There are various ways to value a startup depending on their stages of development. We prepared an overview to help you distinguish between different valuation models so that you can choose the method that best fits your company or investment case.
‘The Startup Rating model by Venionaire Capital’ is a proprietary model for investors, which may be applied across different stages, without limitations of pure qualitative or financial models. The model adjusts the average valuation you have calculated or observed from the market and makes it transparent how much you should over- or underpay compared to an average valuation in order to make a fair deal.
Following the first introduction to the pre-revenue startup valuation, in this article we review the other well-known model for pre-revenue startups: the ‘Berkus Method’, named after its inventor, Dave Berkus, a well-known Californian angel investor.
The Venture Capital Method is often used for valuing early-stage companies. We show you how it is done.
Raising capital is always difficult – on average Startups get rejected over 100 times before they close a sufficient seed-round (to be clear: Investors not FFF). It’s obvious that this process wastes a lot of times for founders, as they should be working on their products, services, technologies, and clients.
Having raised money for a lot of startups and SMEs in different stages over the last years, we have discovered a pattern which will make you successful in fundraising.
Our playbook in 7 steps
1.) Build relations
Build relations in times you are not running for an investment. Investors / Fund-Managers like to get to know founders and follow their progress early. This helps them to understand your business better and it will build trust in your management capabilities.
2.) Set a Schedule
Set yourself a timeframe (e.g. 2 weeks for Research, 3 weeks for approaching, 4 weeks for first-round calls and 2 months moving forward) and be realistic about it. Fundraising takes about 3 to 6 months. Set your self a strategy for your fundraising and stick to it. Investors will understand that you do not want to waste time – therefore it’s ok to communicate a timeframe and be transparent about it.
3.) Be prepared.
Make sure you have a good FAQ for all your fundraising partners prepared and all relevant documents – legal, financial, KPIs, technology, roadmaps, strategy papers, research, etc. – arranged in a data room, ready to be shared.
Professional investors need to be efficient as well, so make their lives as easy as possible and show them that you are prepared to raise funds now.
4.) Manage your process.
You will need to manage involved team-members, Business Angels and consultants – and maybe press (if you run transaction PR to increase visibility). Therefore you should use a professional software tool to manage your fundraising funnel, tasks, documents, reports, including a growing investors database – all in one place – like foundersuite.com.
5.) A good storyline
Make sure you have a good storyline for your campaign. Investors like traction, momentum, numbers (does not always have to be revenue) and it is important to support your fundraising campaign with a strong story which gets repeatedly updated during the process. Launch successful press releases of achieved milestones, partnerships or new alliances you have been able to close.
Drip this information – piece by piece – and communicate with your audience.
6.) Be realistic about your valuation
Some startups slam doors by calling for ridiculous valuations – this is simply stupid. You should know in which area your company should be valued, but it is always to signal that you are open for negotiations. Valuations and terms play together like a swiss-clockwork and you will have to find a good balance between them.
7.) Ask for more
Make sure you ask for more than money. It’s important to understand that early-stage Investing is not like calling a bank loan. The right investor will bring your company up to speed and be worth a fortune. His reputation can even be the underlying asset, which opens doors for next rounds and exits. Ask investors, why you should work with them instead of their competitors. All the best for your fundraising!
Finally, if you need advice or simply additional (professional) resources for fundraising – we are always happy to look at your deal and see if we can be of value for your venture.
Nowadays, there are several discussions about a potential tech bubble in the US Venture industry. Valuations of companies like Uber make markets fear that the world is heading towards a crisis similar to the bursting of the dotcom bubble in the first decade of this millennium. But what is actually a “bubble”? There is a wide range of literature about economic crises, but this would dig a little too deep into scientific publications. I personally like the neat and easy definition of Paul Krugman from New York Times:
It is a situation in which asset prices appear to be based on implausible or inconsistent view about the future.
The market has changed
Now that we are settled with the definition of a bubble, we can focus on the question if there is actually one or not. Take a look back: 15 years ago, the internet was just at the beginning of its global commercialization. It was in its strongest growth phase, but was far away from a solid market, ready for trillion dollars of revenue. In 1997, only 2% of the world population had access to the internet compared to 55% or over 4 billion user in 2018. If there was a bubble today under the same metrics, the valuations would need to be 200 times higher than 15 years ago and this is certainly not the case.
These numbers are the key driver for changes in all industries. The landscape of internet based, tech revolution is currently spread over all fields and has in some industries just started to knock on the doors. Nowadays, we have increasingly inexpensive and capable mobile computing devices and internet connectivity, with huge bandwidth and much higher data-storage capabilities. After 15 years of post-dotcom successes and failures, the approaches of startups and investors changed dramatically. Both sides of the market are much more professional nowadays.
Consistent and plausible market
Bubbles behave very much like black swans – they are not predictable if you just look at events in the past. Nevertheless, there are several indicators to which people refer. Let´s see if some of the most commonly used indicators implicate implausibility or inconsistency as described in our definition of a bubble. If you read articles across the venture blogs where people argue for a bubble, you will always see these indicators mentioned:
- Investors put more money in late-stage rounds
- Private company valuations are rising
- IPO Exit ratios are dropping
In fact is, the average amount raised has increased in the last two years. But on the other hand, the number of total deals stayed rather flat. So the money is therefore invested in a small selected group of companies and not strayed to everyone who claims to be next “unicorn” (and there are many of them). This implicates a raise of valuations: otherwise the founders and early stage investors would get diluted too strongly which is actually a good argument against a bubble. Ljungqvist & Willhelm pointed out in their publications that the fragmentation in stakeholder ownership was one of the main factors for the dotcom bubble.
The IPO exit ratios are falling and there simple explanation for that. The attitude of founders has changed dramatically. 15 years ago the main goal was to just build a business and make an IPO at whatever costs to get rich as fast as possible. Now, companies have solid revenue streams and significant amount of money on their bank accounts. They want to keep private, expand their business and exploit their opportunities on their own rather than just go public or get bought. They prefer bigger late stage rounds (nowadays also called “Private IPOs”) instead of IPOs.
The companies are in the same stage of development so they need similar amounts of money (low exit ratios) as in the past – they just follow a different strategy nowadays. The same phenomena is the reason for the increased activity in the “Venture Debt” market (i.e. Netflix with a 1bn$ bond emission last year).You also see this if you look at the average time from the first VC funding to IPO/M&A. It has more than doubled from less than 4 years (1997) to 8 years (2014).
Now what is the reason for an investor to put in so much money in these deals? Just consider a PE investor who is struggling to keep up his IRR because of the low interest rates. The average IRR in PE has fallen to 8%-12% p.a. It is plausible for a PE investor to enter a late stage Venture Market. There is a trillion dollar market with plenty proof of markets and an average IRR of 23% in case of an IPO. It just appears that after 15 years the border of late stage Venture and PE are converging, and this is not to be confused with a speculation bubble.
Nevertheless, it has already happened that the valuation of the D-round is higher than the followed IPO. Which would be a contradiction to high IRRs for the investors at a first glance. But as I mentioned in a previous article “your price, my terms”, the deal value often does not equal to the value of the assets. At this point, the effect of Real Options kick in. Especially in Late-Stage rounds, investors accept high valuations in return of specific Real Options which influent the IRR of an investor in case of an IPO. For example a Liquidation Preference would be such a Real Option.
Impact on the European Venture Market
Due to the rising valuations in the US Venture Market many US investors turn to Europe. They want to take advantage from the “Silicon Valley Vortex” – It is no mystery that crossing the Atlantic for European startups will increase their startup’s valuation, sometimes by as much as 3x.
But the raising valuation are just one reason for this shift. European startups are used to the low VC supply in Europe and have learned how to operate under huge pressure with big competition. They understood that in order to survive in a market with low supply and high demand, they have to develop business models which are viable from the very beginning. Furthermore, European startups are confronted with a fragmented and complex market early on, which helps them during their expansion period. This unique attributes of European startups and the recent developments in the US Venture Market has led to an attractive and emerging European startup ecosystem.
Many practitioners at venture capital funds use net present value (NPV) and discounted cash flow (DCF) as methods during their valuation process of early-stage companies. In fact, the International Private Equity and Venture Capital Valuation Guidelines focus mainly on those two methods. The weakness of these two methods is that they concentrate on a certain “expected scenario” of cashflows. For example they do not capture the flexibility of the management to adapt their strategy in response of an unexpected market development. Especially in the early stage world with strategy shifts very common, this “expected scenario” outlines a big restriction. Flexibility in the future while facing new information arrivals, which could change your investment outcome drastically, is key.
In our previous article, we introduced the First Chicago Method which addresses this problem in a trivial way. However, it is not dynamic i.e. there are scenarios which you can’t even consider right now because of their unlikeliness. This is the point where the concept of option pricing comes into play.
A broad theory has been developed over the last 50 years, first started with the celebrated Black Scholes formula. While these models initially were used to value traded options, in the recent years they found their way into Venture Valuation Methods. Benefits in a highly volatile and uncertain market are pretty obvious. The main purposes of using options are:
- Improving upside potentials
- Minimizing downside losses
This works well with Options, as they may be considered like an insurance. Actually, many venture investors are already using this concept without knowing, as they use “hedge terms” (like “anti-dilution” and such) in their shareholder agreements. Many transaction terms are equivalent to contingent claims. To differ between classic options based on financial assets and specific terms during a venture capital transaction, we will call them Real Options. Real Options are based on the investment project itself.
This fact enables a way to determine the strategic value of an asset, facing an investment/acquisition decision. Of course, this strategic aspect brings a lot of subjectivity into the process which aggravates the valuation process under the assumption of information asymmetry between the contracting parties.
Although almost all professional venture investors use Real Options in their early stage investment process, few of them determine a value for them and even less startups usually see the implied discount given to their investor when accepting them.
Due to the enormous possible ways of setting up a term sheet and/or a shareholder agreement and the subjective nature of real options, it is a complex task to develop a consistent framework for the valuation of any real option. Nevertheless, there are real options which depend directly on the enterprise valuation. In these cases, we will first calculate the enterprise value following common valuation concepts and then determine the real option value conditioned on the assumptions we used for the enterprise valuation.
This approach fits Real Options which have “direct” impact on the investment return (e.g. liquidation preference). They don’t have a direct influence on the enterprise value, rather they are derived from the enterprise value in a linear way (in other words the dependence between the value of the enterprise and the real option is linear). Hence the expectation is a linear functional, the deal valuation expresses in the following way:
Deal Value = Enterprise Value + Real Option Value
Now we want to address values of Real Options which have “indirect” impact on the investment return (e.g. vesting). In general, the value of these options are far more difficult to measure. They are more adjustments to the assumptions you considered during your enterprise valuation process (similar to the concept of Bayesian inference). For example, if you have vesting as a term in your transaction you have to consider the change in the part of the risk-factor which belongs to the team. This thoughts lead us to the following representation of the deal value (“|” means conditioned on in this context):
Deal Value = Enterprise Value | Real Option
At Venionaire we have a sharp focus on Real Options as part of the valuation process. After calculating an enterprise value, we shift to Real Options trying to the hedge certain risks and enhance the flexibility as an investor. There are Real Options with a wide scope which deliver a good adjustment for many cases. On the other side, every transaction is unique and needs its own customized Real Options. Our team developed a framework to structure transaction in a way which fits best to the investor profile as well as the current stage, industry and region of a startup.
Once confronted with the problem of evaluating an early stage company for the first time, you will find a number of valuation methods and sooner or later you will question yourself, which model does consider all the relevant factors.
The absence of comparable companies, the inexistence of historical data, the complexity to estimate volatility, and a large number of intangible assets, which unfortunately are key drivers for value in tech-related companies, make this discipline so difficult.
In fact, there is a simple answer: There are no precise valuations for early-stage companies. In most cases, professional VCs will, therefore, calculate a number of valuation models and scenarios and take a weighted average of them (depending on the estimated fit of the model to the underlying business case), as a starting point or an instrument for negotiations. A deal will eventually happen for a certain price (market price) and companies will also refer to this price as their “market-valuation”.
Let´s start with a little orientation:
Source: Achleitner, Nathasius (2003)
As already discussed in a previous article these Valuation methods belong to different concepts. In this article, we will focus on a comprehensive evaluation method, the so-called “First Chicago Method”. For a more easily done valuation method please head over to our article about the Venture Capital Method.
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The First Chicago Method is a situation-specific business valuation approach used by venture capital and private equity investors for early-stage companies. This model combines elements of market-oriented and fundamental analytical methods. It is mainly used in the valuation of dynamic growth companies. Let’s go through this method step by step.
Step 1: Define different future scenarios for the Company
Usually, you create three scenarios for an enterprise:
First, you have to set up a financial forecast (including revenues, earnings, cash flows, exit-horizon etc.) for each case. A detailed qualitative analysis of the market trends and the company are necessary in order to estimate these scenarios. In general, the mid-case scenario is the expectation of an Analyst after the Due Diligence (DD).
Hence, in many businesses, which are mainly driven by the scalability factor (e.g. the market is in a “winner takes it all” situation), it is reasonable to set the worst-case equivalent to the event of a total loss of the invested capital. Then again there are businesses where the market determines a natural maximum cap of the financial outcome.
Still, step 1 is not easy to master and needs extensive analytical research of the circumstances. You might even have the freedom to consider strategy-shifts in your financial forecast depending on the assumptions of each case.
Step 2: Estimate divestment price for each scenario using multiples
After setting up your financial-forecast, you need to determine the Terminal Value (TV) at the time of the exit (divestment price). At this point, we apply a market-oriented valuation concept, Multiples. The idea is to estimate valuation by comparing the investment to other transaction within the same peer group. Peer groups in the venture industry are characterized by:
- Enterprise industry
- Enterprise stage
- Enterprise region
There are various forms of Multiples each suitable for different asset classes. Professionals in the venture industry will use Multiples based on KPIs like EBIT, Revenues etc. The critical factor in this market-oriented approach is the transaction data of the peer group. Data about M&A activity in the venture industry are rare, nevertheless, there are data providers on the market specializing in the venture industry.
Step 3: Determine required return and calculate valuation for each scenario
Many VCs determine the required return internally. They do not trust concepts like WACC (Weighted Average Cost of Capital) and CAPM (Capital Asset Pricing Model) due to of the incompleteness of the private equity market (you can´t replicate the payoff of an investment with a portfolio of assets). However, we will give a brief introduction into the WACC concept which is adjustable to the venture market. Furthermore, we will assume the absence of debt capital in the financial forecasts, which reduces the WACC to the cost of equity (not a strong assumption approaching the valuation of early-stage companies).
Source: Damodaran (2009)
Estimating market risk for the industry, stage and region and determining a risk premium individually for each company are key factors.
The valuation for each scenario is the sum of the discounted Terminal value and the discounted cash flows until the exit-horizon.
Step 4: Estimate probabilities of scenarios and calculate the weighted sum
For this last step, you have to allocate a probability to each scenario. These probabilities are naturally correlated to your definition of the scenarios and the number of them. Of course, it is impossible to estimate precise probabilities for every scenario. The idea is to take extreme outcomes into your valuation process.
At the end calculate the weighted sum of the valuations depending on each scenario.
Source: Venionaire Capital (2015)
The First Chicago Method is a technique of wide scope. Step 1 gives you the freedom and the opportunity to consider events with low probability but a huge impact on your investment pay off. On the other side, this freedom brings more complexity to your valuation framework. We at Venionaire Capital don’t fear the additional effort. We are specialized in a comprehensive analysis of tech-related young companies and screen every company until we get a clear picture of all possibilities.
At Step 2 we use dataflow through our cooperation partners and professional data providers. The choice of the multiple depends on the peer group and the structure of the enterprise. Due to our long experience in this sector, we developed an advanced framework for clustering the Startups.
At Step 3 we investigate the market through a short-term analysis focusing on the potential of the Business case and a long-term analysis to identify fundamental market trends. Our analysis includes all aspects of the Enterprise which will be considered based on their impact in the specific Company-peer group.
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Estimating the probabilities of the scenarios is a challenging task and seems arbitrary at a first glance. Nevertheless, they are various mathematical approaches to overcome this problem, addressing the extreme possible scenarios and assuming fat-tailed and highly skewed distributions for the underlying risk-drivers of the business. Furthermore, there is uncertainty in estimating the exit horizon because private companies are infrequently traded assets.
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Work hard and grow fast! Take your opportunity and work global. Digital technologies allow startups to address global markets. It has never been as easy to build such a scalable business. Aside from a fabulous idea, a great team and a phenomenal product, receiving enough funding is essential to succeed on a global scale. As viral growth is rather considered a myth or a so called black-swan than a standard – it is hard work and still quite capital intensive to achieve an international brand awareness for your product.
Unfortunately 90% of all startups will neither receive an Angel Round, nor a Venture Capital investment. So the question is: “Why is it so tricky to get early stage funding?” Most startups usually do not have strong enough historic financial records, which may be inserted in a “standard” business valuation framework. As a result banks and other “traditional” investment institutions, will not be able to calculate the risk of default and will therefore back off. What remains are Business Angels and Venture Capital Funds, who are specialized in high-risk investing and usually provide much more than just money – so called “smart-money”.
In order to come up with a valuation, early-stage investment professionals will take factors like competition, technology risk, capability and quality of the founder team, attractiveness of the market and scalability of a business case, into account. Hence the fact, that most of those highly scalable enterprises focus rather on traction, than on revenues and profits in early stages – they will have a quite significant burn-rate in their first years. Investors and startups will find it difficult to consider this fact regarding classic valuation concepts, and therefore need to use different valuation approaches.
Two main questions remain:
“What is the Enterprise Value of a startup?”
“How do you measure this Enterprise Value?”
There is no such thing as a one and only, true value for a startup company. There is a set of valuations, which all need to be considered and paired with negotiated deal-terms – combined they may be used to set a specific price for a transaction. In order to understand the full picture it is necessary to avoid a selective analysis. The following standard valuation approaches are determined by different external and internal circumstances.
We usually differentiate between, three standard approaches for Enterprise Values (EV):
1. Fair Market value – the value of an enterprise determined by a willing buyer and a willing seller – both conscious of all relevant facts – to close a transaction.
2. Strategic value – the value the company has for a particular (strategic) investor. The positive effects like synergy, opportunistic costs and marketing-effects are considered and calculated for this valuation approach.
3. Intrinsic value – the measure of business value that reflects the entrepreneur’s in-depth understanding of the company’s economic potential.
Fair Market Value
The “Fair Market Value” implicates full knowledge of all the “relevant” facts on both sides. In other words, information symmetry between Startup and Investor – in practice this will be highly unlikely to establish. In case of a young company, without meaningful track record and often a lack of understanding of the product on Investor’s part, it is more likely to have systemic information asymmetry. Because of the nature of startups, it is tough to determine a “Fair Market Value”. Market values of startups will turn out arbitrary, as stakes of privately held companies are infrequently traded assets.
To overcome this problem investors tend to compare the transaction to other deals within a peer-group, which as a group executed a large number of transactions. This sample delivers a statistical figure, also known as a Multiple. The weak side of this method should be adequately considered, as there is a considerable incomparability of Startups. Never the less it is a benchmark.
The “Strategic Value” is deeply influenced by the Investor himself. A strategic investor always carries a hidden agenda. There are synergies, opportunistic costs and potential advantages in terms of market competition, among other factors, which will lead to a certain strategic premium. This premium could eventually lead to a higher valuation of a startup he is willing to acquire.
It is difficult for startups, to get a feeling for this strategic premium an investor might be willing to pay. This premium will most likely appear if you have a very good understanding of the buy-side industry, the specific buy-side company, or if there are a view companies in competition for a transaction. On the other side strategic investors may be highly valuable partners for startups, if they have troubles to overcome difficulties, in terms of go-to-market or production scaling. Synergies with a strategic partner in this sense could be a huge asset and eventually lead to a discount of a startup valuation.
Deal parties will need to weigh out carefully who will profit the most out of a deal. A Startup and its potential investor need to evaluate how much worth support, experience, contacts and knowledge of markets have. On the other hand, they need to value the amount of savings (e.g. cheap external R&D), additional returns or the ability to hold a market position, an investor may enable due to a partnership.
The valuation is strictly correlated with potential future synergy effects, and is usually implemented through premiums or discounts to a certain Multiple or a given valuation (so called “Anchor”).
Also known as the fundamental value it requires detailed knowledge about the company, product, market, current trends and a good feeling for probabilities in future business development. A qualitative and quantitative analysis of the business model is necessary to estimate the future impact on the market. Technological competitors, advantages and disadvantages also need to be considered as key risks.
One of the most common valuation approaches in this case is the Discounted Cash Flow method. This method has been criticized a lot. A Valuation is calculated through the sum of discounted future cash flows (so called “present value”). The discount factor is another critical factor, it determines the riskiness of the business case. The discount factor is a composition of the required rate of return (ROI), the time value of money and a risk premium, which is directly correlated with the deviation of future cash flows and other aspects of the startup. Small changes of the discount factor lead to large changes of the valuation. Hence there is no uniform Methodology (yet) to determine the risk-premium, the output of the DCF method is not satisfying for many cases.
We have introduced three standard valuation approaches and explained the backgrounds for potential tensions and conflicts, when it comes to negotiations and the complex question of a company valuation. Early stage startups offer great chances, but bare various risks, which are hard to calculate.
Some Business Angels and early stage Venture Funds concentrate primarily on founder teams – as they believe there is no point in calculating any models. This approach is not as trivial as it sounds. Current studies have shown that it is hard to find reliable criteria for successful teams and that statistically investors will not do very well if they only trust on their expert knowledge and life-experience. From aprofessional perspective I would call this “gambling”, which certainly does not mean that it will definitely lead to a fiasco – sometimes gamblers win too, the odds are just not good enough for us. In a professional transaction process investors and startups will build up trust, take external research into account, calculate a couple of models for negotiations and eventually find a deal structure, which takes most of the considerable likely hoods into account.
One of the most complex valuation questions may be solved easily if you define clear terms along side your investment. In practice professionals will consider external advice and research to obtain a different and unbiased point of view. They will compare valuation concepts, weigh synergies and will consider premiums and discounts. Offers will come with a Term-Sheet, which will show a valuation and a corresponding deal-structure.
We consider deal-structuring as an art! Even with drifting valuation beliefs it is easily possible to close satisfying deals for both sides – if you find the right structure. Contact us to find out more!
Co-Author: Sasan Haji-Hashemi, Senior Analyst – Venionaire Capital