PS#019: How to Value a Startup (1/4)

How do you value a startup?

This is a question that I often get from aspiring investors.

It’s a really important question and a critical part of the job, but it can be confusing.

To be honest, I completely understand the confusion. Startup valuations, especially over the past few years, have changed pretty drastically. With all this volatility, it can be hard to understand the methodology (if any) that is being used.

Over the next few issues of Preferred Shares, we are going to talk about how investors value startups for venture investments.

Today, let me explain why this is so complicated.

It’s an art, not a science.

Startup valuations are tricky.

Unfortunately, there is no simple equation or fancy formula that will spit out the answer. It requires balancing several factors that very much depend on the nuances of the situation.

To complicate matters further, unlike with public or mature companies, startups have limited information from which to base your calculation.

You might have as little as a few months to a few years of data on how a company has performed. Those data points could range from just a team and idea (pre-seed – seed investments) to a few months or years of revenue (Seed – Series B).

Whatever the case may be, investors are trying to use that limited data to predict a startup’s future growth potential. And not just any growth potential, but exponential growth.

As I said, it’s tricky.

This gets even more complicated when we consider all of the different stakeholders involved in a typical venture investment.

Startup valuations are all about aligning incentives.

There it is. That’s it. That’s the big secret.

Startup valuations are about aligning the incentives of everyone involved around the future potential of a company, not necessarily a company’s true value today.

If you can hold on to this concept, the methodologies I outline later will make a lot more sense.

So, when I say “everyone,” who does that include?

Well, in no particular order, this includes…

• Founders, key executives, & employees

• Current & future investors

• Future acquirers

All of these parties play a key role in the building and exiting of a venture investment.

We need all of these stakeholders properly incentivized in order to succeed.

Let’s talk about each of them in a bit more detail.

Founders, Key Executives, & Employees

None of this works without properly motivating the team building the startup. When structuring a venture investment, investors need to make sure the team is properly incentivized to keep pushing towards the seemingly impossible task of building a venture-backed company. This requires ensuring that the team has enough ownership for a successful outcome. If the valuation is too low, this can be in jeopardy. Dilution from the incoming financing will lower the team’s ownership percentage, reducing the probability of a successful outcome and overall motivation.

Current & Future Investors

Most startups require multiple funding rounds to hit the scale required for the business to be sustainable and profitable on its own. This is the whole point of venture capital – helping startups achieve that scale significantly faster than they could otherwise. Valuations need to make sense for current and future investors to invest the amount of capital that is required to build the company. If valuations are too high, current and future investors may feel that the risk is not worth the potential return.

Future Acquirers

Ultimately, the venture capital ecosystem only works if there is an ability for the investors and startups to eventually achieve liquidity on their investment, which could mean an acquisition, secondary sale in the private markets, or a sale of shares post-IPO. Again, if the valuation from the previous financing rounds is too high, this can lower that overall return potential (even for successful companies) for the team and its investors.

Investors use several different approaches to value a startup.

As I mentioned previously, there is no one formula that can provide the answer for us.

Investors will use several different methodologies to support their perspective and ultimately align incentives between the stakeholders that we discussed previously.

At a high-level, these methodologies will include…

• Comparable investments – how are similar VC investments pricing in the market?

• Comparable transactions – what recent or historical transactions can inform valuation?

• Dilution analysis – what type of dilution should we expect today & in the future?

• Exit analysis – what can we expect in a future exit scenario?

• Returns analysis – what is required from a returns perspective?

• Scenario analysis – how do we think about the different future scenarios for this startup?

Of course, when thinking about a venture investment, valuation is just one aspect of structuring the deal. There are many more factors that can be just as (if not more) important, depending on the situation. For now, we’ll focus on understanding these methodologies.