“Venture capital is about capturing the value between the startup phase and the public company phase”- Fred Wilson
What is the difference between valuing Google and an analytics startup in its first rounds of funding?
Google is a company with more than 23 years of operations, has relevant financial information for interested investors, and is listed on recognised and efficient capital markets. In contrast, a startup in its first rounds of investment is characterised by limited operational and financial information due to its recent creation and is subject to the Venture Capital-VC ecosystem, which some might consider inefficient. In addition, many at this stage may not have a monetisation model and their projections are not yet substantiated.
The relative valuation of a corporate with traction, operating in efficient markets, is done through comparative market multiples and M&A transactions; the intrinsic valuation is derived from the discounted cash flow of the company. In the case of a startup, this information is more difficult to access or is not available, so valuing startups, especially those in the pre-sales stage, is a challenge.
Valuing a startup when making an investment decision is often a subjective and uncertain process. On the one hand, there are asymmetries in the information that different investors exploit to make their decisions. In addition, the supply and demand effect is highly visible; on the one hand, there is a large number of interested parties wanting to invest in startups, and on the other hand, there are several developing businesses looking for capital, a situation that has considerably increased the value of transactions. Additionally, there are different actors involved in startup investment such as angel investors, VC funds, corporates, family offices, etc., who exercise different power when negotiating the economic value.
As a result of the above, there are different approaches to determine the value of a startup. In initial rounds, capital is usually raised through convertible notes or SAFE’s without determining a valuation of the company and leaving this decision to the next equity round. By contrast, in growth rounds, capital is usually invested, and a company value is determined. Among the elements used to value a company are the team, traction, business model, capital structure, among others.
However, the market has tried to develop some valuation models that systematically capture the real value of a startup according to its industry sector, geography, and stage of development. Three commonly used methods are:
- Venture Capital Method:
This method was developed by William Sahlman and basically assumes an expected rate of return from the investor, the amount to be invested, the term and the expected valuation of the startup at the end of the period. It uses these elements to determine the percentage of equity the investor would require meeting these assumptions.
To achieve an IRR of 30% over 5 years and invest USD$1.5mm with projected company sales of USD$3mm in year 5, the calculation of the value of the future investment is as follows:
And the company would be worth USD$30mm considering a multiple of 10x sales.
- Berkus Method:
This method was developed by investor Dave Berkus in the 1990s. This valuation technique consists of establishing qualitative parameters related to the startup’s operation and market and applying an increase or decrease to the value of the company depending on its competitiveness in these areas. For example, let’s say we want to value a retail-tech startup that has a solution in a market with a few competitors. At the same time, it has growth potential, a proven prototype ready for production, has not yet made real sales, has an experienced team but no previous ventures, and has some strategic allies. In this case the valuation could approximate the following:
- Scorecard Method:
The scorecard valuation method was created by Bill Payne in 2010, which evaluates startups by comparing them against other companies of equal size in the same or similar industry, deriving a relative valuation. This method is based on comparing the strength of the company under review against other comparable companies in the market. To use this method, the team, market size, product, competition, operating strategy, need for future investment and other factors that allow us to understand the advantages that the company has over its competitors in the market:
Once these characteristics are reviewed, we proceed to obtain the factor or multiple by which we will multiply the average valuation of the comparable companies to obtain the valuation of our company. Continuing with the example, the average valuation of the comparable companies is USD$1.5mm pre-money; multiplying by the factor, we obtain a pre-money valuation of USD$1.725mm.
In addition to these valuation methods, there are other valuation methods that some investors use, such as qualitative, quantitative, risk, sales-based, among the most common.
Venture Capital investors are often guided by the market, they consider assumptions they have had in other investments, which leads to value judgments and sometimes even feelings and emotions when valuing a startup. In addition, there is the phenomenon of competition for transactions and the mindset emanating from the investor group. Added to this are the effects of signaling by entrepreneurs with an emphasis on brand, reputation and the excessive optimism that characterizes them.
VC valuation remains subjective, piecemeal, and arguably irrational.
“Success in investing comes not from being right but from being wrong less often than everyone else.”- Aswath Damodaran
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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