The Craftsmanship of Startup Valuation
“Success in investing comes not from being right but from being wrong less often than everyone else”- Aswath Damodaran
Valuation is one of the most important elements for entrepreneurs, since it represents the potential value that they can extract from their startup in a potential liquidity event. For investors it is also relevant, since derived from their investment and the value of the company, they have access to a percentage of equity ownership with the idea that the startup will continue to increase its value and thus have a financial return.
On the web there is a large amount of literature on the subject. However, ignorance leads entrepreneurs and some investors to not know which methodology to apply. Some methodologies are:
- Venture Capital Method
- Berkus Method
- Scorecard Valuation Method
- Risk Factor Summation Method
- Cost-to-Duplicate Method
- Discounted Cash Flow Method
- Valuation by Stage Method
- Comparable Method
- The Book Value Method
- First Chicago Method
Valuation as Aswath Damodaran, a NYU professor would say is like being a craftsman; you must do a lot of trials prior to being an expert on the subject. In addition, it is important to mention that the valuation method changes according to the stage in which the startup is at. The methodology of valuing a startup that only has an idea is different from one that already has sales of +USD$1mm or more.
Consider the case of WeWork, a coworking company founded in 2010 that tried to do an IPO in 2019 at a valuation of aprox. USD$47bn. According to Forbes, if we compare WeWork to Regus (IWG), WeWork has approximately 45mm square feet vs 57mm square feet by Regus. The first generates sales of USD$1.8bn against Regus’ USD$2.8bn; and WeWork reports an operating profit of -USD$1.7bn vs USD$177mm from, its counterpart. IWG’s estimated value was just USD$3.7bn against WeWork’s disproportionate USD$47bn estimated valuation. Somehow, WeWork’s capital raising led the entrepreneur and SoftBank-led investors to generate a disproportionate valuation. The result was the cancellation of the IPO and a new estimated valuation of USD$2.9bn.
“Einstein was right about relativity, but even he would have had a difficult time applying relative valuation in today’s stock markets.”- Aswath Damodaran
Taking into consideration the case of WeWork, entrepreneurs and investors must recognize the need for a fair valuation using the main methodologies such as:
- Trading comparables (relative valuation)
- Acquisition / M&A comparables&A (relative valuation)
- Discounted cash flow (DCF) (intrinsic valuation)
The trading comparable methodology takes public companies similar to the company to be valued, preferably in common geographies and similar business models. You have to consider operational and financial metrics. The main valuation multiples are:
-EV / EBITDA
-EV / Sales
-P / E
The acquisition / M&A comparable methodology considers acquisitions made in similar geographies, industries and business models. Usually the valuation reflects a premium for control and for synergies. The process to follow is similar to the market comparable methodology.
The discounted cash flow methodology is an intrinsic valuation that derives the value from the startup future expected cash flows. The methodology requires:
- Make a financial projection usually for 5 to 10 years
- Estimate the terminal value of the business (by perpetuity or by an exit multiple)
- Calculate the appropriate discount rate
- Discount cash flows and terminal value, and bring them to present value
- Determine a value range
- Interpret the results and do a sensitivity analysis
“The intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows.”- Aswath Damodaran
Once these methodologies have been carried out, the valuation must be compared and analyzed according to the results of the different methods, to make the best decision. The objective is not to have a single value, but a range of values that will guide you in negotiating with entrepreneurs or investors.
It is important to emphasize that the valuation of a company will depend on its life cycle, industry and geography. As shown in the following graph:
For example, a company that just graduate from an acceleration program, which already has a proof of concept, pilots and perhaps sales, could have an implicit valuation of USD$2mm. In the case of Y-Combinator, they make an investment of USD$125k for a equity participation of 7% (pre-money USD$1.66mm + investment USD$125k = post-money USD$1.785mm).
Usually, in Series A, startups already have market validation, have conducted pilots, and have sales of at least USD$100k per month. These may have a valuation of USD$8mm to USD$100mm, considering a round of USD$2mm to USD$15mm, with an approximate dilution of 10% to 20%.
Series B onwards will raise + USD$15mm to USD$50mm with valuations greater than USD$100mm.
In summary, the valuation depends on the stage in which the company is, its financial projections, traction, competitive position in the industry and geography where it operates. When doing the valuation, consider the dilution that you will have as an entrepreneur or investor in each round of financing.
Remember that there are external factors that affect the valuation such as:
- The economic cycle of the industry in which the company operates
- Supply and demand of capital
- External factors (eg. COVID-19)
Don’t look for the best valuation, look for the optimal valuation for the conditions of your startup. As an entrepreneur your should have a long-term vision and if you do things well, you will maximize the valuation in the future. Remember that good things take time.
“A firm can have value only if it ultimately delivers earnings” — Aswath Damodaran
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund.
Ricardo Latournerie. Investment analyst at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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