PS#021: How to Value a Startup – Exit (3/4)
Last week we covered the dilution component of startup valuation.
This week we will be discussing the potential exit valuation.
Building a perspective on a startup’s potential exit valuation helps investors determine the range of entry valuations that are possible to meet the fund’s return thresholds.
In this issue of Preferred Shares, we are going to discuss some of the methodologies VC’s use to understand a startup’s potential exit valuation and how this ties into the valuation process as a whole. This will include two of the six pieces of analysis we discussed in part 1 of this series…
Comparable transactions – what recent or historical transactions can inform valuation?
Exit analysis – what can we expect in a future exit scenario?
OK, let’s jump in…
Entry point matters.
As a venture investor, you’re trying to invest in great companies. That’s the game.
Companies that have the potential to reach significant revenue levels (i.e., $50M+) in a relatively short period of time (i.e., 5-10+ years vs. decades), thanks to the upfront capital being provided through venture investments.
However, it’s not just enough to find these great companies – we, as investors, need to make great investments in order to meet our return expectations.
To do this, we need to make sure we find these great companies at the right price. To figure out the right price, we need to have an understanding of what the company could be worth in a potential exit scenario.
This is where exit analysis and comparable transactions come into play.
Take a historical perspective on valuations.
Remember, venture capital is a long-term game.
Investments can take 5-10 years or more to eventually exit.
This means that we are projecting future valuations way into the future. This can be quite difficult and leaves a lot of room for error.
With that being the case, we want to take a long-term, historical perspective to understand the potential exit options for the startup/investment.
We’ll handle this in three steps…
Project the profile of the startup at the time of exit.
Find comparable companies/transactions that meet this profile currently and historically.
Calculate the relevant multiples from this information.
Let’s get started…
1. Project the profile of the startup at the time of exit.
Based on your projections for the startup, build the financial profile at the time of exit.
This should include…
Revenue generation, composition, and growth
Gross margins and operating costs
Cash burn and/or level of profitability
2. Find comparable companies/transactions that meet this profile currently and historically.
Once we have the profile, we are looking for companies or transactions that have a similar profile. This will help us build a basis for the exit valuation.
You should be looking for comps within…
Public & private companies
IPOs
Private and/or M&A transactions
3. Calculate the relevant multiples from this information.
Now that we have the profile and a select group of comparable companies/transactions, we can calculate the relevant multiples of the comp set.
For venture businesses, we are often leveraging an enterprise value / revenue multiple to figure out future valuation. There are plenty of other multiples, but this is the most commonly used one in the venture world.
After you’ve calculated the appropriate range of multiples, you’ll apply this to the range of financial projections you predicted for the startup (i.e., revenue x multiple = valuation). This will give you a range of where you’d expect this company to exit in the future. Based on this valuation, you can determine the entry valuation that will allow you to meet your returns.
This process (like a lot of things in venture) is often more of an art than a science. You’re leveraging the data to prove or disprove the narrative of the investment. Ultimately, you want to see a reasonable range of valuations that will allow you to meet your return thresholds.
Note: If you’d like to dive deeper into these methods, check out my course How to be a VC Associate.
Understand the different exit options.
Attempting to forecast the potential exit valuation is one component, but we still need to think through a very important question – How is this exit actually going to happen?
Will it be an IPO?* Will it be a strategic acquirer? Will a private equity firm buy the company?
*Note: Technically, an IPO is another financing round for the company. The exit opportunity comes from selling shares in the public market.
As we calculate our range of exit valuations, we should be thinking about how this exit happens in practice. We want to at least have a vision for how we eventually exit our investment. This exercise should include answering two major questions…
Who will buy this company?
Why will they buy it?
The types of exits generally include the list above (i.e., selling in the public market, strategic acquirer, private equity firm, etc.), but the reasons to purchase a company (or some level of ownership) can vary depending on the situation. Reasons may include…
Company offers a complementary or competitive solution
Acquisition could create a new line of business
Firm is looking to add new technology and/or talent
The financial profile of the business is attractive
These are just a few examples, but the reasons help us think through a buyer’s motivation.
To paraphrase Stephen Covey, we want to begin with the end (or exit) in mind. As investors, we should have a perspective on how an investment will eventually exit.
By using a combination of the exit analysis and comparable transactions, we will be able to do just that – build a view on the liquidation (or exit) potential for our investment.
As I mentioned in part 2, this is just one part of the process. We’ll need all the pieces to make the right decision in valuing a startup.
