How do you value a startup?
We are faced with some big questions in this life. Who am I? Is there a God? How did Leicester win the Premier League? What does Kim Kardashian actually do? But up there with the most perplexing of them is: how do you value a start up?
Let me start with the bad news. The simplest way to value a start up, is to assume it’s worth nothing. Because that’s the uncomfortable truth. If you don’t believe me, try and sell your start-up and see how much people will pay you. Unless you have invented something ground breaking, your idea, a prototype and a few tame pilot customers, have almost no value in the real world.
But there is flaw in that argument. If all start-ups were valued at zero, it would be impossible for investors and founders to do a deal that worked for both. So, we have to find a way of applying a “notional valuation”, to an entity that, otherwise, has almost no intrinsic value.
Start up valuations happen in a little bubble where disbelief is briefly suspended, and businesses without a penny of revenue are valued at millions of pounds. An elaborate bet on what might happen.
In the real-world, valuing businesses is a reasonably exact science. What’s Vodafone worth? Easy. Just open the FT, see what the share price is and multiply it by the number of shares in issue.
What’s a large established private company, with sales and profit worth? Easy. Open the FT and see what the earnings multiple is for that sector and apply that to the company’s EBITDA number.
A simple science.
In the start up world, there is no such science. In the absence of sales, earnings and cash-flow, there are no metrics to get hold of. Value is placed on largely intangible qualities. Potential, differentiation, first to market, people. Unfortunately, there is no index for any of those attributes in the FT.
The truth is that valuing a start up is an art. An art that most likely boils down to the simple equation of what a buyer will pay and what a seller will accept.
But that doesn’t mean that an entrepreneur shouldn’t understand the various ways start up valuations are reached. At the very least, you want to go into your funding discussions with a valuation and a solid defence of it. Investors will certainly arrive with those facts and figures and if you aren’t prepared for that, it is very hard to push back.
So here are several methods you can use to arrive at a valuation for your start-up.
The Comparable Method
The first method is a crude one. It’s just finding out what other early stage investment deals have been done recently in your sector. It’s called The Comparable Method.
Whilst this copycat method might seem too simple for the rarefied world of finance, it does have some merit. If you find that start up valuations in your sector are particularly high, it helps you to build that case. It ceases to be your opinion and becomes factual evidence.
In the companies I work with, we always try and include a “comparable investment” slide in the investor pitch deck.
The Discounted Cash Flow Method
From the very simple, to the unnecessarily over-complicated. The Discounted Cash Flow (DCF) method
DCF is the best attempt at a scientific method of valuing start ups. DCF works on the assumption that most of a start up’s value is about future potential, and is underpinned by the premise that money is worth more today than it is tomorrow.
It takes projected future cash flows and using a given rate of return, calculates what that cash flow is worth today, you then take the first number of your mother’s birthday and multiply it by the number of goals that Mohamed Sala scored for Liverpool this year…..you don’t really!
DCF is complicated and unless you are completely conversant and able to hold a discussion about your assumptions, it is probably one to steer clear of. Investors are more likely to use it to ensure an investment fits their return criteria, than they are to use it to arrive at a definitive valuation
The big flaw with the DCF method, is that for all its appliance of science, the key number that sits at the heart of it, projected cash flow five years in the future, is completely speculative.
Mike Tyson said that everyone had a great game plan for fighting him, until he punched them in the mouth. Start ups are a bit the same. The business plan and cash flow forecasts are great, but rarely survive contact with the real world of business. Cash flow forecasts may be accurate for the first six months and directionally accurate for a couple of years, but they’re pretty useless after that. And therein lies the flaw of the DCF model. At some point, an investor has to apply a risk factor to those numbers and how he does that is totally subjective.
The Venture Capital Method
So maybe the best method is a fairly well used piece of reverse engineering. I don’t know if it has a name, but I’m going to call it The Venture Capital Method.
Investors know a couple of things. They know what return they want and they know what your EBITDA forecast is for year five of your plan. Using those numbers and working backwards, they can calculate the stake they need to take in the business today, to achieve their required exit value in five years.
It goes something like this:
You are asking an investor for £1M of funding
The investment fund requires a 6x return on any capital it invests.
Your start up is forecasting £10M of EBITDA in year 5
Let’s suppose you’re are in a frothy sector and businesses in the sector sell for 10x EBITDA
So, in five years time, your business will sell for £100M
Your investor requires £6M back for his £1M investment, so on the face of it, he will need a 6% stake when you sell, BUT (there’s always a but)……
You will need to raise another round of funding to get you there. Let’s assume that dilutes the investors stake by 30%. So, he will need an 8.5% stake before the dilution BUT, hang on, there’s one more thing……
We have assumed all will go well. It won’t. We need to factor in some risk. Let’s assume the investor is going to apply a 50% discount to take account of the risk that you won’t make it to £10M of EBITDA in five years time. So, he will need a 17% stake at the outset.
To achieve that, he will have to value your start-up at £5.88M post money or £4.88M pre-money.
What I like most about this method is that there is only one subjective figure in there, and that is the risk factor. So, unlike the DCF method, where you need an A Level in Applied Mathematics, this method boils down to a grown-up business discussion: “Is the discount factor reasonable”.
Before you approach investors, I would strongly urge you to have a clear idea of valuation. I would also urge you to arrive at that using a method and then spend some time really understanding the factors that most influence your method. Those are the things you have to defend in your investor discussions.
My other piece of advice is, when an investor tells you their valuation, always ask them to explain how they reached it. They won’t have plucked it out of the air. Make them walk you through their thinking. In all likelihood, the factors that most influence their method, will be the ones that influenced yours. So, you are already prepared to discuss them.
But for all the science, we probably end up where we started. Valuations are just an expression of the price the investor will buy at. Like any transaction, the deal is eventually struck at a point where the buyer will buy and the seller sell.
Sometimes the conversation leaves the realms of investment and enter the world of haggling. If you have more than one offer, and have created some competitive tension, then you can talk the valuation up based on nothing more than the laws of supply and demand. During the height of the dot com madness in the late 1990s, investors lost their cool a bit and got as close as professionals will ever get to begging to be included in the funding of some really hot start ups. As a result, valuations went through the roof. At one point an online retail play which was miles from profit, was valued at more than W.H.Smith. So it does happen.
On the other hand, if you have one offer only, then the simple question maybe: “Do I want to launch my business or not”. That very pragmatic question often frees an entrepreneurs mind enough to be flexible.