Startups: Please Don’t Get Hung Up on Valuation
By Lior Ronen (@Lior_Ronen) | Founder, Finro Financial Consulting
In previous posts, I covered two important aspects of tech startups: seeking feedback and keeping the financial model simple. There’s something else that comes up often, too often, I think. Founders and investors tend to spend too much time fretting about valuation.
There’s no set formula for placing a value on a company. Every company and every situation is different. On top of that, entrepreneurs and investors approach valuation differently.
When entrepreneurs approach me they’ve usually done homework online, and have a valuation model in their minds based on comparable companies, or they have theories about valuation.
When investors approach me they have a good sense of what they’re looking for based on their prior experience. They rely on me to apply the right methods for the company and situation.
How do you marry those two approaches? Here’s how I look at it.
First, I’ll discuss briefly the seven primary valuation and allocation methods that are relevant here. There are other methods and general rules for specific niches or business types but they won’t be covered in this article.
There are two general types of valuation methods:
· Total equity valuation is used to estimate the entire value of the business.
· Equity allocation further estimates the impact of potential deals on different stock class.
Equity allocation methods consider the various terms of stockholder agreements, which include the level of seniority among the securities, dividend policy, conversion ratios, and cash allocations—that can impact the distributions to each class of equity upon a liquidity event.
The total equity valuation group includes four primary methods:
1. Discounted Cash Flow (DCF): An income approach method which involves estimating the future cash ﬂows of the subject company and discounting them to their present value.
2. Guideline Public Company (GPC), also known as ‘Multiples’ method: A market approach method which involves analyzing publicly traded (and in some cases - privately held) companies similar to the subject company and calculating the relevant multiples (usually revenues and EBITDA). Then we apply to the subject company's historical or forecasted financials.
3. Guideline Merged and Acquired Company (GMAC), also known as the Transactions method: A market approach method which involves analyzing previous transaction prices and terms in the subject company's niche, market or similar companies, calculating relevant multiples, and then applying theses multiples to the subject company's historical or forecasted financials.
4. Net Asset Value (NAV): An asset approach which defines an enterprise's fair market value as the total of the enterprise's assets, minus the total of the corresponding liabilities.
The equity allocation group includes 3 primary methods:
1. Current Value Method (CVM), also known as the ‘Waterfall’ model: An allocation methodology that assumes an immediate sale or liquidation of the company and allocating the current company's value to the different equity classes of stockholders.
2. Probability-Weighted Expected Return Method (PWERM), also known as the VC Method: An allocation methodology that combines CVM and future potential exit scenarios. Share value is based on the probability-weighted present value of expected future investment returns, which considers each of the possible future outcomes available to the enterprise as well as the rights of each share class.
3. Option Pricing Method (OPM): An allocation methodology that treats common stock and preferred stock as call options on the enterprise’s equity value, basing exercise prices on the liquidation preferences of the preferred stock.
After we lay down the ground for the discussion and decide the method that we’ll refer to, we can start answering the questions below.
Question 1: What is the purpose of the valuation?
There are various reasons to valuate a startup, including: to issue stock options, craft a term sheet, regulatory and tax purposes, competitive analysis, deal analysis, due diligence and many more. If the situation requires an overall valuation of the company, usually the first four methods in the table above would be appropriate. If the situation requires a specific valuation of certain stock classes, or if it requires to consider different stockholder terms such as liquidation preferences, floor price guarantees, conversion, and dividend policies, etc. the bottom three methods will apply.
Question 2: Has the company raised funds yet?
This is an important piece of the puzzle that’s sometimes overlooked by founders seeking to raise the seed round. If the company doesn’t have a cap table or if the founders hold 100% of the shares with no specific terms or special clauses, there’s no added value in using any of the equity allocation methods. Rather, one or more of the total equity valuation methods should be used to valuate the business and divide this number by the number of shares for the share price, if it’s needed.
Question 3: Is there available information about the competitors’ valuation and financial performance?
Financial information of comparable publicly traded or privately held companies is needed to develop a robust valuation based on the multiples and transactions method. However, the comparable data is also needed for a few aspects of the WACC calculation (discount rate) that lays in the basis of the DCF method. In the rare case that we can’t find market data to use from comparable companies, industry averages, or trusted market reports, we rely on Finro assumptions based on previous cases and experience in the specific market or niche.
Question 4: Do you have the cap table of the company?
This is relevant mostly for investors that buy shares on the secondary markets and might not always have the full financial package of the company. Holding the target company’s cap table is fundamentally important to valuate the company based on the OPM or PWERM methods. If there’s no cap table available but the company has already raised multiple rounds and the situation requires a valuation we build an estimated cap table based on our proprietary assumptions and analysis.
It’s important to remember that every company and situation is different, and there are many methods and approaches to valuating a company. Founders might believe that it’s a simple process because they heard a start-up ‘valuation story’ from a friend of colleague, or they read it in the media.