Understanding Startup Valuation
I often get asked by startup founders, most of them with little to no business background on how to holistically think about capital raising and startup valuation during the evolution of their venture. Many struggle with being under-prepared for investor meetings and unable to defensibly quantify their venture’s worth (or valuation) to a an interested Venture Capital firm (VC). Some have paid a heavy price for this lack of know-how and prep. One founder I met a year ago complained about having only 11% equity in his own company (down from 85% post initial funding) due to poor capital raising strategy and consistently undervaluing his startup, thereby allowing every new investor to sharply dilute the founder’s stake.
You can’t let limited entrepreneurial finance knowledge undermine the unbelievable effort and energy you have put into your startup.
So let’s start with the fundamentals. In this article we will cover the basics of startup valuation going over stages of financing, how VCs measure themselves, how to value your startup and finally how to maximize your startup’s valuation.
Stages of Financing
At a high level one may consolidate financing rounds into three main categories: Seed & Angel Stage, Growth Stage and Exit Stage.
Seed & Angel Stage — Fairly self-explanatory reference to the financing required for “birthing” the idea.
- Seed funding — Most startups are funded by the founders themselves and/or with the help of friends and family members.
- Angel funding — Seed investors and other investors may pour in more capital to take the idea beyond birth and into marketing and customer acquisition.
Growth Stage — This stage requires capital to experiment with the business model, scale the business, and ramp up the operations to a viable critical mass. Generally VCs play a pivotal role in offering growth capital.
- Series A funding — This is the earlier part of the Growth Stage where investors provide capital to test the preliminarily vetted business model in the market. Typically Series A rounds may finance $2-$5 million.
- Series B funding — This too is considered an early funding round within the Growth Stage and capital raised generally helps refine the scope of the business opportunity, fine tune the above business model, build a strong team and further develop the product or service. Typically Series B rounds may finance $5-$15 million.
- Series C funding — We are now in the later part of the Growth Stage where investors back the venture once the team, product and a verifiable customer base is established and its time to scale up. The startup may be scaled globally and/or in its offering and/or in regards to its distribution channels, etc. A company raising Series C or beyond funding indicates it has achieved the critical mass needed for viability. Typically Series C rounds may finance $15+ million.
Exit Stage — At this point VCs intend to capitalize on their investment gains and consolidate profits back to their fund’s investors. In essence the startup investment journey for early stage investors has largely come full circle and is now complete.
- Mergers & Acquisitions(M&A) — Most startups opt to get acquired than to go to the public markets. Growth Stage investors may exit their investment at this stage.
- Initial Public Offering (IPO)— Some startups like Google and Facebook choose to remain independent and seek higher valuation and liquidity in the public markets by offering Secondary shares in an IPO. The trade off is now the company is in the public eye with more scrutiny and regulation but well-run companies seeking access to liquid capital go down this route and get their shares listed on stock exchanges.
- Private — Similar to the M&A option, if a company chooses to remain off the public markets, it may raise further rounds of funding, e.g. Series D and E, etc., to bridge its financial needs to profitability and self-sustainability. Once company achieves sound financial visibility it may also opt to raise debt financing instead of equity financing thereby limiting potential shares dilution of existing shareholders.
Note that the earlier the stage of the venture, the less proven the business model, the higher the risk and the lower the startup valuation. In other words Series A investors would seek a higher return than Series B who would seek a higher return than Series C investors and so on.*
What motivates a VC?
Part of valuing your startup also requires the appreciation to know the motivations of the “valuer” or the investor/VC. Getting funded by a VC is not easy. Most startups are denied even a first meeting based on an idea submission or pitch deck. Most Silicon Valley players would probably place a less than 1% chance of funding a startup — most VCs will back only 1 out of perhaps 150 deals they see. Why are VCs so picky? They must be fantastic at picking winners, right? Well, yes and no. Successful VC firms do pick winners but its the quantum of their win not the number of wins that helps them beat other VC firms and continue to grow their funds.
A VC firm does not only select winners in their fund portfolio. There is no magic ball to tell and then guarantee the future. As a matter of fact most VC investments fail and VCs make their returns off a minority of star investments. So in VC land you try to win big and super big on a few bets so that you can overcome the losses on most other bets that didn't pan out. They win less but when they win, its exponentially rewarding.
For example, lets say a VC firm has to invest $1 million of capital into 10 startups (SU1 through SU10) and return 26% annually on the entire fund for a 10-year period. If the firm is able to meet the 26% IRR target (Internal Rate of Return as expected by its Limited Partners or Investors) the fund would grow 10x in 10 years, i.e. from $1 million initial investment to more than $10 million. Theoretically each of the ten investments (i.e. $100,000 each) should payoff 26% IRR for 10 years, giving a 10x return on each investment, i.e. every $100k bet should turn into $1 million after a decade. That is highly unlikely. Typically most investments would not amount to much or anything in some cases. In our sample scenario below, only three investments (SU8, SU9 and SU10) combined drive vast majority of the returns for the fund (highlighted in yellow rows) while three investments (highlighted in green) collectively return modestly (SU5, SU6 and SU7) and the remaining four investments (SU1, SU2, SU3 and SU 4) flat out go flat!
In order to achieve 26% IRR or 10x return for the entire portfolio over 10 years ONLY three investments had to return between 38% and 44% IRR or 25x to 38x returns over 10 years. In other words SU1 to SU7 combined investment was $700,000 and resulted in Year 10 capital of $525,000 or a loss of $175,000 while SU8, SU9 ad SU10 combined investment of $300,000 resulting in Year 10 capital of $9,560,686 or a gain of $9,260,686.
The question is: does your idea pass the high bar of promising exponentially high returns? Good ideas don’t get funded, great one’s with fantastic teams and a bit of timing luck occasionally do. Remember only 1 out of 150 ideas may get VC funding and most of the funded ideas still fail!
Sticking with the above example, it would suggest that the 10 funded startups (SU1-SU10) each were part of the 1-out-of-150 club, i.e. 10 picked out of 1,500 ideas vetted and out of these only 3 drove the kind of returns that keep VCs in business. That is a 0.2% success rate or 1 out of every 500.
How to value your startup?
There are around half a dozen ways to value a startup from DCF model (Discounted Cash Flow) to Peer Multiples to Scorecard approach.**
In my experience Series A and B rounds typically follow Multiples and Scorecard approaches to valuation.
Since most startups coming out of Seed & Angel stage are investing heavily in product, people, infrastructure, marketing, etc., it is more suitable to apply a Sales Multiple to a future expectation of annual revenue run rate rather than accounting for profit, which is largely non-existent at these stages. For a high growth startup with strong margins and high visibility into revenues (recurring sales, e.g.) it is possible for the company to demand 5x to even 10x multiple on its future sales. Therefor a startup that is rapidly acquiring customers and doing a good job of retaining them as well and is projected to achieve $1 million in sales in next 12 months may set its Pre-money valuation at around $8 million (i.e. 8x $1 million, e.g.).
Pre-money valuation is simply the valuation of the company as it stands before raising new capital or any additional financing.
Another way to arrive at startup valuation (still Pre-money) maybe that the VC applies a Scorecard framework where five to seven key factors are weighted and valued individually and then added up to arrive at an overall multiplier, which is then applied to a comparable market transaction. Sounds complicated? Don’t fret. Its actually quite simple and intuitive.
The VC may rely on six consideration factor, for example, including team quality and prior experience, size of market and disruptive potential, offering quality or technology differentiation, market competition intensity, marketing and distribution strategy and other factors including customer feedback. The VC would then assign weights to each of the factors under consideration and related position of the startup compared to peers in each of the factor categories. Each VC may assign a different weight based on its view of potential for success — some VCs may weight team quality above opportunity size and vice versa.
The resulting factors for each category are arrived at by multiplying the weight of the category with the relative position of the startup. In the above case it appears the startup is relatively better positioned compared to peers in team quality, opportunity size and offering quality while the VC has assigned a relatively weaker position compared to market in areas of competitive pressure, marketing/distribution and customer feedback. Adding up all the factors, the transaction or valuation multiple comes out to 1.12x.
Assuming recent and comparable peers have raised funding in the ballpark of $5 million (list all transactions and compute average of capital raises), then the Pre-money valuation for this startup would be $5.6 million (i.e. $5 million x 1.12).
Note the Scorecard valuation approach resulted in a meaningfully lower valuation, i.e. $5.6 million as compared to Sales Multiple approach by the company, i.e. $8 million. No two valuation approaches will result in exactly the same valuation so nothing to be concerned about here.
Let’s now get to the investor roadshow. Suppose this startup is seeking $2 million in capital in its Series A round and a VC is willing to accept the $8 million Pre-money valuation set by company management. We then arrive at Post-money valuation using the following simple formula:
Pre-money valuation + Series A funding = Post-money valuation
$8 million + $2 million = $10 million Post-money valuation.
Therefore, an investor would inject $2 million for a 20% equity stake in the startup, i.e. ($2 million / $10 million) x 100%.
Assuming there was an intense negotiation with the VC and both parties agreed to a Pre-money valuation of $5.6 million instead of $8 million that the founders asked for, then Post-money valuation would be $7.6 million and investor would acquire 26.3% equity stake up from 20% when Pre-money valuation was higher, i.e. ($2 million / $7.6 million) x 100%.
Only actual negotiations reveal what the valuation walk-away points are for investors and founders but the above exercise illustrates how existing shareholders including founders and Angel investors may get diluted more than expected should their Pre-money valuation figure become somewhat indefensible. The investor has to be sold on your assumptions for valuation and if you genuinely believe you are being shortchanged on valuation by the investor then you should walk away from the transaction. Easier said than done, I know! How do you walk away from sure shot capital injection and potentially one of the last few life lines for your startup over a 6.3% difference in dilution?
Well, that’s why you think this scenario through several dozen times well in advance and do the best possible job on getting your pitch down, your financial model right, your assumptions triangulated and have a separate term sheet negotiation plan in place (final agreement outlining all relevant capital raise terms and conditions including stake acquired by investor in lieu of capital injection). Most investors are not unreasonable and will give your position a thorough review but you have to do your homework on why your startup deserves a higher multiple.
How to maximize your startup’s valuation?
As pointed before, the VC would try its best to pick more exponential winners in its portfolio and may use the following questionnaire to short list a startup. The same list of questions may also help decide the multiple range for computing your startup’s valuation.
A multiple is about capturing the story — the better the story (not a fable but in reality) the higher a VC would be willing to pay. There is a 25% valuation difference between an 8x story vs. a 10x story. The more boxes the VC checks in reviewing your pitch, the better your prospects for “multiple expansion.” Ask yourself the following questions and see how many you can respond to with confidence:
- Is the product/service serving a real need in the market in a unique way?
- Is the opportunity disruptive enough to attract future investments from other early stage investors?
- Is the opportunity large enough to be attractive?
- How well does the offering compete or even better is there a Blue Ocean opportunity (i.e. there is limited to no competition)?
- What is the company’s “unfair” competitive advantage? Technology? Patent? Team? Relationships?
- Is the business model pivotable within a reasonable period? Businesses that can adapt live to fight another day, another market trend.
- Is the business model high margin or mass-volume dependent?
- Is the revenue composition more one-time or recurring in nature?
- Does the team have a solid feel for metrics driving company valuation? Average Revenue Per User (ARPU), Contribution Margin, Customer Acquisition Cost (CAC), Retention rate, Monthly Recurring Revenue (MRR), Life Time Value (LTV) analysis?
- Are there opportunities to significantly increase ARPU or Revenue per Unit, by adding security features or mobile functionality, for example?
As can be deduced from the above list, valuation for a startup would benefit if the business model has high sales growth expectations, high margins, high revenue visibility, high customer stickiness, large market size, flexible pivot options and most importantly, a top class team. Keep all of these story elements in mind and don’t leave anything on the table. Even if you presently don’t find yourself giving profound and factual answers to the above, be mindful of how integrate thoughts around this list into your future pitch.
Having a comprehensive sense of both the business and financial model wrapped in a succinct narrative can significantly improve your chances of getting funded at the right valuation at the right time. ***