Valuation

Valuation is one of the most-discussed topics in the startup community, but calculating a company’s valuation is often viewed as a mysterious, esoteric process. Your startup’s valuation directly determines how much funding you can raise, and a large valuation can add to your startup’s credibility in the eyes of lenders, customers, suppliers, and prospective employees. Given the valuation’s central role in financing negotiations, we will try to peel back the curtain and explain how investors arrive at their conclusions about your startup’s value.

We begin with a general discussion about the concept of valuation and related terminology. The article then presents different valuation techniques, offers an illustrative example, and summarizes how founders can benefit by understanding the principles of valuation. Although we will briefly mention the public markets, most of the article focuses on the valuation of privately-held companies.

Why Valuations Matter for Founders

Founders have many responsibilities as they work to grow their companies, and probably will not be involved in valuation work on a day-to-day basis. However, there are two important situations when founders should be aware of how valuations can affect their company: 1) stock compensation and 2) financing activities. Many companies hire valuation advisory firms to assist in these valuations and provide an independent opinion. Since valuations are subjective, the valuation given by an advisory firm may differ from that of an incoming investor.

This article primarily focuses on how valuations affect company financing activities. However, you can learn more about the impact of valuations on stock compensation in our articles entitled 409A Valuations and Cheap Stock.

Valuation

All financial aspects of equity-fundraising negotiations revolve around the proposed valuation. Before making an offer, investors calculate how much they believe the startup is worth. This amount, called a valuation, and the investor’s desired ownership percentage in the company determine the size of the investor’s offer. For example, if an investor values a startup at $100 million and wants to acquire 10% of the company, then the investor would offer $10 million for a 10% stake.

When valuing companies, investors calculate the estimated worth of the company’s equity. This is equivalent to valuing the company’s overall business and subtracting the market value of the company’s debt and other liabilities. Valuations measure how much a company’s equity ownership is worth or, equivalently, how much you would need to pay to purchase a 100% ownership stake in the business.

Since shareholders have the right to share in the company’s excess profits while it stays in business, valuations take into consideration not only the company’s profits for the current year, but for each year of the company’s projected existence. As a result, investors trying to value a company face the difficult task of forecasting the company’s performance well into the future. Investors rely on all currently available information to estimate the success of the company’s future operations, and continually adjust their projections as new information becomes available. If a company performs much better or worse than investors had projected, the company’s valuation can change dramatically in a short period of time.

Unlike the relatively objective financial metrics of revenue and earnings, valuations are investors’ inherently subjective best estimates of how much the company is worth given all currently available information. Since estimating a company’s future performance is an inexact science, investors routinely reach different valuations when analyzing the same company. Each investor’s valuation could be equally justifiable depending on the investor’s opinions about the company and its future. In fact, stock analysts, whose job consists of recommending whether to buy, sell, or hold specific publicly-traded stocks, disagree all the time. Even though these publicly-traded stocks are valued by the market, some may believe that a company is “over-valued” or “under-valued,” which may bear out as future information and company results become available.

Differences in opinion about valuations stem from conflicting beliefs about companies’ future performance on key metrics which form the foundation for investor’s financial projections. Some of these metrics include revenue growth rates, profit margins, and financing costs, to name a few. Many industries also have additional metrics that offer insight into the operations of companies within those industries. For example, retail investors use the same-store sales metric¹ to adjust revenue for new store openings while SaaS² investors scrutinize monthly recurring revenue³ (MRR) to learn how much revenue is generated from long-term contracts. Early stage investors sometimes use unconventional valuation metrics such as monthly active user growth, especially when a monetization plan has not been developed yet.

Although valuation techniques typically focus on quantitative measures like earnings, revenues, and cash flows, qualitative factors also play an important role. Companies that do not have a strong management team or motivated employees usually fail to generate as much financial success as companies with such traits. Investors consider the company’s intangible qualities when forming financial projections; therefore, qualitative factors often have an indirect influence on a company’s valuation.

Startup Valuation Terminology

Learning some basic investing terminology will improve your ability to understand and discuss startup valuations.

‍Pre-money valuation –Value of the company before accepting additional outside financing (“money”)

‍Post-money valuation –Value of the company after accepting additional outside financing (“money”)

The following formula succinctly describes the relationship between the two valuation types.

When negotiating equity funding rounds, both the incoming investors and the management team should be clear about which term they are referring to. In most circumstances, investors and management will negotiate what the pre-money valuation should be. The new investor’s ownership percentage is then calculated based on this valuation.

In scenarios called “up rounds,” where the valuation increases compared to the prior round, existing investors experience an increase in the value of their shares. A “flat round” describes an equal valuation to the prior round. Similarly, a “down round” occurs when a round of funding values the company at an amount less than the preceding round. Effectively, a down round implies that the shareholders who entered the previous funding round have lost money on their investment in the interim period.

Early Stage v. Late Stage Valuations

The valuation process for early- and late-stage companies is very different due to the disparity in company maturity at each stage. Most early-stage startups have net losses, little to no revenue, and unpredictable future cash flows. These characteristics make it very difficult for investors to accurately forecast the company’s future financial performance. Many valuation techniques rely on assumptions that are not true for most startup companies.

How do venture capital firms come up with valuations for early-stage companies? Rather than focus on historical financial performance, early-stage investors focus on the potential of proposed products, the leadership team, and the size of the total addressable market⁴ (TAM). Despite decades of experience, even seasoned startup investors admit that the valuation process remains more of an art than a science. Early-stage investors use a variety of techniques to value startups, and select the best technique based on the startup’s development and the investor’s preferences.

When predicting how startups and markets will develop, investors consider the outcomes related to different sets of assumptions about the future. All valuations rely on assumptions about future performance, but early-stage startup investors must make significantly more assumptions than investors in companies with proven track records. Given the uncertainty of a startup’s future, investors adjust the valuation to reflect the probability of achieving the desired results.

Late-stage companies usually have a more established financial history which investors can use as a baseline to project the company’s future performance. Valuation in the context of late-stage companies relies less heavily on speculative assumptions about the company’s potential and focuses more on the company’s current growth trajectory. Late-stage valuations more closely resemble the valuation techniques used for public companies.

Valuation Techniques

When conducting a valuation, investors can choose from several well-established techniques. This section does not provide an in-depth discussion on how to conduct a valuation, but instead provides a conceptual foundation for valuation to enhance your understanding of equity financing.

The two most prominent valuation philosophies calculate a company’s worth based on either (1) its intrinsic value or (2) its market value. The intrinsic value philosophy aims to measure how much an asset (or company) is worth based on its underlying ability to generate cash flows. The market value philosophy measures how much another party is willing to pay for an asset, regardless of how much cash flow the company can generate. Although financial analysts use many different techniques under both the intrinsic value and market value philosophies, we introduce several common valuation techniques below:

1. Discounted Cash Flow Analysis (DCF) – Involves projecting free cash flows and adjusting the cash flows based on the time value of money and the investor’s desired rate of return (or discount rate).

A critical component of the DCF valuation is the concept of the time value of money. This financial theory encapsulates the idea that a dollar in your possession today is worth more than a dollar in your possession tomorrow. Inflation⁵ and opportunity costs⁶ are the two most prominent reasons why cash flows in the present are more valuable than future cash flows.

Investors apply the concept of the time value of money to their analysis through the creation of a discount rate, also known as the required rate of return or cost of capital. A discount rate is the rate at which future cash flows are converted into a current dollar value. The higher the discount rate, the less value future cash flows have when measured in today’s dollars and the lower the company’s valuation. From the perspective of investors, this rate represents the opportunity cost related to other investment options. From the perspective of the company, the rate represents the overall cost of financing its business operations.

In determining a discount rate, investors incorporate expected inflation levels and their mandatory return on the investment given the assumed risk. An investor with alternative investment opportunities that provide high returns will use a higher discount rate when performing a valuation than an investor without such opportunities. Thus, the discount rate should reflect the risk of attaining future cash flows in comparison to other investment opportunities. The selection of a discount rate has a significant impact on the results of a DCF analysis, and small changes to the discount rate can significantly alter the valuation.

        1. Comparable Company Analysis (CCA) - Compares the potential investee to a similar, publicly-traded company and calculates how the value would change based on the evaluated company’s financial performance. This approach uses financial metrics called valuation multiples that compare a measure of company value (i.e. stock price) to the company’s financial performance (i.e. earnings/profits). In mathematical terms, the multiple is a ratio where the value measure is in the numerator and the performance measure is in the denominator. The following are common multiples used in CCA:

        2. *EV: Enterprise value (EV): The entire economic value of a company, including debt. Enterprise value is calculated as the sum of the market value of equity, the market value of debt, and minority interest minus cash and cash equivalents.

        3. Precedent Transaction Analysis – Compares how much a buyer paid for a stake in a company with similar characteristics in the recent past to estimate how much the company should be worth after adjusting for any major differences.

        4. Venture Capital Method – Quantifies the value of early-stage companies by looking past their current high-growth, high-risk characteristics to a potential future where the company has matured enough for a financial exit⁷. Investors can then back into a valuation based off the anticipated exit value and their desired return on investment. To estimate the future exit value, investors first evaluate the size of the market opportunity by predicting the future size and growth rate of the startup’s TAM. Investors then apply a market share assumption to quantify how much revenue the company could realistically capture in the future. After developing a revenue estimate, investors use their industry knowledge to forecast the company’s future cost structure and profitability. Using an earnings multiple (like P/E), investors can calculate the expected future exit price. After calculating an expected exit price, investors divide the anticipated exit value by their desired return on investment (ROI) to arrive at a post-money valuation.

From this point, investors can calculate a pre-money valuation and adjust the pre-money valuation for any dilution from future funding rounds, as follows:

‍        5. Asset Method – Calculates the fair value of the company’s assets and subtracts off the company’s liabilities. Investors use this method in situations where the company has valuable intellectual property

        6. Buy v. Build Model – Compares the cost of developing another company’s technology internally as opposed to purchasing the company outright. This technique is commonly used by corporate acquirers who desire to quickly implement new technology, avoid royalty payments, or keep the technology away from competitors⁸.

Each of the techniques listed above provide insight into the value of a company, but each also has its limitations. For example, the DCF technique relies heavily on forecasting future financial performance, which can be very difficult to estimate. The CCA technique assumes that there are publicly-traded companies with operations very similar to the company being valued. This is not always the case, especially among startups with unique business models or innovations. Also, the precedent transaction technique depends on both the existence of prior transactions with similar businesses and the existence of information about those transactions in the public domain. Without a large sample size of recent, comparable transactions, the precedent transactions technique becomes less conclusive.

Since each technique has shortcomings, investors can be more confident in their analysis if multiple valuation approaches converge to a relatively small range of values. In practice, investors typically use multiple valuation techniques to approach a consensus valuation. Depending on the business and the available information, investors may feel more confident with the results of some analyses compared to others. In these situations, investors can give more weight to results that they feel more confident about.

Illustration of Different Valuation Techniques

To better understand valuation, consider a hypothetical scenario where an individual, Bob, wants to buy an outdoor sporting goods store called Heather’s Hiking with earnings of $200,000 last year. Bob is looking to acquire 100% of the company and will pay the entire amount in a single cash payment later today. Bob wants to know how much Heather’s Hiking is worth so he knows how much he should pay for the business. How should Bob go about valuing the store? Bob considers three widely-used late-stage techniques: discounted cash flow analysis, comparable company analysis, and precedent transaction analysis.

Discounted Cash Flow Analysis – Using the DCF technique, Bob projects how much cash he expects the outdoor sporting goods store to generate each year after projecting the store’s future revenues and costs for each year. Bob then adjusts each years’ projections back to what they would be worth in today’s dollars. Bob expects Heather’s Hiking to experience 20% revenue growth per year for the next five years due to the region’s rising population and the increasing popularity of outdoor activities. After that, Bob thinks the revenue growth will gradually slow down and eventually reach a sustainable plateau of 2% growth. With the help of some former classmates who are now investment professionals, Bob decides to use a discount rate of 18%. (This is a much higher discount rate than the 4-8% range associated with large, stable public companies, but much less than the 40-100% range for very small businesses. , ) After many hours of gathering data, building an Excel financial model, and fine-tuning his assumptions, Bob arrives at a valuation of $4.75 million⁹.

Comparable Company Analysis — To get a different perspective on the store’s valuation, Bob decides to use information about publicly-traded companies in the form of a comparable company analysis. He carefully identifies three publicly-traded sporting goods companies with business operations similar to the local store: VF Corp. (owner of North Face and Timberland brands), Columbia Sportswear, and Rocky Brands, Inc. After researching each comparable company’s financial information, Bob calculates a P/E multiple to see how the market prices each stock.

Since Bob believes that the business operations of the store closely resemble those of the publicly-held companies’ business operations, the market should theoretically value the companies equally for the same level of performance. As a result, Bob multiplies the Heather’s Hiking store’s earnings by the average publicly-held company’s P/E ratio to discover the outdoor sporting goods store’s implied market value.

Precedent Transaction Analysis — As a third and final analysis, Bob researches local records to find outdoor sporting goods companies that have been purchased in the area during the past few years. After analyzing several of these transactions, he finds two transactions of outdoor gear retail businesses with revenues similar to Heather’s Hiking¹¹.

Although these two companies are similar to the store that Bob wants to buy, several differences exist. Sally’s Sporting Goods is a high-end outdoors equipment store with profit margins higher than those of Bob’s future store. Cal’s Camping was a smaller store in need of extensive remodeling at the time of acquisition. Due to these differences, Bob decides to adjust the transaction prices to better reflect the value of the business that he will be purchasing.

Completing the Valuation—After completing the three valuation techniques, Bob realizes that each produces a different value. Instead of a fixed result, he has a range of possible valuations between $4.75 million and $6 million. Since each technique uses different assumptions, disparity in the results is expected. Bob can take comfort in the relatively tight range of values and use these results as evidence that the true value of the store is probably somewhere within that range. Since Bob feels most confident in the assumptions used in the DCF analysis, he decides to place the initial offer at $5 million, closer to the low-end of the spectrum. He can now enter negotiations with the current owner better informed about what constitutes a “fair” price for the store.

Why Valuations During Financing Activities are Important for Founders

Valuations are routinely the focal point of negotiations between founders and investors when raising equity financing. Nearly all the financial elements of an equity financing agreement revolve around the company’s proposed valuation. Incoming investors have a strong incentive to push for a low valuation, allowing them to capture a higher ownership percentage for the same amount of invested capital. Conversely, previous investors and entrepreneurs have an incentive to negotiate a high valuation, making their current holdings more valuable. A basic understanding of valuation will help you as a founder to negotiate a higher purchase price with VCs and recognize when an unrealistically low valuation is proposed.

If you do not have a basic understanding of the concepts and process of valuing a company, you will not be able to challenge investor’s proposals and assumptions. All valuations are based on a set of assumptions that may or may not reflect a company’s actual future. If you can convince investors that the assumptions behind a valuation are wrong and convincingly replace the initial assumptions with a more favorable set of assumptions, then you can increase the valuation of your company.

If you and your team have gone through the process of creating your own financial model to value your company, you will be better prepared to negotiate a fair valuation for your startup. Creating a financial model forces you to make well-reasoned assumptions that you can then use as alternatives to the investor’s beliefs. By negotiating a higher valuation, you can raise the same amount of money while giving up less ownership to the incoming investors. In startup financing parlance, you can prevent dilution by negotiating a higher valuation. (For more on dilution, see our Dilution and Stock Option Pools article.)

By remembering the fluid, inexact nature of valuations and the market-based investing philosophy, some highly-sought after companies can negotiate very large valuations. For example, when a company is seeking an exit via acquisition, the “valuation” is simply the highest amount that any of the bidders are willing to pay for the company. For a company with strategic value, the valuation can increase well beyond what a traditional valuation analysis would suggest. A great example of this phenomenon occurred when Facebook outbid other tech-sector rivals to purchase Instagram for $1 billion, even though Instagram had not yet generated a single dollar of revenue.

Valuation in one equity round also influences a company’s ability to raise additional capital in the future. When a company goes through a down round, the company’s image can be permanently tarnished. Previous investors become worried about the safety of their investment and may become more reluctant to provide additional capital to the company. The fact that the company was willing to accept financing that required a “devaluation” of the company indicates desperation for capital and may scare off other investors. Even if the company can negotiate a new funding agreement, the investors may demand special accommodations that better protect their investment by including liquidation preferences¹² in the terms of the preferred stock arrangement or using convertible debt instead of equity. Also, company morale may slump and employee turnover increase as workers grow concerned about the direction of the company and the value of their stock options.

Conclusion

Although valuation can be a complex and difficult topic, the concepts presented in this article are essential for understanding any equity financing arrangement. Learning about different valuation techniques and philosophies can help you become a better negotiator when raising outside investment. This knowledge can give you confidence that your startup has received a fair valuation, which will allow your company to grow without unnecessarily diminishing your ownership percentage.

Resources Consulted

• Forbes article: “The Art of Valuing a Startup”
• Bill Payne’s Blog (Angel Investor)
• NYU Cost of Capital by Sector
• Business Valuation Resources
• TechCrunch article on Instagram purchase
• The Entrepreneurial Bible to Venture Capital by Andrew Romans
• Term Sheets and Valuations by Alex Wilmerding