Company valuation is key for startups

Company valuation is the process of determining the monetary value of a startup or any other business. It reflects the potential return on investment that a company offers to its investors. For example, if a VC invests €10m at a valuation of €100m it expects the company to be worth at least €100m in the event of an exit or IPO. 

Before negotiating with potential investors, the first thing needed is a company valuation of the startup – and it should be as realistic as possible. The problem is that the younger the startup, the more difficult it is to make such a valuation. 

Startup valuation must strike a balance  

Startups must strike a balance when valuing their company. While it is tempting to seek a high valuation to retain more ownership, setting an unrealistically high valuation can deter potential investors and hinder fundraising efforts. Conversely, undervaluing the company may lead to founders giving up too much equity prematurely.

While the valuations of mature companies are determined based on hard KPIs, this is not possible with young startups. Usually, they still make little revenue and no profit. Often there is not even a mature product. 

And still, the valuation is necessary. So how exactly can it be calculated, and what factors influence it?

Methods to value a startup

There are many practices to determine the valuation of a startup. Here are three of the most widely used methods:

1. Discounted Cash Flow 

A widely used approach is the Discounted Cash Flow (DCF) method. The name describes the core of it: An investor estimates the future cash flows a startup will generate and discounts them to their present value.

Advantages of the DCF method

• Fundamental valuation: DCF is a valuation method focussing on the underlying cash flows a business is expected to generate. It provides a comprehensive and detailed analysis of a company's financial health and prospects. 
• Customization: DCF allows for customization by incorporating different assumptions about future cash flows, growth rates, and discount rates. This flexibility makes it applicable to a wide range of scenarios and businesses.
• Sensitivity analysis: DCF analysis can be used to conduct sensitivity analysis by varying input assumptions to assess the impact on the valuation. It helps in understanding the range of possible values and the sensitivity of the valuation to different variables. 
• Long-term perspective: DCF inherently considers the long-term prospects of an investment, making it suitable for assessing businesses with a focus on sustainability and long-term value creation. 
• Risk assessment: DCF forces consideration of risk factors through the discount rate, helping investors and analysts account for the inherent risks associated with an investment.

Disadvantages of the DCF method

• Sensitivity to assumptions: DCF analysis heavily relies on assumptions about future cash flows, growth rates, and discount rates. Small changes in these assumptions can significantly impact the valuation, potentially leading to inaccuracies.
• Complexity: It can be complex and time-consuming and requires a deep understanding of financial modeling and forecasting.
• Subjectivity: Since DCF is highly reliant on assumptions, there is a degree of subjectivity involved in the valuation process. Different analyses may use different assumptions, leading to varying valuations for the same asset or business.
• Short-term vs. Long-term focus: DCF may not be well-suited for valuing assets or businesses with unpredictable cash flows or those where short-term performance is more critical than long-term sustainability.
• Ignoring market sentiment: DCF focuses on intrinsic value and cash flows, often ignoring market sentiment, which can play a significant role in short-term price movements, especially for publicly traded assets.

Generally, it only works for startups with a positive cash flow, but that is not always the case. Overall the DCF method is more suitable for later-stage startups.

2. Market multiple or market comparable

With the market comparable, investors look at companies with publicly available KPIs such as revenue, EBITDA, ARR multiple, or net profit and use them for the calculation. Based on these figures, an estimated value can be determined.

Advantages of the market comparable

• Reliance on market data: This method uses real-world market data, such as recent transactions and publicly available financial information, to determine valuation. It is grounded in the actual market conditions and investor sentiment.
• Simplicity: The market comparable method is relatively straightforward to understand compared to complex financial models like DCF. It's accessible to a wide range of investors and analysts.
• Objective: Since it is based on publicly available data, the market comparable approach can be relatively objective. It depends less on subjective assumptions and forecasts, making it suitable for assets or businesses with significant trading history.
• Benchmarking: It provides a direct benchmarking opportunity for the subject company or asset, allowing for a quick comparison to similar entities within the same industry or market segment.

Disadvantages of the market comparable

• Limited data availability: The availability of comparable company data can be a limitation. In some cases, finding truly comparable companies or transactions can be challenging, especially for early-stage startups or businesses in niche industries.
• Market volatility: Valuations based on market comparables are susceptible to market fluctuations and short-term sentiment. These valuations may not reflect the long-term intrinsic value of the asset or business.
• Ignore unique factors: The market comparable method may not account for unique factors or characteristics that differentiate the subject company or asset from its peers. This can lead to an incomplete assessment of value.‍
• Lack of forward-looking information: This method is primarily backward-looking and may not capture future growth potential, changes in the competitive landscape, or other forward-looking factors that are considered in other valuation methods like DCF.

3. The venture capital method

As the name implies, many use this method. It helps them to calculate their potential return on investment. The method is comparatively simple to apply and suitable for early growth phases.

1. First, investors determine the exit strategy. The choice of exit strategy impacts the valuation method, whether the founders want to sell their company or go public at some point. 
2. VCs project the expected exit value and the anticipated price at which the startup will be sold or go public. It's often based on industry benchmarks and the startup's growth potential. 
3. Investors specify the minimum required return on their investment, which implies the risk level associated with the startup. 
4. Using the estimated exit value and the required return, VCs calculate the present value of their investment using the following formula: Present Value = Exit Value / (1 + Required Return)^number of years until exit 
5. The calculated present value is considered the post-money valuation of the startup at the time of exit. The pre-money valuation is then determined by subtracting the investment amount from the post-money valuation.

Advantages of the VC method

• Alignment with investors: This method aligns the interests of the investors and founders. It focuses on the expected return required by investors, which helps founders understand the investor's perspective.
• Tailored to VCs: The venture capital method is specifically designed for early-stage startups with high-growth potential that are the typical targets of VC funding. It considers the unique characteristics of these investments.
• Simplicity: The method is relatively straightforward, making it accessible to both investors and founders, especially in the context of negotiations.
• Emphasizes growth potential: The valuation reflects the startup's potential to achieve a significant exit event, which can be appealing to investors seeking substantial returns.

Disadvantages of the VC method

• Subjectivity: The required return used in the calculation is subjective and may vary among investors. It can be challenging to agree on an appropriate required return.
• Exit value uncertainty: Estimating the exit value is inherently uncertain. It depends on future market conditions and potential acquisition or IPO opportunities.
• Ignore ongoing operations: The method focuses on the exit event and may not consider the ongoing operations and cash flows of the startup. This can lead to a disconnect between the valuation and the startup's intrinsic value.

These are just a few examples of widely used methods, and there are many more. Unfortunately, none of them is a one-size-fits-all size solution. They can only provide approximate values. Those methods are also often combined.

These factors influence the company valuation of a startup

The valuation of a startup is influenced by a combination of factors, many of which can be complex and interrelated. Some relate to the characteristics of the company and team, others to the market in which the company operates. However, there is a distinction between quantitative and qualitative factors.

Quantitative factors of a startup valuation

• What is the startup's growth rate?
• How high is the Monthly Recurring Revenue or Annual Recurring Revenue?
• What is the Net Dollar Retention?
• What is the current Burn Multiple?
• How many customers does it have already?
• What is the CLTV-to-CAC ratio?
• What is the Gross Profit Margin?
• What does cost development look like?

Qualitative factors of a startup valuation

• The founding team: How much know-how, network, and experience does it bring to the table?
• How unique and innovative is the product? 
• What stage of development is the product at? 
• What is the value proposition? 
• Is there a product market fit yet?
• How scalable is the business model? 
• How great is the growth potential?
• How effective are the marketing measures?
• How attractive and promising is the market in which the startup is positioned?
• What is the current and future regulation of the market, and what impact does this have on the business model?
• How is the competitive situation?

Company valuation: pre-money and post-money

Post-money valuation and pre-money valuation are important terms in the context of startup financing and equity investments. They help determine the ownership stake investors receive in exchange for their capital. 

Pre-money valuation

Pre-money valuation is the estimated value of a startup or company immediately before it receives external funding, such as an investment from VCs or angel investors. It represents the value of the company before any new capital is injected. In other words, it is the company's valuation "pre" the additional investment. 

Pre-money valuation is a crucial figure in determining the ownership stake investors will receive for their investment. It is often expressed as a specific amount or a per-share value. 

The formula for calculating the pre-money valuation is: Pre-Money Valuation = Post-Money Valuation - Investment Amount 

Post-money valuation

Post-money valuation is the estimated value of a startup or company immediately after it receives external funding. It reflects the total worth of the company, including the newly injected capital. In other words, it is the company's valuation "post" the investment. 

Post-money valuation is crucial for determining the ownership stake of the investors. It is also used to calculate the per-share value if equity is divided into shares. 

The formula for calculating the post-money valuation is: Post-Money Valuation = Pre-Money Valuation + Investment Amount

What to do in case of a low company valuation?

In recent years, metrics like profitability and capital efficiency have gained importance. Pure growth numbers have lost relevance. This impacts company valuations. A recent example is Stripe, whose value dropped by almost half to $50 billion. The drop was even more significant in the case of Klarna, falling from $45.6 billion to $6.7 billion.

Sometimes startups face such down rounds. A down round refers to a situation in which a company raises capital at a valuation lower than the valuation it achieved in a previous funding round. In other words, the company's post-money valuation decreases compared to its previous round.

There may be various reasons for this:

• If a company fails to meet its financial projections or growth targets, its valuation may be adjusted downward in subsequent rounds.
• Economic downturns or adverse market conditions can lead to lower valuations for startups, as investors may become more risk-averse.
• The market in which the startup operates is going through a rough time.

What startups can do to protect themselves

That’s why timing is crucial and can have a huge impact on how a startup valuation turns out. Can I wait until I close two big accounts and than go fundraising in two or three months? Or are there any regulation changes which have a positive impact on my business? Sometimes it can be beneficial to wait until certain events give the company some extra boost.

Other than that, startups have to do their usual homework. To mitigate the risk of down rounds, they must carefully manage their finances, meet or exceed growth targets, and maintain investor confidence. 

Additionally, investors may negotiate protections, such as anti-dilution provisions, to safeguard their investment from the potential impact of a down round.

The company valuation is a basis for a startup to negotiate with investors

Startup valuations are a dynamic and multi-faceted aspect of the entrepreneurial landscape. They play a pivotal role in attracting external investment, guiding strategic decisions, and determining the ownership stakes of founders and investors. 

The valuation of a startup is influenced by a complex interplay of factors, including market opportunity, financial performance, growth prospects, technology, competitive landscape, and the expertise of the management team. They should therefore be used as a basis for negotiations with investors and less as exact mathematics.

In practice, it is often the case that startups are more likely to agree to a slightly lower valuation with an investor who is a great fit and has an excellent reputation and network.