Demystifying startup valuation

For many startups and investors alike, valuing a company is a highly subjective task that has sparked endless debates over what should be the ‘right’ approach. There seem to be two extreme views. Those who consider it to be a hard science argue that valuation, done right, leaves little room for analyst views or human error. Those who feel it is more of an art point to how shrewd analysts are able to manipulate the numbers to generate what they want.

Is valuation more of an art or a science, or somewhere in the middle? Is there really a correct approach to valuing startups at the early stage?

Theoretically, there are several ways to value a startup. The most common methods can be broadly categorised into two approaches — ‘market-based’ or ‘intrinsic value’. ‘Market-based’ methods involve estimating the value using certain benchmarks, which could be either past valuations of the startup, market comparables, or even exit values. ‘Intrinsic value’, on the other hand, include techniques such as DCF/financial modelling, or estimating value based on market size and potential. However, the two approaches above are not without their limitations. The main concern with ‘market-based’ methods is that benchmarks for which current valuations are anchored upon were formed during a specific period under certain market conditions, which likely differ from the present context. ‘Intrinsic value’ methods pose even larger problems as these tend to be ridden with assumptions (e.g. growth rate of the startup, discount rate, etc.) and metrics that seem almost meaningless to track for an early-stage company.

So, how is valuation derived in reality when a startup raises funding? Truth be told, there is no exact science. Most investors or VCs either follow their gut (put bluntly, is almost no different from picking a number out of thin air), or base it upon the stake they want (i.e. startup needs $500k to get to their next milestone, VC wants 20% of the company post-financing, thus valuing the startup at $2.5 mil). If you've watched enough Shark Tank, you should know that investors need to own enough of the company (usually between 15 and 25% at the early-stage) to make their time and effort worthwhile. From the founders’ perspective, valuation should then stem from the question of how much sweat equity you would be comfortable giving up in exchange for the value that the VC can bring to your startup.

Since most would agree that the valuation of an early-stage startup is simply a proxy, why is it difficult then for founders and VCs to come to a consensus on this figure? Answering this involves understanding each player’s motivations and what they hope to get out of the deal.

Founders aim to maximise the valuation of their startup as they are eager to prove the tremendous value of their new idea. On the other hand, VCs want to minimise the valuation as they want to own as much of the company as they can for a given funding amount. Neither extremes would do each player any good. If the valuation is too low, the founders or CEO would become disincentivised to work to build up the business. This would also affect the morale of their employees if they feel they do not own enough of the company (if their stock options aren’t worth much). Conversely, if the valuation is too high, this creates an (often unrealistic) expectation on how the outcome should look like. As a result, founders face great pressure to deliver this outcome, failing which would likely land them in a ‘down round’ (lower valuation than preceding funding round) at the next stage. Such ‘signalling’ is not ideal, and only makes it harder for them to attract prospective investors.

This implies that settling on a valuation between the two ends of the spectrum would make most sense. Both parties need to feel that they have struck a fair deal, and are aligned to build as much value together moving forward. Of course, this is easier said than done.

Instead of stalling negotiations due to disagreements over valuation, it might be more useful for founders to view valuation through a different lens. There will be many ‘battles’ to fight over the lifetime of the startup. Entering into many back-and-forths over a valuation figure during deal negotiation at the early-stage probably isn't the wisest use of time. Given how valuation represents only a small part of the financing deal, founders should not be overly-focused on this number, and lose sight of other major components in the process.

As put forth by Brad Feld, there are two main things to look out for in any venture deal: economic provisions and control provisions. While a VC might offer a high valuation, it usually comes with other ‘strings attached’ such as requesting for participating preferred stock with dividend that accrues, or provisions which give them veto rights during the startup’s next financing round, complicating issues for founders right from the beginning. In some of these cases, it might be more beneficial for the startup to accept a lower valuation as opposed to trading away some key non-financial provisions. As such, in any deal, it is important for the founders to weigh the stakes and figure out which is a better trade-off — less friendly economic provisions for more friendly control provisions, or the other way around.

This is also the reason why startups are often advised to raise early-stage funding via convertible notes or through standardised, well-established legal documents such as SAFEs (Simple Agreement for Future Equity by YCombinator), allowing the discussion of valuation to be side-stepped to a later stage.

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