How Would an Investor Value a Start-Up? (Detailed Version)
Following our previous article, we have been asked for more details on valuing a start-up business. This article will shed more light on start-up valuations from an external investor perspective.
A common question at start-up events and/or investor panels relates to how investors carry out company valuations for a start-up. The answer is it depends. Company valuation for start-ups is more of a relative science than an exact one.
The short answer is that a start-up’s value is mainly decided by the market forces of the industry and sector in which it operates. Key factors include: the balance between supply and demand of capital, the recency and scale of recent exits, the ability of an investor to pay a premium to enter into a contract and the level of money-seeking urgency of the entrepreneur seeking to invest.
There are multiple company valuation tools and approaches that may be used by investors when assessing a start-up. These range in purpose from small businesses all the way to large public companies. Unsurprisingly, in order to get an important return for the company, the decisions you need to make about the future of a company relative to past performance are varied.
To give an example, older and public companies are ‘easier’ to value as historical information is available and may be used to ‘extrapolate’ past performance into the future. It is therefore almost just as important to know which ones are the easiest to use and under what conditions (and their pitfalls) they should be used in the first place.
There are multiple company valuation methods that you may have heard of, including:
Discounted cash flow (DCF)
The First Chicago method
Market and Transaction Comparables
Asset-Based Valuations (including the book or liquidation value)
Examining the details of these methods will not be presented in this article; for more information, we suggest some independent research. Now, we can start by taking on what an investor is looking for when carrying out a company valuation for a start-up and how they may use the above mentioned mentions as part of their decision.
The value of a start-up company’s value, as discussed above, is dictated largely by the forces in the market/industry in which it operates. More specifically, the current value of a start-up is dictated by the within market forces in play currently as well as whatever perception exists on what the future will bring.
Basically, if your company operates in a space where the market for that particular industry is low and future outlook is bleak, regardless of how your company performs, an investor is likely to pay less, regardless of any success that your company is actually having. The only exceptions to this are if the investor is aware of information on a potential market shift or if they are wiling to take the risk. If your company is in a particularly hot market, the opposite will be the case.
When an investor is trying to decide whether to make the jump and invest, typically, they will need to estimate the likely exit size for your company, considering the industry within which it operates, and then there needs to be a judgement on how much equity their fund must have to reach a goal based on return on investment over the lifetime of the company in question. This may sound difficult considering you will not know, necessarily, how long a company will need to exit, how much and how many rounds of cash will be required and how much equity the founders will relinquish so you can meet your goals.
Investors will have a mental image of what represents ‘average’ size round, price and amount of money the potential acquisition company will do relative to others within the same space. There are various financial models available to investors that have margins of error as well as assumptions of what will likely happen to companies they are considering investing in. Based on these data, investors may determine how much money they essentially need now, recognising that they will have to spend along the way (if they can) so they can hit their goal for return on investment goal. If the numbers don’t work, i.e. either because of what the founder is asking for or because of various indicators from the market, investors can either pass or wait and see what happens (if they can).
An important question remains: how would an investor size the ‘likely’ maximum value (at company exit) of a given company for their calculations?
Several methods exist. These can be broken down into either “instinctual” or quantitative methods. Instinctual methods are those used more in early-stage deals. As company maturity grows, along with its financial information, quantitative methods are preferred. Instinctual methods are not necessarily lacking quantitative analysis though; it is just that this method of company valuation by in large hinges on an investor’s sector experience (i.e. the average price on a deal at entry (when they invest) and at exit). Quantitative methods are not all that different but they do incorporate more figures to come to a figure on potential exit scenarios for a given company. For these calculations, the market and transaction comparables method is the preferred approach.
Most of the tools on company valuation list take into account the influence of the market, be that how the market is doing or a larger stock index, such as the S&P 500 stock index. It can be difficult to use these sorts of tools, such as the DCF, that try and use past performance as a way through which future performance can be extrapolated. This exact reason is why comparables, particularly transaction comparables, are better suited for early stage start-ups as they provide a better look into what the market would pay for a start-up that is very similar to the one an investor is considering.
Even if an investor knows with some degree of certainty what the likely exit value of a company will be in the future, how will they determine what the value should be now?
Understanding what the exit price will be, or at least having an idea of what it will be helps the investor to calculate what their return on investment will be. It can, alternatively, help them determine what their percentage will be at exit.
If an investor can determine what percentage of a company they own after investing, and they can estimate the company’s exit value, they can divide the latter from the former and work out a multiple of what their investment will give them (cash-on-cash multiple). Some investors use IRR values as well.
Let’s assume that a 10-fold multiple for cash-on-cash returns is what every investor wants from a start-up deal. (The reality is more complex as investors will have different appetites for risk vs returns for their investments) One thing to keep in mind though is that it is rare where there is no need for continual investment down the line from the initial assessment. Investors will need to assume how much more money a given company will require and how much dilution there will be.
Now that an investor has the relevant assumptions, they will determine a ‘range’ of acceptable company valuations that will mean they will meet their expectations on return on investment (top-down approach). Sometimes they will not meet their expectations; when this happens, they will pass on the investment for reason of ‘economics’.
If there is a ‘top-down’ approach then logically there must also be a ‘bottom-up’ approach. This is largely based on the ‘top-down’ assumptions but takes the average entry company valuation for companies of a certain stage and type and estimates the value of a company relative to that entry average. The reason this is based on the ‘top-down’ is because if you back-track the figures, the entry average used for the ‘bottom-up’ approach is based on a data point that would probably give investors a substantial return at exit for the sector in question. Be sure to keep in mind that it would not be appropriate to use the bottom-up average when comparing different industries or sectors.
The important question of how much money is required will form part of the discussion with your potential investor and is not elaborated here. The company valuation will reflect this discussion.
Now, let’s consider what other factors can influence an investor asking for a discount in value or one where they are willing to pay a premium over the average entry price for a given company:
An investor may be willing to pay more for a given company if:
It is in a hot sector: investors entering into sectors late may be willing to pay more to ensure a stake in what they consider to be hot stock.
If your management team has a great history: professional entrepreneurs can often command a better valuation. A good team gives investors faith that you can execute your company goals.
You have a functioning product (particularly relevant for companies in their early stages).
You have traction: nothing shows value like customers demand.
An investor is less likely to pay a premium over the average or may pass on investments if:
The company operates within a sector with historically poor performance or one that is highly commoditized with little profit margins.
The company operates within a sector that has a large set of competitors with very little differentiation between them.
Your management team is missing key people or has no track record.
The company has no customer validation and/or your product is non-functional or you are running out of money.
To conclude, current forces in the market majorly affect the value of a given company. An excellent thing to do is to do your research and get an idea of what values are in the market before you speak to an investor.
You can do this by speaking to similar start-ups like yours and, in essence, make your own mental comparables table. Work out what other start-ups like yours have raised money and see if you can obtain data on their valuation and how much money was raised when they were at an equivalent stage as you. The news, particularly the tech news, sometimes has information where you can estimate these values.
Speak with our start-up valuer for a free consultation today.