Any attempt to value a startup company will likely involve both art and science. Quite honestly, the valuation method will likely involve (far) more art than science.
The reason for this “artistic” bias in startup valuation methods is pretty simple: by definition, startup companies—being new and, well, “startups”—lack both the reliable past performance as well as the predictable future performance required to employ any of the more grounded valuation methods over which the financial community has come to agreement. In fact, those of you reading this Note who can actually do real financial math will most likely characterize the methods described below as “voodoo.” Welcome to startup valuations!
In this Note, we will describe seven approaches to startup valuation that are common and one that is less common, but nevertheless employed: Comparables, Conformity, (Venture) Capital Method, Construction, Combination, Competitive Loss, and Cash Flows.
The Comparables method for startup valuation relies upon exactly what the title implies: comparables. A comparable is simply “a person or thing that can be likened to another” (thank you, Oxford English Dictionary).
Valuation by comparables is built upon an instinct that is core to the human experience: social comparison. We naturally compare ourselves to others—whether we are taller, smarter, faster, hipper, etc.—and simply found a way to transpose this instinct to the world of valuing things other than ourselves.
The most well-known domain within which the comparables method is employed would be real estate. In fact, the real estate industry will even use the word “comparables” without shame.
Example: Two homes, A and B, are set next to each other, both being mid-century ranch homes, in similar condition, with three bedrooms and two (full) bathrooms. Both homes are built with brick exteriors, and both are on 1/4 acre of property. House A recently sold for $375,000. And so, it seems reasonable that House B should be worth approximately $375,000 as well. Similarly, startups have been valued according to the actual or implied valuations of other, similar startups. In fact, these methods get even more interesting as various ratios and/or multiples may be used to account for what may not be completely similar, or “likened,” between two ventures.
For example, if Startup X is acquired for $15,000,000, and the website had 500,000 active users, that price may be transposed to some ratio between the dollar price and the number of users. As a result, the conclusion may be that the acquisition price of Startup X implied an underlying multiple of $30/user. Startup B, with 250,000 users, may then try to use this multiple to argue for a valuation approaching $7,500,000 (which is equal to 250,000 multiplied by $30).
Conformity is a completely different species of startup valuation. This approach to valuation has little to do with attributes of the company and just about everything to do with the preferences, if not simply the habits, of the investor—and whether the terms of the deal “conform” to these preferences and/or habits.
Valuations based upon conformity sound like this:
“We like to invest between $100,000 and $250,000 in a startup and own about 10% of the outstanding equity.”
What goes unstated in this method is that the investor is only looking for ventures that he/she believes could be a breakout success (i.e., worth hundreds of millions if not billions of dollars). And yet, they prefer to invest at a moment in time that some number between $100,000 and $250,000 might acquire roughly 10% of the equity in the venture.
Sounds crazy? Let’s look at the valuation approach applied by Y-Combinator (YC), one of the most successful, seed-stage accelerators and investors of the past decade:
We have a new standard deal at YC—we’ll invest $120k for 7%. While we may deviate from this in exceptional cases, it will still be the case for almost all of the companies we fund.
This [standard deal] replaces our previous standard deal of on average $17k for 7%, plus a safe that converted at the terms of the next money raised for another $80k.
Simply stated, an investment of $120,000 for 7% of the venture (post-money) results in an implied valuation of $1,714,285.71 (or, $120,000 is 7% of what number?) of that venture. Not to mention, that valuation is nearly seven-times that implied by YC’s previous terms (i.e., $17,000 for 7%)!
Quite honestly, it is highly unlikely that anyone at Y-Combinator spent hours laboring over a financial model the results of which suggested the present value of the venture being considered was $1,714,285.71.
Instead, these terms are simply those with which YC is comfortable. Any founders who agree to these terms are simply happy to join YC, and to receive the $120,000 investment (and terms) in exchange for that opportunity.
What has become known as the Venture Capital Method involves a combination of the Comparable, Conformity, and Cashflow (described later) approaches to startup valuation. This approach to valuation may also be known as “deal algebra” or, for those old enough to remember, the First Chicago Method.
The Venture Capital Method essentially takes some exit valuation for a venture—usually based upon comparables—and then works backwards from that exit, taking into account various rounds of funding as well as the desired return on investment for the investor, towards a valuation in the present round (i.e., now under consideration) that would conform to the investor’s preferences.
Another way of thinking of the above, from the mind of the investor, would be:
“If the company is sold ten years from now for $50,000,000, and we face the dilution resulting from five rounds of funding between now and then, and we like to see an annualized rate of return of at least 50% (or some multiple of the dollars invested), then we can commit no greater than $Y in this round in exchange for Z% of the company, post-money.”
Since the Venture Capital Method is widely adopted, there will be an additional teaching note to provide some insight and experience with this approach to valuation.
Methods for startup valuation based upon cashflow treat the opportunity to own the company as similar to the opportunity to own any investment vehicle, whether a stock, bond, real estate, etc. The dollars remaining after a venture earns all of its revenue and pays all of its expenses (including taxes) each year are treated as a flow of cash—a stream of dollars that could head straight into the owner’s pockets each year.
Since there are all sorts of investment opportunities that involve an initial purchase, followed by a subsequent flow of cash each year (or other period), ending with some final value of the entity that was initially purchased (the so-called “terminal value), valuation methods based upon cash flow are common.
Furthermore, once the premise of the time value of money is established—the idea that the dollars we receive years from now are “worth less” than dollars we receive today—the valuation method accounts for discounting these future cashflows according to this time value. Hence, what is widely known as the discounted cash flow (or, DCF) approach to valuation.
The DCF approach faces one challenge when applied to early-stage startups, however: these ventures often lack both a history of cash flows, as well as some reliable future for such cashflow. Not to mention, these startups are usually losing money, rather than producing profits. As a result, the DCF approach would actually conclude that the startup needs to pay the investor/buyer to acquire the company, rather than the other way around.
Given the above-described reliability challenge, when the DCF approach is employed around startups this employment almost always involves the story of some imagined, financial future for the venture—after the venture grows up from a startup to a company. Accordingly, these hypothetical, future cashflows are then discounted back to the present in the effort to construct some version of a valuation.
Perhaps the most straightfoward approaches to valuations are those based upon construction; specifically, either the deconstruction or the reconstruction of the venture itself.
Methods based upon the [de]Construction of the venture are most often associated with the raw liquidation of the venture, usually due to bankruptcy (alternatively known as insolvency). In this approach, the venture is nothing more than the sum of its most sellable parts, and these parts may simply amount to nothing more than the furniture, some computers, and the art on the walls.
Valuation methods based upon the [re]Construction of the venture are most commonly known as the “build it or buy it” approach to valuation. In this approach, some core asset of the venture is believed to be of value, and that valuation is simply no greater than what it would cost to replicate (i.e., re-build or re-construct) that asset.
For example, if some core asset of the venture were simply an information database (say, of addresses), and it would take approximately 1000 hours of human labor to reproduce that database, then the value of this asset may likely be no greater than the cost of the 1000 hours of human labor required to create a similar database.
Valuations based upon the combination of things can seem to be the most basic, as well as the more nuanced approaches to the valuation of a venture.
The more basic form of combination, sometimes known as the Berkus Method, simply stacks up the perceived value of various dimensions of the startup to arrive at some present value of that startup. One great thing about the Berkus Method is that you can read what Berkus has to say about this method, in his own words, right here.
The more nuanced form of the combination approach involves asking (and answering) the question, “What else might be possible if we, rather than someone else, owned this venture?” As a result, the startup now has two implicit valuations: one, were it to remain an independent entity; the other, were it to be acquired and gain the benefits of that acquisition.
For example, imagine some startup that has invented a better way of targeting advertising alongside search results, resulting in higher revenue for any search entity that also serves ads online. If this startup goes about the challenge of developing its own search audience, and building an advertising sales team, the value of this venture given the prospects of survival might be quite low.
However, the value of this startup—specifically, the invention developed by the startup—to a major search company could be much higher. These mature companies, already serving a large audience, and supported by well-developed sales teams, could quickly benefit from this targeting improvement. And, perhaps most importantly, that benefit could be measured as a direct increase in revenue, which leads to the inputs for cashflow-based valuation.
The flipside of the combination approach to valuation is that of competitive loss. This approach asks the opposite question: “What might happen if someone else, rather than we, owned this venture?” Essentially, the competitive loss approaches is based upon the negative, financial consequences that could result from a competitor gaining the benefits from the acquisition of some venture.
A simple example here could be that of a gas station located across the street from a convenience store. The convenience story is for sale, and it is learned that the land includes the option to add a gas station to the store. The owner of the gas station has a decision to make. If some other entity acquires the convenience store, an ongoing price war at that corner could emerge—the result likely negatively impacting the financial prospects of the first gas station. Were the owner of that station to acquire its neighbor, however, then the owner “controls” the corner—the result likely positively impacting the prospects of both the convenience store and the gas station.
As a result, the value of the convenience store—at least for the owner of the gas station—could also take into account its possible, negative impact upon the financial standing of the gas station.