How do we define value when it comes to a startup?
Whether you are looking to evaluate your business for operational purposes or are preparing for a capital raise, trying to lock-down a justifiable valuation is tricky.
In a Venture Capital firm, investors understand the risks associated with early stage investments; 9 out of every 10 startups fail, right? However, they also recognize that there is huge opportunity for reward.
An experienced investor will discern specific factors that correlate with success and will be able to predict, relatively well, whether your investment is worthwhile for them. Taking these factors and the investors’ own due diligence into account, VC firms quantify your investment in a valuation method called “The Venture Capital Valuation Method”. Rather than subjectively tallying asset value or score-carding your firm, investors are able to take a reversed heuristic to valuing your startup.
How the Valuation works:
Start at the exit value (because why else will they invest?)
Exiting is the complete sale of ownership of your company. This exchange of ownership can be through an Initial Public Offering (IPO) or a complete merger/acquisition. For a seasoned investor, a comparable company’s method is often the most prominent way to determine the exit value. If reasonable comparables are difficult to find, the investors may also just ‘guesstimate’ based on your expected growth, relative to overall industry projections.
Dictate the exit multiple.
How risky is the venture? How early would the investor be entering? Are you pre-revenue or are you established? These are all questions you need to critique in order to justify specific assumptions for your valuation.
The earlier an investor joins, the more risky their investment and the higher the multiple. Here, multiple simply means what factor of your initial investment you expect to get back. A multiple of 20x (Twenty-X) means that if an investor injects $1MM in a firm, she would expect to receive $20MM on a successful exit.
Post-Money Valuation – Divide and Conquer
With your exit value and your exit multiple, you can easily work out the post-money valuation (the value of the startup after a financing event).
To do this, divide the Exit Value by the Exit Multiple.
Specify the size of the investment
How much will the investor be willing to invest? How much does she expect it will cost to bring you from your current operations to the exit value? This also determines how much of the company you are willing to pass to the investor.
Pre-Money Valuation – Take it or leave it.
With your Post-Money Valuation and the size of the investment, you can calculate the pre-money valuation by subtracting your investment figure from the post-money valuation.
Step 6 (for Investors only)
This step is solely for investors. Often, there will not only be one round of financing as the company scales. As a result, investors must take future dilution of their ownership into account. This can be done by adjusting the Pre-Money Valuation by the percentage of Expected Dilution.
Dilution-Conscious Pre-Money Valuation = (Pre-Money Valuation) * (1 – (Dilution/100)).
Theoretically, that’s how the method works. Let’s look at a practical example.
Your company, Potluck, is a shared-economy of chefs and waiters for high-end social events. You are looking to scale into different geographies and reach out to Conifer Capital in an attempt to raise capital for a Series A round. It will conduct a venture capital valuation to decide whether or not it wants to invest in your firm.
Step 1: Exit Value
According to industry standards and similar shared-economy exits, Conifer thinks that Potluck has the potential to exit at $200MM.
Step 2: Dictate the Exit Multiple
As Conifer will be investing during the Series A, it will expect a very large exit multiple. It thinks 20X justifies the investment.
Step 3: Post-Money Valuation
Post-Money = ($200MM / 20) = $10MM
Step 4: Size of the Investment
Conifer has experience in this sector and believes that Potluck needs $5MM to really stand out and flourish at this stage.
Step 5: Pre-Money Valuation
Pre-Money = $10MM – $5MM = $5MM
Step 6: Consider Dilution
For Conifer, it is certain that its investment won’t be diluted by over 20%. It agrees to integrate a 20% dilution factor into its valuation (and will be willing to reinvest to remain at at least 20% ownership).
Dilution-Conscious Pre-Money Valuation = ($5MM) * ( 1 – (20/100)) = $5MM * 0.8 = $4MM
Overall, Conifer Capital values Potluck at $4MM