The Problem With Valuation in VC: Beyond Traditional Methods
What are the limitations of traditional valuation methods?
As the world continues to witness a surge in technological advancements, more and more startups are emerging, presenting endless investment opportunities for venture capitalists. However, valuing these companies has become an intricate undertaking, with conventional valuation methods proving ineffective in this fast-paced, ever-evolving landscape.
In this article, we delve into the fascinating world of venture capital investments and explore the complexities associated with valuing early-stage startups. Drawing on insights from over 60 experts in the field, I uncover the challenges that VCs face in determining start-ups worth and propose alternative valuation approaches that may hold an advantage to unlocking their true value. I will begin with explaining the most common valuation methods, their relevance in VC and lastly show the results of the survey.
So, buckle up, and let’s dive into the world of venture capital valuation.
Discounted Cash Flow (DCF)
The Discounted Cash Flow (DCF) model is a widely-used approach in valuing companies, which involves forecasting the future cash flows and discounting them to their present value. Typically, a forecast of the upcoming 5 years, as well as a perpetual annuity, representing the growth over an infinite period, are considered. In the context of the DCF model, two approaches can be distinguished, namely the equity and entity method. For reasons of complexity, the entity method, and more specifically the WACC approach, will be quickly explained below.
Here, the free cash flows (FCF) within the time frame, usually 5 years, are first discounted with the weighted average cost of capital (WACC). Then the residual value, which is based on the perpetual growth rate (g), is added. With the help of the WACC, the total cost of capital of the company can be determined. There are various ways to determine the cost of equity within the WACC. The Capital Asset Pricing Model (CAPM) could be used for this purpose. Basically, the CAPM model is used to determine returns. With regard to the theory of opportunity costs, however, the return can now be represented as the cost of equity, since here, without using equity, precisely this return would be generated.
For venture capital investors, however, adjustments must be made due to the immense risk. According to a study by Roedl and Partner, the discount rate is rarely calculated on the basis of instruments such as the CAPM. Rather, it is based on empirical values and is often significantly higher than, for example, in the CAPM model. Discount rates of over 20 % are not uncommon in early-stage financing.
Multiples
In addition to the Discounted Cash Flow (DCF) model, multiples are widely employed as a means of determining and validating enterprise values. This method involves setting the enterprise value in relation to a relevant factor, such as turnover, EBITDA, or net profit. The choice of factor is contingent on its relative position in the Profit and Loss (P&L) statement, where a lower factor generally indicates a more mature company. As venture capital (VC) investors specialize in start-ups, the EV/sales multiple is commonly used, with sales occupying the foremost position in the P&L. The EV is calculated as follows:
EV= Value of equity + interest-bearing debt — cash and cash equivalents
To determine the enterprise value, investors calculate multiples of comparable companies and markets, and then apply these to the company’s sales figures. For instance, an EV/sales multiple is calculated as an industry average of 5x. The company to be valued has a turnover of € 100,000. The calculated enterprise value is therefore € 500,000 (€ 100,000 × 5).
Income approach
The Capitalised Earnings Method is a widely adopted approach for company valuation, with its objective being the computation of the present value of future earnings. The method utilizes past values to estimate future revenue surplus, adjusted for non-operating expenses/income and the period. This estimated revenue surplus is subsequently discounted using a capitalisation rate, which is a composite of the risk-free interest rate and a risk premium.
The risk premium is generally derived from the difference between the risk-free interest rate and the return on a risk investment and typically falls within the range of 3–4%. A higher capitalisation rate translates to a lower enterprise value.
Now that we know what some traditional valuation methods are: Why are these methods only partially suitable for vc company evaluations?
The problem
Although all the valuation methods mentioned above are often used in the financial industry, they have some weaknesses and problems in the field of venture capital financing. The rapid growth of start-ups poses a challenge to the computation of residual value and the forecasting of future earnings or cash flows. While growth rates beyond 100% are not uncommon in the early stages of start-ups, it is evident that such rates cannot be sustained indefinitely. Consequently, uncertainty arises regarding future growth rates, given that residual value and forecasts primarily rely on past values. Finding a realistic perpetual growth rate or forecast is highly improbable.
Moreover, the data situation presents an obstacle. Established listed companies can draw on past data spanning several years, which helps stabilize their valuation. Conversely, start-ups are usually in operation for only a short time and can hardly provide a robust dataset of past values. Forecasting based on a linear trend of past values or regression analysis is challenging, as the future often veers significantly from the past, and there is insufficient data for statistically significant computations.
Start-ups also face a liquidity challenge and negative cash flow. They often exhibit negative cash flow and profits in their early stages, which can exacerbate liquidation issues. Consequently, valuation methods that rely on cash flow or income, such as discounted cash flow or net present value, would yield negative valuation. Valuation based on multiples would be a more feasible option in this case. Nonetheless, multiples pose their own challenges. Start-ups often show high top-line growth rates, while recording high losses. Therefore, a valuation based solely on turnover may not be practical.
Since the classic valuation methods show clear problems in the valuation of start-ups, alternative valuation methods have become established over time.
What other ways to value a start-up are there?
There are many ways to evaluate an early stage start-up. In the following, we focus on two possible approaches for determining the value of an early stage start-up. It should be said, however, that ultimately a mixture of several methods and, above all, one’s own experience play a major role in determining the value.
Venture Capital Method
The VC method was made famous by Harvard professor William Shalman. It involves using enterprise value (EV) and return on invest (ROI) to approximate the pre-money valuation of the company. Initially, the derivation of EV is based on multiples, which have already been explained above. The VC method attempts to approximate the EV in the exit year. For this purpose, the industry median of company sales in the exit year is taken as the basis. Otherwise, it is also possible to apply the industry growth rate to the figures already available and thus infer the exit year.
Subsequently, the industry multiple is applied to the calculated figure and the approximated EV in the exit year is obtained. In the case that the median sales are €50 million in the exit year and the median sales/EV multiple is 4.5x, the EV is €225 million. The next step is to determine the target ROI of the investment. This is usually 10–30x in early-stage investments. Assuming an ROI of 20x, the post-money valuation is: 11.3 mio €. In order to arrive at the pre-money valuation, the targeted investment amount on the part of the founders must be deducted from the post-money valuation.
First Chicago
The Chicago method is based on the DCF or VC method. Three scenarios are assumed here:
1. Best case
2. Base case
3. Worst case
Each of these scenarios is assigned a probability of occurrence. Furthermore, the EV is calculated for each scenario, in each case matching the scenarios. This can be either done by DCF analysis or the VC Method. Finally, the 3 scenarios, together with the probabilities of occurrence and EV values, are multiplied as shown below.
Survey results: Which valuation methods are actually being used?
A total of 63 participants successfully completed the survey, providing valuable insights into the valuation practices of start-ups. The three most commonly represented verticals were FinTech, SAAS, and Consumer. 97% of respondents employ more than one assessment method when valuing start-ups, indicating a comprehensive and sophisticated approach to the valuation process.
According to the respondents, 97% often or always utilize their personal experience as an evaluation standard, while a frequent occurrence of multiple evaluations was observed, with 91% reporting that they often or always incorporate multiples in their valuation. In contrast, the employment of the DCF model was less frequent, as none of the participants reported always using the model, although 55% frequently use it. Similarly, the earned value method was rarely used, with only 55% of respondents indicating that they occasionally utilize the model while the remainder never use it.
The most significant alternative valuation method employed by respondents was the VC method, with 38% reporting that they often or always use this approach and only 12% never employing it. Other alternative methods, such as risk factor summation or the Berkus method, were generally infrequently utilized, with most respondents indicating that they sometimes or never use these methods.
Conclusion
In conclusion, the valuation of early-stage startups is a challenging task that requires a deep understanding of the market, the company’s potential, and the risks involved. Traditional valuation methods have limitations when it comes to startups, which are characterized by high growth rates and lack of financial data. However, alternative methods such as the VC method or First Chicago can provide a more suitable framework for assessing the value of these companies. Nevertheless, it is important to recognize that there is no one-size-fits-all approach, and the valuation process must incorporate both quantitative and qualitative factors. Ultimately, the value of a startup depends on a complex interplay of different variables, and experience and judgment are key components in arriving at a fair and accurate valuation. As the startup ecosystem continues to evolve and new technologies emerge, the challenge of valuing these companies will remain an ongoing and dynamic process.
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