way (if they can) so that when your company reaches its point of most likely going to an exit, they will hit their return on investment goal. If they can’t make the numbers work for an investment either relative to what a founder is asking for, or relative to what the markets are telling them via their assumptions, then an investor will either pass, or wait around to see what happens (if they can).

So, the next logical question is, how does an investor size the ‘likely’ maximum value (at exit) of my company in order to do their calculations?

Well, there are several methods, but mainly “instinctual” ones and quantitative ones. The instinctual ones are used more in the early-stage type of deals and as the maturity of the company grows, along with its financial information, quantitative methods are increasingly used. Instinctual ones are not entirely devoid of quantitative analysis, however, it is just that this “method” of valuation is driven mostly by an investor’s sector experience about what the average type of deal is priced at both at entry (when they invest) and at exit. The quantitative methods are not that different, but incorporate more figures (some from the valuation methods outlined) to extrapolate a series of potential exit scenarios for your company. For these types of calculations, the market and transaction comparables method is the favored approach. As I mentioned, it isn’t the intent of this post to show how to do these, but, in summary, comparables tell an investor how other companies in the market are being valued on some basis (be it as a multiple of Revenues or EBITDA, for example, but can be other things like user base, etc) which in turn can be applied to your company as a proxy for your value today. If you want to see what a professionally prepared comps table looks like (totally unrelated sector, but same idea), go here.

Going back to the valuation toolset for one moment… most of the tools on the list I’ve mentioned include a market influence factor , meaning they have a part of the calculation that is determined by how the market(s) are doing, be it the market/industry your company operates in, or the larger S&P 500 stock index (as a proxy of a large pool of companies). This makes it hard, for example to use tools (such as the DCF) that try and use the past performance of a startup (particularly when there is hardly a track record that is highly reliable as an indicator of future performance) as a means by which to extrapolate future performance. This is why comparables, particularly transaction comparables are favored for early stage startups as they are better indicators of what the market is willing to pay for the startups ‘most like’ the one an investor is considering.

But by knowing (within some degree of instinctual or calculated certainty) what the likely exit value of my company will be in the future, how does an investor then decide what my value should be now?

Again, knowing what the exit price will be, or having an idea of what it will be, means that an investor can calculate what their returns will be on any valuation relative to the amount of money they put in, or alternatively what their percentage will be in an exit (money they put in, divided by the post-money valuation of your company = their percentage).  Before we proceed, just a quick glossary:

Pre-Money = the value of your company now
Post-Money = the value of your company after the investor put the money in
Cash on Cash Multiple = the multiple of money returned to an investor on exit divided by the amount they put in throughout the lifetime of the company

So, if an investor knows how much % they own after they put their money in, and they can guess the exit value of your company, they can divide the latter from the former and get a cash-on-cash multiple of what their investment will give them (some investors use IRR values as well of course, but most investors tend to think in terms of cash-on-cash returns because of the nature of how VC funds work). Assume a 10x multiple for cash-on-cash returns is what every investor wants from an early stage venture deal, but of course reality is more complex as different levels of risk (investors are happy with lower returns on lower risk and later stage deals, for example) will have different returns on expectations, but let’s use 10x as an example however, because it is easy, and because I have ten fingers. However, this is still incomplete, because investors know that it is a rare case where they put money in and there is no requirement for a follow-on investment. As such, investors need to incorporate assumptions about how much more money your company will require, and thus how much dilution they will (as well as you) take provided they do (or don’t ) follow their money up to a point (not every investor can follow-on in every round until the very end, as many times they reach a maximum amount of money invested in one company as is allowed by the structure of their fund).

Now, armed with assumptions about the value of your company at exit, how much money it may require along the way, and what the founding team (and their current investors) may be willing to accept in terms of dilution, they will determine a ‘range’ of acceptable valuations that will allow them, to some extent, to meet their returns expectations (or not, in which case they will pass on the investment for ‘economics’ reasons). This method is what I call the ‘top-down’ approach…

Naturally, if there is a ‘top-down’, there must be a ‘bottom-up’ approach, which although is based on the ‘top-down’ assumptions, basically just takes the average entry valuation for companies of a certain type and stage an investor typically sees and values a company relative to that entry average. The reason why I say this is based on the ‘top-down’ is because that entry average used by the bottom-up approach, if you back-track the calculations, is based on a figure that will likely give investors a meaningful return on an exit for the industry in question. Additionally, you wouldn’t, for example, use the bottom-up average from one industry for another as the results would end up being different. This bottom-up approach could yield an investor saying the following to you when offering you a termsheet:

“a company of your stage will probably require x millions to grow for the next 18 months, and therefore based on your current stage, you are worth (money to be raised divided by % ownership the investor wants – money to be raised) the following pre-money”.

One topic that I’m also skipping as part of this discussion, largely because it is a post of its own, is “how much money should I raise?”. I will only say that you will likely have a discussion with your potential investor on this amount when you discuss your business plan or financial model, and if you both agree on it, it will be part of the determinant of your valuation. Clearly a business where an investor agrees that 10m is needed and is willing to put it down right now, is one that has been de-risked to some point and thus will have a valuation that reflects that.

So being that we’ve now established how much the market and industry in which you company plays in can dictate the ultimate value of your company, lets look at what other factors can contribute to an investor asking for a discount in value or an investor being willing to pay a premium over the average entry price for your company’s stage and sector. In summary:

An investor is willing to pay more for your company if:

  • It is in a hot sector:investors that come late into a sector may also be willing to pay more as one sees in public stock markets of later entrants into a hot stock.
  • If your management team is shit hot: serial entrepreneurs can command a better valuation (read my post of what an investor looks for in a management team). A good team gives investors faith that you can execute.
  • You have a functioning product (more for early stage companies)
  • You have traction: nothing shows value like customers telling the investor you have value.

An investor is less likely to pay a premium over the average for your company (or may even pass on the investment) if:

  • It is in a sector that has shown poor performance.
  • It is in a sector that is highly commoditized, with little margins to be made.
  • It is in a sector that has a large set of competitors and with little differentiation between them (picking a winner is hard in this case).
  • Your management team has no track record and/or may be missing key people for you to execute the plan (and you have no one lined up). Take a look at my post on ‘do I need a technical founder?‘.
  • Your product is not working and/or you have no customer validation.
  • You are going to shortly run out of cash

In conclusion, market forces right now greatly affect the value of your company. These market forces are both what similar deals are being priced at (bottom-up) and the amounts of recent exits (top-down) which can affect the value of a company in your specific sector. The best thing you can do to arm yourself with a feeling of what values are in the market before you speak to an investor is by speaking to other startups like yours (effectively making your own mental comparables table) that have raised money and see if they’ll share with you what they were valued and how much they raised when they were at your stage. Also, read the tech news as sometimes they’ll print information which can help you back track into the values. However, all is not lost. As I mentioned, there are factors you can influence to increase the value of your startup, and nothing increases your company’s value more than showing an investor that people out there want your product and are even willing to pay for it.

Hope this helped! Feel free to ask questions in the comments.

Other Pieces on the subject

http://www.quora.com/How-do-VC-firms-value-a-start-up
http://www.quora.com/Internet-Startups/How-do-investors-value-a-consumer-internet-start-up
http://www.entrepreneur.com/article/72384

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