What About Late Stage Startups Valuation?
We’ve mainly spoken about startup funding for early stage startups, before they enter the growth stage. But what about late stage startups valuation?
You might believe that it is just the same financial approach than early stage ones or even traditional companies. The truth lies between the two models, and we have a great opportunity to understand more of the valuation methodology used by mutual funds thanks to the wave of markdowns of high-flying companies like Snapchat, Dropbox, Uber, Didi, Zenefits, etc. A close readings of publicly disclosures (mutual funds are required to fill securities filings) enables us to understand how these companies got valued.
Different investors, different approaches
Let’s start with some general principles to explain why we need to make a focus at late stage startups valuation.
Early stage investors are focusing a lot on the team, the product and the total addressable market. The more you move into the funding stages, the closer investors look at traction and eventually at revenue. Growth funds or mutual funds set sophisticated expectation of returns when the company gets acquired or goes public.
This is easy to explain. When you are an A-Round investor, you are less price sensitive when you know that the company that you invest in with a pre-money valuation of €2–5M can be worth €200+M in less than 6–8 years. Even if the growth (and the growth of the valuation) still continues for late stage investors, the multiple won’t be of the same range.
If you value a company €1B before going public, a 5% variation can make the difference between making big profits & loss. That also explains why mutual funds are making down their high tech companies: public markets are getting rougher so the expected valuation gets lowered. And generally speaking, the more predictable a business model can be, the more investors will focus on future cash flows (and risks), like any traditional company.
Late stage startups valuation
The value of late stage startups should be approached very similarly than other companies. The methods are very well described in this guidelines from the IPEV (Price of Recent Investment, Multiples, Benchmarks, Discounted Cash Flows, Net Assets, etc.).
The main difference lies in the uncertainty in late stage startups, which are still meant to grow a lot. So the difficulty is evaluating how much more the startups can capture market shares (and how much they can expand the market) and making good estimations of the probable scenarios.
But no more preliminary talks, let’s explain the 3 main approaches (and the correction method):
1. Recent Transactions
The easiest way to give a fair price is when the last investment were very fresh (either a primary investment, such as a new round table, or a secondary investment, such as when some of the shareholders sell some shares). If neither the market nor the company have tremendously changed, the last transaction price is a good indicator of the valuation of the company.
Yet, if the conditions have changed (eg: the company didn’t reach its milestones or the competition changed drastically) or if the last investment were made too long ago, this approach can’t provide a fair price. When using the price of the recent transactions, investors also looks at preferences which can misrepresent the picture.
2. Probability-Weighted Expected Return Model
The idea of this approach is to compute the expected returns using different exit scenarios (exit type, growth of revenue, valuation, liquidation preferences) for the company. For instance, TheInformation shows the use of this approach by T. Rowe Price:
T. Rowe Price also used a probability-weighted model to value its LivingSocial shares in September, using enterprise values ranging from zero to $270 million that averaged out at $105 million. It also applied an average discount to LivingSocial of 70%, citing liquidation preferences, which were presumably held by other investors. Preferences can guarantee payouts to some investors before others in the case of acquisition or liquidation.
One of the scenario for late stage startup valuation can also be liquidation value: the valuation is then highly discounted, often as low as the price of assets in the company such as their Intellectual Property.
3. Market Comparables : benchmark & multiples
Mutual funds are also using more traditional approaches for late stage startup valuation. They use valuation multiples. In theory, several kind of multiples could be applied: sales, gross profit, EBIDTA, revenue. The idea is to look at the company’s sales/gross profit/EBIDTA/revenue and apply the valuation multiple of similar public companies, taking into account the growth of the metric considered.
For instance, to value Uber shares in November, BlackRock took into account their revenue growth (373%) and used a revenue multiple formula of peer companies that eventually led to a revenue multiple of 27.5.
The different approaches can indeed be combined, for instance using market comparables within a probability-weighted model:
BlackRock valued its shares in Domo and India-based commerce app Snapdeal using this model. In October, it valued Domo shares by assuming an 85% likelihood of IPO, along with 159% revenue growth and a revenue multiple of 7.5x to 15.75x. In September, it pegged Snapdeal’s IPO probability at 70%, with revenue growth rate of 86.44% and a projected revenue multiple of 1.43x to 3.28x. The time frames for the projections are unclear but the expected IPO for Domo was in one to two years; for Snapdeal, it was one to three years.
4. Premium and discount
Mutual funds are also modulating the pricing by integrating illiquidity discount (typically between 10% and 20%), especially when the company restricts secondary transactions, and different stock preferences, such as liquidation preference or voting rights.
Late stage startups valuation is based on different approaches, taking into account growth AND revenue.
Embracing A Hybrid Approach
These difficulties to evaluate a fair valuation for fast growing companies are leading to situations where the same company is valued differently by different mutual-fund manager. The Wall Street Journal found 12 instances of that phenomenon that on the same date.
Bottom line: Late stage startups valuation is based on different approaches, taking into account growth AND revenue. They most often use computing Probability-Weighted Expected Return Model or market comparables, moderating them with premium and discount.
As we’ve seen, forecasting is very hard, especially for early stage startups but also for later stage ones. Consequently, without surprise, startups investors make a lot of mistakes: they fail often but not that fast.
Want to know more about startup funding? Read our articles:
Part 1 — Startup Funding: Growth Is The Only Way
Part 2 — The Jedi Trick: You Have to Choose Between Growth And Profits
Part 3 — If Growth Was Easy To Forecast, There Would Be Only One VC fund: Nostradamus Partners
Part 4 — You Need to Lose Money, But Some Loss Are A Really Bad Idea
Part 5 — How To Have Growth AND Profits? (Part1: Transactional models)
Part 6 — How To Have Growth AND Profits? (Part2: Non-Transactional Models)
Part 7 — What About Valuation For Late Stage Startups?
Part 8 — Fail Often, Fail Fast. Investors Do Half of That
Part 9 — What daphni will not invest in
Reminder: daphni investment thesis
Reminder: daphni investment thesis