Why Your Startup Valuation is Often Faulty or Correct! Or Both!
Startup valuation is such a thing that often has no objective method or rational criteria, especially if it’s a pre-revenue startup. If you try to fixate startup valuation techniques by the linear logic of market peer group comparison or any fixed valuation method like DCF you will feel an apparent lack of rhythm from different startup to startup. Here’s a simple example of why:
Startup 1: Startup 1 has no traction, no minimum viable product, and no revenue. They raise money on a BDT 3 crore pre-money valuation.
Startup 2: Startup 2 has a minimum viable product, traction, and strong founder background. They raise money on a BDT 1 crore pre-money valuation.
What could possibly be the reason? It is because the startup world is full of surprises, secrets, and opportunities. This universe stands on opportunities and secrets that are perceived differently from person to person. And these opportunities are very hard to measure quantitatively till series A stage. The only people who get the opportunities are the founders, the employees, and the investors who trust them.
For example, Grab recently acquired wealth tech startup Bento to bring wealth management and investment solutions to Asia. Now a question may arise that why would a Singapore based ride-hailing company acquire a Robo-advisory startup? Because actually they see lack of access to wealth management and retirement planning products which are traditionally available to only high net worth and institutional investors. By using Grab’s familiar platform to the existing client base they can adopt a low-cost model to make wealth management accessible to general retail clients. On the other hand, the OCBC bank in Singapore was the first South Asian bank to launch a Robo-investment service, an automated algorithm-based digital investment platform. But the platform required and an initial minimum investment of SGD 3500. Now if OCBC were to acquire Bento, the value and inherent opportunity it would see would be much different than Grab who is aiming to democratize access to wealth management service to millions across Southeast Asia. Maybe you can just start your disciplined investment plan with 5 Singapore Dollar leftover currency remaining in your GrabPay account!
So a typical comparison based valuation model of what industry they are, their revenue growth or what are the nearly comparable companies won’t work because opportunities are not created equal, opportunities to solve problems have a dynamic value differing from person to person.
So first of all what are the valuation methods out there by which we can value a company. Here a graph from Corporate Finance Institute:
But most of the time we cannot value a pre-revenue startup company by these traditional valuation approaches as we do for established companies with a track record or for exchange-listed companies. This is because:
- At the initial stage, there’s no cash flow or revenue or profit track record. It is difficult and sometimes vague if you project the future cash flow or profitability to find the inherent value of the company. Moreover, VCs invest in a startup for explosive growth, not stable cash flow or revenue in the next five years or so.
- Often it is very difficult to find a comparable company because most of the time if you are raising fund and VC agreed to give you a check that’s because you have a unique value proposition or distinct point of difference. Also, the market dynamics of similar startup concept or idea varies from place to place, even within districts.
- Often tech startups have no tangible asset rather they create value by their team qualification and opportunity inherent in the idea. So the cost approach of a tangible asset is totally misleading.
So what to do when valuing an early stage or seed-stage startup? Even an idea stage startup when not even an MVP has been developed?
Valuation for a Startup: It’s an intuitive thing
Suppose an investor just offered you BDT 10 lacs for 20% of your startup. So, 20% of the startup is worth BDT 10 lacs and post-money valuation is BDT 50 lacs.
So, the pre-money valuation of your company is = 50–10 = 40 lacs BDT
So how did the investor come up with a valuation of 20% stake for an amount of BDT 10 lacs?
Here are some methods that help investors to value startups even from the idea stage but remember neither of them is a foolproof method.
Scorecard Method
This method is popular among angel investors.
The first step is to look for the average pre-money valuation of pre-revenue startups at a similar stage in a similar industry in a similar region. Then look at the factors of a new business idea in a valuation scorecard. The factors can be industry attractiveness, market size, quality of the management team, etc. The main parameters, or criteria, of the Scorecard Method, in order of importance, along with their respective weights, are: entrepreneur, team, board (30%), size of opportunity (25%), product/technology (15%), sales/marketing (10%), need for more financing (5%) and other (5%). Angel investors can change these weighting or can also add or deduct parameters based on their own preferences and insight. If you think that the company management is 20% better than other similar stage startups within the same region then you multiply the respective weight of the factor with 120% for an adjusted weight. After you sum all the adjusted weights you end up with something like this:
Now you can arrive at a pre-money valuation of your targeted startup by multiplying the total adjusted weight (1.07) with the average pre-money valuation of similar pre-revenue startups.
As you can see we can get an approximate value of a pre-revenue startup by scorecard method, but the weighting allocation and similar companies you take into consideration make this valuation method highly subjective.
Berkus Method:
This is another intuitive method for exclusively pre-revenue startups. You can think of your startup as a basket. The more you put into your basket the more is its value. Also if you put BDT 1 taka into the basket it will give BDT 2 or 4 or 10 in return. But you have to have some contents in your basket to reach that return. And an investor will value your startup based on the contents in the basket when it’s at the pre-revenue stage. The contents are:
Sound Idea (Basic Value)
Prototype (Technology)
Quality Management Team (Execution)
Strategic Relationships (go-to-market)
Product Roll-Out (Sales)
Now investors will give different values to each of these contents and will reach a final value of the basket by summing values of all contents. The amount of value investor puts depends on his personal judgment, industry, location, and ecosystem the startup is operating in.
DCF Method:
DCF method is basically not recommended for a pre-revenue startup for the reasons stated above. There are a lot of uncertainties for a pre-revenue startup due to their high probability of failure and unique model. Also, there’s no track record of revenue or earnings to project the free cash flows for DCF estimation. If someone uses a DCF method for valuing a pre-revenue startup then it is highly recommended to use it by calculating different scenarios. You can estimate the different probability of success for the startup — very high, very low, and normal. For example, you take 30%, 5%, and 15% probability of success as very high, very low, and normal. Then you estimate three different hurdle rates based on three different probabilities. Then if you discount the projected cash flows with three different hurdle rates, you will get three different valuations. You can then decide a percentage reflecting a probability to happen for each scenario. Your final valuation is then decided based on the weighted average of each case. For an example:
Risk Factor Summation Method:
This is another pre-revenue startup valuation method but a more evolved version than the Berkus Method. You determine the base value of your startup and then adjust the base value based on several risk factors. The base value is determined based on the average value of similar startups in the area, which is often very difficult to determine. The risk factors are tagged from very low to very high.
For example, you can model risk factor as a multiple of BDT 150,000 whereas for Very High-risk factor you deduct BDT 300,000 from the base value, and for Very Low-risk factor you add BDT 300,000 with the base value.
By adjusting nine risk factors we have come up with a final value of BDT 11.5 lacs from a base value of BDT 10 lacs.
VC Method:
This method is mostly used by VCs and can be used for both pre-revenue startups and post-revenue startups. It is one of the most used methods for establishing the pre-money valuation of startups. An investor is always looking for Return on Investment (ROI) and if we multiply ROI with the post-money valuation we can get the exit value of the company.
Exit Value = ROI* Post Money Valuation
Exit Value is the anticipated selling price of the company at some point down the road. It can be determined by multiplying company projected earnings by industry average PE multiple or multiplying company projected EBITDA by the industry average EV/EBITDA multiple. Return on Investment (ROI) is calculated by the hurdle rate that is calculated by adjusting the required rate of return by VC’s subjective judgment on the probability of success.
ROI= (1+hurdle Rate)^t
(1+hurdle rate)^t = (1+required rate of return)/probability of success
Now if we divide the exit value by ROI, we can reach a post-money valuation of the company. If you deduct the investment amount from post-money valuation then we can reach to pre-money valuation. If we anticipate further dilution from the subsequent rounds later, then we can just reduce the pre-money valuation based on the percentage of dilution. For example:
Pre-money valuation = BDT 50 lacs
Investment amount = 10 lacs BDT
Post-money valuation = 10+50 = 60 lacs BDT
Investor stake= 10/60 = 17% approx
Now, if the investor assumes 50% dilution in a later round of financing, he reduces pre-money valuation by 50%:
50*0.5= 25 lacs BDT
So post-money valuation= 10+25= 35 lacs BDT
Investor stake = 10/35= 29% approx
Now, valuation is basically based on opportunity. How opportunities are perceived vary from person to person. That’s why the valuation done by startups will not match with the valuation done by angel investors or analysts working at VC firms. So which method is the best method? The answer is neither. Valuation is most of the time an estimate based on the probability of an opportunity to become successful. In short, it’s a guessing game.
Basically the correct valuation is the one that supplies fund to the entrepreneur to reach milestones that both the investor and entrepreneur agrees within a specific time frame and the dilution is limited to a level where the fund raised is more benefiting to the company than it is demotivating to the entrepreneur .
In the angel round or seed round investors often estimate pre-revenue startup valuation by using multiple methods. Ultimately it is important for a startup to remember that on an early-stage company the valuation is based not only on the future prospects as the odds of the company being successful is so low, rather it’s on the intangible factors like investor’s perception about the opportunity and mostly investor’s belief about the strength of team or strength of the idea. It is very important for an entrepreneur not to shoot up for a high valuation to the extent that his company cannot sustain it. Arriving at an amount that both parties agree when you are fundraising is not a linear or straightforward way. It’s often a mix of arts and science. So you can be wrong about your startup valuation, you can be right as well. Or both at the same time!
Kamrul Arefin
Co-Founder & CEO, Stellar Value Partners Ltd.
Stellar Value Partners is a startup valuation consultancy, advisory and research firm that can help startups for idea validation, market research, deal structuring, valuation report, pitch deck, investment prospectus, and other fundraising material preparation
You can reach to Kamrul Arefin at arefin@svpbd.com
