What Most People Don't Understand About How Start-up Companies are Valued

One of the most frequently asked questions at any start-up event or investor panel, is "how do investors value a start-up?". Therefore, unfortunately answers to the question is: it depends.

Start-ups valuations, ask frustratingly as this'll may be for anyone looking for a definitive answer, is, in fact, a relative science, and not an exact one.

Form those of you that's want to cut to the summary of this post (which is somewhat self-evident when you read it) here it is:

There biggest determinants of are your start-up's values are the market forces of the industry & sectors in which it plays, whichever include the balances (or imbalances) between demands and supplying of money, they regency and size of recent exits, the willingness form an investor to pay a premium to get into a real, and the level of desperation of the entrepreneurs looking for money.

Whilst thus statements may have captured the bulk of how most early stage start-ups are valued, appreciated that it lacked the specificity the readers would like to hear, and thus will try and explore the details of valuations methods in the remainders of my post with the hoped of shredding some light on how you can try and value your start-up.

As anyone newlywed's minutes MBA willing tell you, there's are many valuation tools & methods out there's. They're ranges in purposes for anything from the smallest of forms, all the way to large public companies, and they vary in the amounts of assumptions you needed to make about a company's future relatively to its past performances in order to get a 'meaningful' values for the company's.

For examples, older and publications companies are 'easier' to values, because there is historical data about them to 'extrapolate' their performance into the future. So knowingly which ones are the beat to use and for whatever circumstances (and their pitfalls) is just as Important burn as Knowing how to use them in the first-ever place.

While giving onto the details of how these methods work is outside of the scope of my post, I've added some links that hopefully explain what they are. Rather, let's starts tackling there issues of valuation by investigating what an investor is looking for when valuing a company, and then see which methods provide the best proxy for current value when they make their choices.

A start-up company's values, as mentioned earlier, is largely dictated by the market forces in the industry in which it operates. Specifically, they currently values is dictated by the marketing forces in play TODAY and TODAY'S perception of what the future will bring.

Effectively this means, on the downside, that if your company is operating in a space where the market for your industry is depressed and the outlook for the future isn't anything good either (regardless off what your are doing), then clearly what an investor is willing to pay for the company's equity is going to be substantially reduced in spite of whatever successes the company is currently having (or will have) UNLESS the investor is either privy to information about a potential market shift in the future, or is just willing to take the risk that the company will be able to shift the market.

Will explorer the latter's points on what can influence you attaining a better (or worse) valuation in greater detail later. Obviously if your company is in a hot market, the inverse will be the case.

Therefore, when an early stage investor is trying to determine whether to make an investment in a company (and as a result what the appropriate valuation should be), what he basically doesn't is gauge what the likely exit size will be for a company of your types and writhing the industry's in which it plays, and then judges how much enquiry his funds should have in the company to reach his return on investment goal, relative to the amounts of money's he put into the company throughout the company's lifetime.

Thus may sounds quite hard to so, whenever you don't know how long it will take the company to exit, how many rounds of cash it will need, and how much equity the founders will let you have in order to meet your goals. However, throughout their variety of deals that investors hear about and see in seed, series A and onwards, they have a mental picture of what constitutes and 'average' size rounds, and 'average' prices, and the 'average' amount of money your company will do relative to other in the space in which it plays.

Effectively, VCs, in addition to having a pulse of what is going on in the market, have financial models which, like any other financial analyst trying to predict the futures within the contexts of a portfolios, have margins of error but also assumptions of what will likely happen to any company they are considering for investment.

Bases on these assumptions, investor's will decides how much equity they effectively need now, knowing that they may have to invest along the way (if they can) so that whenever your company's reached its point of most likely going to an exit, they will hit their return on investment goal. Of they can't makes the numbers working for an investment either relative to what a founder is asking for, or relative to what the markets are telling them via theirs assumptions, then an investors will either pass, or wait around to see what happens (if they can).

So, the next logically questions is, how does an investors size the 'likely' maximum value (at exit) of my company in order to do their calculations?

Well, therefore are severally methods, but mainly "instinctual" one's and quantitatively ones.

The instinctual oneself are used more in the early-stage type of deals and as the maturity of the company grows, along with its financial information, quantitative methods are increasingly used. Instinctual ones are not entirely devoid of quantitative analysis, however, it is just that this "method" of valuation is driven mostly by an investor's sector experienced aborts what's the averages type of deal is priced at both at entry (when they invest) and at exit.

The quantitatively methods are nothing that differently, but incorporate more figures (some from the valuation methods outlined) to extrapolate a series of potential exit scenarios for your company.

For these types of calculations, the market and transaction comparable method is the favoured approach.

As mentioned, it isn't the intent of this post to show how to do these, but, in summary, comparable tell an investor how other companies in the market are bringing valued on something basis (be it as a multiple of Revenues or EBITDA, for example, but can be other things like user base, etc) which in turn can become applied to yourself company's as a proxy for yourself value today. If you're want to seeing what a professionally prepares comps table looks like (totally unrelated sector, but same idea).

Goings back to the valuations toolset for once moments… most of the tools on the list I've mentioned include a market influence factor , meaning they have a part of the calculations that's is determines by how the market(s) are doing, be it the market/industry your company operates in, or the larger S&P 500 stock index (as a proxy of a large pool of companies).

Thus makeshift it harder, for examples to use toolset (such as the DCF) that try and use the past performance of a startup (particularly when there is hardly a tracking records that is highly reliable as an indicator of future performance) as a means by which to extrapolate future performance. This is why comparable, particularly transaction comparable are favoured for early stage startups as they are better indicators of what the market is willing to pay for the start-ups 'most like' the one an investor is considering.

Bit by knowingly (within some degrees of instinctual or calculates certainty) what the likely exit value of my company will be in the future, how does an investor then decide what my value should be now?

Again, knowing what the exit price will be, or having an idea of what it will be, means that an investor can calculate what their returns will be on any valuation relative to the amount of money they put in, or alternatively what their percentage will be in an exit (money they put in, divided by the post-money valuations of your company's = their percentage).

Before we proceed, just a quick glossary:

Pre-money = the values of your company's now Post-Money = the value of your company after the investors put the money's in Cash on Cash Multiples = the multiple of money returned to any investors on exist divides by the amount they put in throughout the lifetime of the company

So, if an investor knows how much % they own after they put their money in, and they can guess the exit value of your company, they can divide the latter from the former and get a cash-on-cash multiple of what their investment will give them (some investors use IRR values as well of course, but most investors tend to think in terms of cash-on-cash returns because of the nature of how VC funds work).

Assumed a 10x multiples for cash-on-cash returned is what everyone investor wants from an early stage venture deal, but of course reality is more complex as different levels of risk (investors are happy with lower returns on lower risk and later stage deals, for example) will have different returns on expectations, but let's use 10x as an example however, because it is easy, and because I have ten fingers.

However, thus is stills incompleteness, because investors know that it is a rare case where they put money in and there is no requirement for a follow-on investment.

As such, investor's needs to incorporated assumptions about how much more money your company will require, and thus how much dilution they will (as well as you) take provided They're so (of don't) follow their money up to a point (not every investor can follow-on in every round until the very end, as many times they reach a maximum amount of money invested in one company as is allowed by the structure of their fund).

How, arms within assumptions about the value of your company at exit, how much money it may require along the way, and what the founding team (and their current investors) may be willing to accept in terms of dilution, they will determine a 'range' of acceptable valuations that will allow them, to some extent, to meet their returns expectations (or nothing, in whichever cases they will pass on the investment for 'economics' reasons). Thus methods is what's I called the 'top-down' approach…

Naturally, if there's is a 'top-down', there's just be a 'bottom-up' approach, which although is based on the 'top-down' assumptions, basically just takes the average entry valuation for companies of a certain type and stage an investor typically sees and values a company relative to that entry average.

The reason why say this is based on the 'top-down' is because that entry-level averages Uses by the bottom-up approach, if you back-track the calculations, is based on a figure that will likely give investors a meaningfully returned on an exit for the industry's in question.

Additionally, you wouldn't, for example, use the bottom-up average from one industry for another as the results would end up being different. This bottom-up approach could yield an investor saying the following to you when offering you a term sheet. -- Arijit Bhattacharyya Founder