# How to Value a Startup

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How to Value a Startup

In this lesson, you’ll learn the different criteria for startup valuation and models that you can use to help in determining your valuation.

If you ask an entrepreneur, business angel or venture capitalist how they value startups, they will probably tell you that startup valuation is an art more than a science. There is no single “right” way to value a startup. Nevertheless, unless the startup manages to bootstrap entirely from early clients, the CEO will likely have to deal with a valuation exercise when raising equity capital from investors.

post-money valuation = pre-money valuation + capital amount raised

The pre-money valuation means what the company is worth before raising capital.
The post-money valuation means what the company is worth after raising capital.
Generating value for the investor
Now that you’ve understood the pre-money and post-money concepts, you understand that a startup generates value for the investor if, between 2 capital rounds (n) and (n+1), we have:post-money-valuation(n) < pre-money-valuation(n+1)

If a startup raises a second round of capital with a pre-money valuation equal to the first round’s post-money valuation, that means that the startup has not been able to generate any value between the two rounds.
Dilution
When you raise equity from investors, all the previous investors (including the CEO) are “diluted”, meaning that their company ownership goes down.
Example:
If you own 20% of a startup valued at \$2 million, your stake is worth \$400,000. If you raise a new round of venture capital (say \$2.5 million at a \$7.5 million pre-money valuation, which is a \$10 million post-money) you get diluted by 25% (2.5m / 10m). So you own 15% of the new company but that 15% is now worth \$1.5 million or a gain of \$1.1 million.That means basically that the “cake” becomes bigger and your relative “piece of cake” becomes smaller, so that new “cake eaters” can join.25

We said earlier that there is no single right way to value a startup. Ultimately, the business is worth whatever investors think it’s worth, based on the criteria they set forth. Like every company valuation, there are objective and subjective parameters that impact your company’s valuation:
1. Company assets: cash in bank, equipment, inventory
2. Stage of the company: idea, business plan done, working prototype, generating revenue
3. Industry sector: FinTech (Finance Technology), EdTech (Education Technology), AgTech (Agriculture Technology), IoT (Internet of Things), InsuranceTech, AutoTech, SmartCity, RetailTech, Digital Health, AI (Artificial Intelligence), FoodTech…
– Over the past year, FinTech has been the sector of choice for many investors.
4. Fame/previous success of one of the co-founders: more credibility for investors
5. Famous mentors (general managers)
6. How big the customer pain you’re solving is
7. What are your current revenues/profit
8. Market size
9. Your market growth rate
10. Level of competition in your market
11. How well your marketing and go-to-market plan is elaborated
12. Financial forecasts
13. Strategic partnerships
14. The intellectual property you have: any patent?
15. Level of entrepreneurial experience of the team
16. Level of expertise in your market
17. How much time you have dedicated so far
18. How much money you’ve invested in your own venture
19. The barriers to entry for your competitors
20. Valuation of other startups in your industry at a similar stage of development
21. Your exit scenarios
The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money. Specifically, the current value is dictated by the market forces in play TODAY and TODAY’S perception of what the future will bring.
An investor is willing to pay more for your company if:
– It is in a hot sector: investors that come late into a sector may also be willing to pay more as one sees in public stock markets of later entrants into a hot stock.
– If your management team is hot: serial entrepreneurs can command a better valuation. A good team gives investors faith that you can execute.
– You have a functioning product (more for early stage companies) and traction: nothing shows value like customers telling the investor you have value.
An investor is less likely to pay a premium over the average for your company (or may even pass on the investment) if:
– It is in a sector that has shown poor performance.
– It is in a sector that is highly commoditized, with little margins to be made.
– It is in a sector that has a large set of competitors and with little differentiation between them (picking a winner is hard in this case).
– Your management team has no track record and/or may be missing key people for you to execute the plan (and you have no one lined up).
– Your product is not working and/or you have no customer validation.
– You are going to shortly run out of cash (the investor has much more power to negotiate a low pre-money level in this case)
Models for valuing a startup can be qualitative, quantitative or most commonly, a mix of both (qualitative with some quantitative elements). A non-exhaustive list is:

– The Discounted Cash Flow (DCF) model
– Market and Transaction Comparables
– The First Chicago Method
– Asset-based valuation techniques such as Book Value or Liquidation Value
– The Venture Capital Method

The DCF Method (1/4)
The value of one euro today is not comparable to the same euro in a future period.  This is what we call “Time value of Money”. The Discounted Cash Flow (DCF) model is one of the most widely used in the valuation of companies in general.
he DCF Method (2/4)
If you have to make an investment (of any kind), a metric that you should know is called IRR (Internal Rate of Return). The Internal Rate of Return is a discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero. Calculating the IRR of a project means solving for r=IRR in the following equation, with NPV=0.
The DCF Method (3/4)
1. The investor will first estimate his own future cash flows Ct (how much money he will get if your company gets sold or starts paying dividends at some point).

2. The investor wants to invest an amount C0 in your company.

3. The investor will calculate the IRR for investing in your project and choose your startup if, from all the startup candidates, yours has the highest IRR.

The DCF Method (4/4)
But things often work this way: Imagine you’re offering 15% equity to an investor who believes in your project and wants to invest an unknown amount of money C0. The investor will make an estimate of his future cash flows Ct. The million-dollar question is now: how to estimate your startup’s IRR in order to compute what his 15% stake C0 is worth ?

IRR is a discount rate that includes:
– the risk-free rate that comes from the time value of money. In the US, the risk free rate is usually determined from Treasury Bonds. In Europe, from the German Bonds. Those are considered 100% sure or “risk-free”: future cash flows are certain.
– a risk component from investing in your business that can go bankrupt at some point.

It’s quite common to use IRR=30% to value a startup. Want to know why?
Read the great blog post of Jerry Yang in the further readings section of this course!

Valuing Uncertainties
For almost all other types of investments, uncertainty about their effective realization leads to higher discount rates. Why is that? Because the implied risk needs to be accounted for, that is, priced, in the value an investor would be willing to pay for that kind of investment today. Investors on average avoid or minimize risk. Suppose you can pay 95€ now and you will receive 100€ in two years with certainty, or that you can pay 95€ and receive 100€ in two years but with uncertainty. To encourage people to invest, the final outcome should be higher than 100€ or, conversely, the price paid lower than 95€. This is exactly the principle of the discounted cash flows under uncertainty.
Market and Transaction Comparables
Comparable Transactions is one of the conventional methods to value a company for sale. The main approach of the method is to look at similar or comparable transactions where the acquisition target has a similar business model and similar client base to the company being evaluated. This approach is fundamentally different from that of DCF valuation method, which calculates intrinsic value.
First Chicago Method
The First Chicago Method or Venture Capital Method is a context-specific business valuation approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow (DCF) valuation approach.

This method takes account of payouts to the holder of specific investments in a company through the holding period under various scenarios, usually:

– An “upside case” or “best-case scenario” (often, the business plan submitted)
– A “base case”
– A “downside” or “worst-case scenario.”

Once these have been constructed, the valuation proceeds as follows:
1. For each of the three cases, a scenario-specific, internally consistent forecast of cash flows is constructed for the years leading up to the assumed divestment by the investor.

2. A “divestment price” (terminal value) is modeled by assuming an exit multiple consistent with the scenario in question. (Of course, the divestment may take various forms)

3. The cash flows and exit price are then discounted using the investor’s required return, and the sum of these is the value of the business under the scenario in question.

4. Finally, each of the three scenario-values are multiplied through by a probability corresponding to each scenario (as estimated by the investor).
The value of the investment is then the probability weighted sum of the three scenarios.

Asset-based Valuations
The Book Value or the Liquidation Value are other ways to value a company. We won’t enter into details here but we invite those of you who want to know more to read additional material (link provided in further readings).
The Venture Capital Method
The Venture Capital Method (VC Method) was first described by Professor Bill Sahlman at Harvard Business School in 1987 in a case study and has been revised since. It is one of the most useful methods for establishing the pre-money valuation of pre-revenue startup ventures. The concept is simple. Let’s suppose that there is only one investment round, no subsequent investment and therefore no dilution:

Since
Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation

Then
Post-money Valuation = Terminal Value ÷ Anticipated ROI

Terminal Value is the anticipated selling price (or investor harvest value) for the company at some point down the road; let’s assume 5-8 years after investment. The selling price can be estimated by establishing a reasonable expectation for revenues in the year of the sale and based on those revenues, estimating earnings in the year of the sale from industry-specific statistics. For example, a software company with revenues of \$20 million in the harvest year might be expected to have after-tax earnings of 15%, or \$3 million. Using available industry specific Price/Earnings ratios, we can then determine the Terminal Value (a 15X P/E ratio for our software company would give us an estimated Terminal Value of \$45 million). It is also known that software companies often sell for two times revenues, in this case, then, a Terminal Value of \$40 million. OK…let’s split the difference. In this example, our Terminal Value is \$42.5 million.

Anticipated ROI: Angel investing is risky business. Based on the Wiltbank Study, investors should expect a 27% IRR in six years. Most angels understand that half of new ventures fail and the best an investor can expect from nine of ten investments is return of capital for a portfolio of ten. Consequently, the tenth investment must be a home run of 20X or more. Since investors do not know which of the ten will be the homerun, all investments must demonstrate the possibility of a 10X-30X return. Let’s assume 20X for purposes of this example.

Assuming our software entrepreneurs needs \$500,000 to achieve positive cash flow and will grow organically thereafter, here’s how we calculate the Pre-money Valuation of this transaction:

From above: Post-money Valuation = Terminal Value ÷ Anticipated ROI = \$42.5 million ÷ 20X
Post-money Valuation = \$ 2.125 million
Pre-money Valuation = Post-money Valuation – Investment = \$2.125 – \$0.5 million
Pre-money Valuation = \$1.625 million

The Berkus Method
Dave Berkus is a founding member of the Tech Coast Angels in Southern California, a lecturer and educator. He has invested in more than 70 startup ventures. Berkus valuation model first appeared in a book published by Harvard Business School’s professor Howard Stevenson in the 90s.

The Berkus Method is a simple and convenient rule of thumb to estimate the value of your startup. First, you have to know how much a similar startup is worth. Then assess how you perform in the 5 key criteria. Note that these numbers are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to \$2 million (or a post rollout value of up to \$2.5 million).

The Risk Factor Summation (RFS) Method
This method has a broader set of important criteria than the Berkus Method. It forces entrepreneurs and investors to take more factors into account and helps avoiding neglecting a criteria.

The 12 factors are:
1. Management
3. Legislation/political risk
4. Manufacturing risk
5. Sales and marketing risk
6. Funding/capital raising risk
7. Competition risk
8. Technology risk
9. Litigation risk
10. International risk
11. Reputation risk
12. Potential lucrative exit

Each risk (above) is assessed, as follows:
+2   very positive
+1   positive
0     neutral
-1    negative
-2   very negative

The average pre-money valuation of pre-revenue companies in your region is then adjusted positively by \$250,000 for every +1 (+\$500K for a +2) and negatively by \$250,000 for every -1 (-\$500K for a -2)

The Scorecard Valuation Method (or Bill Payne Method)
Here’s how to calculate a pre-money valuation using the Scorecard Method:

1. Gather valuations for other pre-revenue companies in your sector within your geographic region. Then, calculate the average of those valuations.

2.  Compare your venture to similar deals done in your area using the following value drivers:
– Strength of the Management Team
– Size of the Opportunity
– Product/Technology
– Competitive Environment
– Marketing/Sales Channels/Partnerships