How to Value a Startup

How to Value a Startup

How to value a startup? Whether your business venture is post-revenue or is at the exciting business idea stage, business valuation is never cut and dry. When we speak to early-stage founders often they find it difficult to determine a reasonable startup value at the pre-seed, seed, or even Series A round. Experienced founders know how to judge if a pre-money valuation offer they receive is “fair and reasonable” –they know not to get hung up on startup valuations.

When it comes to fundraising and exiting, valuation is a factor, but it isn't the most important one. For mature businesses that have steady revenues, there are specific facts and figures we can use to determine a value. For startups with little or no revenue and an uncertain future, applying a valuation is particularly tricky.

Most founders find the fundraising process and pitching to potential investors challenging. VC firms see thousands of deals and get price signals across all of these deals heightening their sense of how particular deals are being perceived by the market. As a startup founder, it can feel like “playing blind” at the table, you're dealing with VCs who essentially have “asymmetric information” on market valuation.

In this article, I'll talk about challenges with how to value a startup whilst focusing on the VC multiples valuation for post-revenue startups.

Startup Valuation

Valuing a startup tends to be an emotional process, this is why businesses such as 7startup exist - an unbiased party that grounds founders' expectations on a fair reasonable valuation. The initial post-money valuation needs to be attractive to early-stage investors and be in line with expected startup growth and profitability to ensure future rounds are priced on an upward trajectory. A scaleup needs to use its valuation as collateral to influence and acquire the best talent, recruiting advisors, getting PR, and attracting future investors. The valuation can even sway future customers and how much they are prepared to pay for your product or services.

I think most and VC investors use valuation methods and relevant valuation statistics to be fair to the management team and business model. However, venture capitalists must de-risk the acquisition by avoiding paying a very high premium on the purchase

Venture Capital Term Sheet Negotiation

When negotiating with VCs, as an entrepreneur you need to understand the VC firm's philosophy on price and VC term sheets. Understanding approaches to valuation is key, whether its revenue growth, future market share, future cash flows, growth rate, stage of development, and other key factors. 

Professional investors, whether an angel investor or a VC, use common startup valuation methods assessing the business plan and future potential to calculate the potential return on investment. Most are flexible on the price but will introduce other terms to essentially influence the effective price:

  • Participating preferred
  • The size of the option pool
  • Anti-dilution provisions Etc

 Other VCs may be more flexible on other terms but have a clear agreement on price. Of course, the most efficient way to negotiate price and startup equity is to have a competing offer. Multiple offers from VCs are the clearest signal of your valuation. The more term sheets you have, the more pressure you're able to able to place on interested VCs.

Revenue Multiple Valuation Startup

VCs have limited capital and try to make concentrated investments across scaleups where they have the highest conviction. VCs use multiples for estimating valuations, a de facto due to the complexity involving tech startups and scaleups. In a nutshell, using multiples, a business is worth the present value of its future free cash flows. As it's vastly difficult to accurately forecast the size, timing, and risk of cash flow over many years., investors have turned to revenue valuation multiples for startups as a substitute for determining what a company is worth

How to Value a Startup
How to Value a Startup.

How to Value a Startup

In public markets, often multiples are earnings multiples of EBITDA multiples:

  • Earning Multiples Formula: price per share/earnings per share
  • EBITDA Multiples: enterprise value / EBITDA

VCs tend to use:

Revenue Multiples Formula: Enterprise value/ revenue

Fast-growth tech companies during Series A or B rounds are generally either unprofitable or considered to have “underdeveloped margins” that can’t be relied on to judge future profitability. A revenue multiple could therefore be viewed as a shorthand for an EBITDA multiple; for example:

  1. A scaleup expected to have 40% long-term EBITDA margins may well be valued at 25x EBITDA at scale;
  2. 25x EBITDA is equal to 10x revenue
  3. 25x EBITDA multiple * 40% EBITDA margin

Multiples are used to determine the value of a business today as well as the value companies some years down the line. Investors seek to avoid a higher multiple compared to what they might pay upon exit. Therefore, assuming a normalised exit multiple of 10x forward revenue, a smart investor would not wish to pay more than that today.

In a discounted cash flow analysis, VCs would model cash flows for an interim period, somewhere between 5 and 10 years. Then can apply a multiple at the end of the forecast period to assess the terminal value (i.e., cash flows beyond that forecast period).

Let’s take an example of a tech software businesses where growth are expected to be asymmetrical  compared to a “normal” mature company

  • Revenues: bottoms-up $60M revenue
  • Raising at a $4B valuation
  • A staggering 67x revenue
  • Company growth expectations are 200% to $180M in revenue in 2021,and 122% to $400M in 2022

The entry multiple could be viewed as 22x projected 2021 revenue or 10x 2022 revenue.

Startup Fundraising Consultants.
Startup Fundraising Consultants.

Conclusion

I suggest that founders compare their startup with similar businesses that have recently raised, benchmarking the competitive landscape including the team size, partnerships, clients, growth rates, and IP. Founders tend to get obsessed with how startups are valued but you need to be mindful that investors typically set the cap or price, not you.

Of course, we understand the significance of a fair value as it affects:

  • how much dilution you take
  • how much ownership you give to VC investors
  • how strong you think your company is
  • what signal you want to send to the market

Any good entrepreneur will say their ultimate goal is to create value and fair market value is a crucial part of their leadership role. Overprice and the round it won’t close, under price and you sold more than you needed to.

The more investor interest you can generate, the better deal and terms you’ll get. At 7startup we help startups and founders navigate these challenges. Get in touch for a chat.

Amit Khanna - 7 startup Advisory
Amit Khanna, Founder, 7startup

Amit Khanna is the founder of 7startup.vc and has 19 years of experience with Startups and the Enterprise, holds an MBA, focusing on Growth and Investments. Amit supports entrepreneurs with every aspect of their business including concept and product development, investor presentations, fundraising, and scaling up.

You may also like this Blog: How to get Seed Funding for a Startup