How Venture Capitalists Value Startups
Below is a short excerpt from a book I am writing on breaking into venture capital. The passage covers — at a high level — how venture capitalists typically think about valuing the startups they invest in.
Valuation in the startup world can be more art than science. That’s doubly true if the startup is very early stage. Fundamentally, startup valuations end up being the result of a negotiation: it’s the price that the startup founder and the investor can ultimately agree on. Because of this, startups with more investor interest will almost certainly end up being valued higher than those with little investor interest, all else equal.
When — as an investor — you attempt to determine the valuation at which you’re willing to invest in a company, what you’re really doing is determining how much you think the company will be worth down the road and then discounting due to risk and the value of money over time. In practice, this is a very difficult calculation to undertake, largely because the risk is challenging to quantify, particularly on a time horizon that’s far enough out to value the company using a conventional method.
For the most part, mature companies are valued using the Discounted Cash Flow (DCF) method. The profits of the company over a given time horizon (often 10 years) are mapped out and then discounted back to the present using a cost of capital. The issue with this method and startups is that most rapidly growing companies don’t have profits yet. There’s an alternate version that subtracts out the extraordinary sales and marketing costs that startups use to fund their growth, but this variation is imprecise and still very inaccurate for very early startups.
For the most part, venture capitalists will determine valuations by looking at revenue multiples for comparable companies (“comps”) upon exit. For instance, when valuating a particularly promising at-home consumer electronics startup, you might use Google’s $3.2B acquisition of Nest as a comp. Some third party estimates put Nest’s revenue for the 12 months prior to the acquisition at just about $100M, resulting in a Last Twelve Months (LTM) revenue multiple of about 30x.
It just so happens that the Nest multiple is particularly high: most tech startups exit at ~5–10x LTM revenue. The Nest example shows why investors will often look at 10 comps or more in determining an appropriate multiple for their valuation: there will invariably be outliers that could justify abnormally high valuations.
Revenue multiples are great for well-established companies with a couple of years of trailing revenues, but what about companies that are too early for such methodology or other outliers that don’t seem to follow the 5–10x rule of thumb (like, at time of writing, Slack with its nearly 100x multiple)? This is where the little bit of science that is typically used in startup valuation devolves completely. Instead, the venture capitalist must rely entirely on projections for what the future of the company looks like. Detailed models will be replaced with statements like, “A valuation of $50M is justified because I can see this being a billion dollar company in eight to ten years.” The reasoning behind the justification will vary widely, but that’s what makes venture capital fun!
