Viewpoint






2021-12-16

START-UP AND EARLY STAGE VALUATIONS

The process of valuing companies - equating a $-figure on a business - differs greatly between a startup and an established company.


For an established company with some years of history, whether it's a public or privately owned company, there are financial figures and established valuation models to calculate the value of the business. Revenue, profit margins, cashflows, equity to debt levels, and so on can all be input for different valuation models such as Discounted Cash Flow (DCF), Price-Earnings Ratio, etc. But when it comes to Startups and early-stage companies, there are in many cases few figures, if any, that can be relied on for traditional valuation models. So how do you place a $-value on an early-stage company?


First, let us take a step back and understand the reasons for valuing an early-stage company. If a Founder of a new business can finance his or her startup business by themselves - transforming ideas into products that sell - then the issue of valuing that specific company is less of a concern. But if a Founder needs investment capital to build a prototype or turn the prototype into a sellable product, the $-value of the business become important. Important because the Investor and the Founder need to agree that X-amount of investment capital equals Y-percent of ownership in the company. Should $100,000 in investment give 1% ownership in the business, or perhaps 10%, or 50%? The %-figure depends on the value of the company. This is why Startup and early-stage valuations matter.


Ideally, Venture Capital is invested as early as possible in a new business, at its very earliest development stage, where a small amount of capital gives the Investor a significant ownership share. Furthermore, ideally also in a business that grows fast, disrupts established industries, and takes a leadership role in new markets which it creates with its unique solutions and technologies. But in this ideal scenario, you find the challenge for valuations: new business, new company, new technology, new product, new team, new market, new value proposition, new business model, and so on. By definition, "new" means it has not existed before - no track record, no financial history - instead, an opportunity for a better future.


The Venture Capital industry has been around for some time now, during which time different valuation methods have emerged to address the challenge of valuing early-stage companies. Some of the models build on comparing early-stage companies and their investments to each other (not an entirely trivial matter), others on quantifying quality aspects such as the execution capabilities of a company's management o founding team. Other models focus on risks, and others combine future-looking forecasts with current industry-specific financial ratios. Some models and discussions approach the challenge from a high-level, and others are more granular and detailed. However, they all build on projections, assumptions, estimates and ultimately as qualified guesses and opinions.


All the above explains that there is not a universal "value" that all investors place on an early-stage company. As the valuations depend on guesses, estimates, assumptions and opinions, these will differ from person to person doing a valuation of a company. Some will perceive a company of a higher value than others. Comparing companies to one another is also not an easy task as apples need to be compared to apples, and access to information and data to make a meaningful comparison is often limited. This also explains why information and analytics firms such as CB Insights, Crunchbase and others are valuable data sources to Venture Capital investors.



So what should a Founder do when trying to assess the value of his or her Startup or early-stage business?


First off, become familiar with the terminology and the factors and mechanics of some of the common valuation models. Second, be prepared to discuss the underlying elements, assumptions and background to the factors part of the valuation models. This is important as ultimately placing a figure on quality factors depend on a combination of supporting facts, opinions and assumptions. All of these can be developed in time and argued for to support a valuation discussion.



SAFE as a bridge-solution


Sometimes to overcome situations where a valuation process is dominated by more guessing than fact-supported assumptions, or when an Investor and a Founder can agree on that they wish to work together but can not agree on the valuation of the business, SAFEs have been used. SAFE stands for Simple Agreement for Future Equity, and is a type of agreement where a company guarantees its investor equity at a future priced financing round. SAFEs regulate factors such as valuation caps, discounts, maturity dates and investment amounts. For Founders, SAFEs allows them to access the capital they need to develop their companies to a more mature stage where more facts have been established, figures are starting to come in place, and at a time when it is easier to place a $-value on the business.



So how much capital should an early-stage or Startup raise, and should the Founders go for the highest possible valuation they can?


First off, only raise as much capital that is needed to develop the company to its next development stage (investment round), within an 18-24 month period. Second, don't max valuations as this increases your and your investors' risk of losing value in the next investment round. The idea is to build value as the company matures and develops, not the opposite. At the same time, don't sell your company cheap. Your business and what you do with it is valuable - therefore, make sure that the value keeps rising as the company matures and grows.




Berkus Method

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Comparables Method

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Risk-Factor Summation (not a stand-alone valuation method, instead used to complement Pre-Money valuations)

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Scorecard Method

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Venture Capital Method

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Book Value and Cost-to-Duplicate

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