How startup valuations work!

Feb 7, 2023 | Blog

No, this article is not just for the ones interested in joining the venture capital space and want to know the actual mechanics of valuations. This is for anyone who has any kind of stake or interest in the startup world to enable a greater shared understanding of how startup valuations work. This includes startup founders and employees who struggle to explain why their startup is valued at a certain sum to the world. This also includes enthusiasts and observers of the space who are curious about the same.

The dominant paradigm used for valuing a company is called Discounted Cash Flow or DCF. However, this paradigm is primarily helpful for valuing listed and mature enterprises. But many often evaluate early-stage loss-making startups using the same paradigm as well. Startups’ valuations are often seen through the same lens of the public market, contrasted with those of the old economy enterprises.

“Early stage valuations aren’t really valuations. They are the exhaust fumes of a negotiation about two things – the amount raised and the amount of dilution.” – Fred Wilson, Co-founder of Union Square Ventures

From journalists creating highlighted stories to financial professionals navigating the corporate world, this notion of viewing startups as a special case of valuing large enterprises is dominant, making startup valuations puzzling to you and I. With the loss-making tendencies of startups and the lower valuation trading of listed companies in the same domain, the well-known DCF structure simply cannot make sense of a startup valuation.

So how do they do it – the venture capitals and the investors? What is their secret? Let’s uncover!

How venture capitals arrive at a value

“Today, when money has no value, because we’ve essentially printed all the money in the world and we’ll continue to print it over and over, you have to find value in other parts of the balance sheet, so you have to go to things like brand or intangibles. And this is where their mathematical models break, and then their brains explode.” – Chamath Palihapitiya, Founder and CEO of Social Capital

Venture valuations are not done through a technique like Discounted Cash Flow or DCF. They are done following a set of steps, referred to as long-term multiparty staging. And much like chess, this process can be learnt in an hour but may take a lifetime to master. So let’s take one step at a time and start with the understanding part of it.

Let’s say that a startup named company A approaches a venture capital (VC) firm for funding. Company A has not approached anyone for funding before and the VC is a seed fund. The VC examines company A on different criteria such as the presence of an MVP and an early customer validation and, subsequently, deems company A as investment-worthy.

Now the VC reaches the part of valuing the startup. And the process here is quite simple. The value of the startup is its funding amount divided by the equity stake the startup is diluting. For example, if a startup is raising $1m from the VC firm and diluting 10% of its equity, then the startup is valued at $10m which is $1m divided by 10%.

This simple arithmetic calculation is done to evaluate any startup in the seed stage and in the upcoming 4-5 years, approximately. Venture capital firms at this stage do not determine the value by following the DCF method or the Berkus method or Scorecard Valuation method or First Chicago method. However, there is still some method to the madness here as the numbers of $1m and 10% stake could not be pulled out of thin air.

The final numbers are derived from the application of years of experience in the investment world as well as a lot of thinking and pondering. The amount of money is perceived by the seed VC as required for the startup to move up to the next stage or Series A. On the other hand, the amount of equity stake is determined as the target stake to hold after the initial stage is complete. The equity is approximated based on years of experience that lets them know that this initial percentage will result in a meaningful 8-10% equity at the time of exit which is their general target outcome for exit in any startup funding.

The preferred amount and the equity stake is likely to vary from firm to firm as every VC has its unique preferences and targets. A certain VC may invest in seed stage startups with a preference of $1-1.5m cheque size and 15-20% equity stake. That particular VC’s experience in the investment world and the tech industry may enable them to know that this amount can provide around 15 to 18 months of revenue-less expense according to the current market in 2023. And as a promising startup moves towards Series A during this time, it can raise capital from another investor. As future fundraising rounds dilute the original VC’s stake size at the startup, they are likely to end up with an 8 to 10% equity stake valued at around $2b – a valuation they might be happy to exit at. However, all these numbers are approximate and vary from startup to startup.

What is multiparty staging?

During seed stage funding, startups usually have acquired very little data to base its future performance on leaving the VC firms to make the decision on the basis of the startup team’s capabilities, the potential market size and the startup’s ability to execute the product or solution. Much of this is done on educated guessing and Excel storytelling. Nothing is certain about the future of the startup at this point.

This problem led the United States VC ecosystem to come up with what’s called ‘stage’ fundraising. This means the capital would be provided to the startup in a series of cheques by giving only the necessary amount to grow the startup to the next stage or level in each one of them.

Here’s the basic idea of how staging works –

  • Angels or microVCs fund idea stage or pre-idea stage startups to grow them into seed stage.
  • Seed VC funds would then fund them to propel to the Series A funding stage.
  • Series A funding helps the startup to grow until another VC firm would back it for Series B.
  • This process goes on until the startup reaches Initial Public Offering.

Each stage has a funding amount, a stake target and some qualifying criteria. The chart below outlines the ‘ballpark’ formula developed by VCs in their respective stages.

Startup Stage Qualifying Criteria Funding Amount Equity Stake Startup Valuation
Pre-seed Worthy idea & some customer validation $250-750k 10-15% $2.5-7.5m
Seed MVP, customer validation & revenue from 1-2 customers $1-1.5m 15-20% $5-10m
Series A Product market fit & annualized revenue of $500k-1m $5-10m 15-20% $25-65m
Series B Successful scaling of GTM playbook & annualized revenue of $3-5m $15-30m 15-20% $75-200m
Series C, C+ Successful scaling, adding new product lines or new geographies & annualized revenue of $10m+ $50m+ 10-15% $300m+

How does this process look over the long term?

To understand this, let’s go back to company A and see how it’s doing after 12 months of receiving seed funding. Luckily (and fictionally), the startup is doing well. It has perfected its go to market strategy and has been yielding results. Growth has happened to company A both in terms of product demand and employee numbers. It has grown up to an annual revenue of $750,000. At this point, the seed VC introduces company A to a number of Series A VC firms. One of them finalizes to back company A for the following round.
Like the previous round, the Series A VC also has its preferred amounts which is shown in the table above. Let us assume that in this specific case, the Series A VC agrees to give Company A a cheque of $10m for a dilution of 20% equity stake. This funding round results in the valuation of company A to grow to $50m from the $10m of seed round. Much like earlier, the number $50m is derived from dividing the cheque amount of $10m by the equity stake of 20%.
But, in non-fiction, not all startups perform expectedly well. So we have to consider a scenario where company A has not performed as good and is unable to secure funding for Series A. What happens then?

Chances are that the Seed VC will provide another cheque of $250-500k for the startup to take some time and pivot. But if the startup fails to convince another VC for funding even after that, the Seed VC is likely to stop funding the startup anymore and the startup might die. This failure might seem like a massive hurdle. But honestly, in the startup world, failure is a norm. And relationships are rarely impacted because of VCs’ disagreement to further funding. More often than not, the entrepreneurs are keen to quit this failed startup and move on to their next venture as well.

Let us now go back to our original story of Company A crushing it and moving on to raising Series B. Another VC comes up to share the risk and the amount they provide affects the valuation again. Eventually with the growth of the startup, its valuation starts to get determined using standard valuation methods such as DCF. And as it gets closer to listing, its valuation converges with similar listed businesses.
Let’s compare some key criteria among early stage, late growth and listed companies.
Early Stage Startups Late Growth Startups Listed Entities
Revenue is highly unpredictable. Revenue is medium to highly predictable. Revenue is highly predictable.
Over 100% annual growth. 30 to 70% annual growth. 2 to 10% annual growth.
Valuation derived from funding preferences. Valuation derived from funding preferences as well as public market comparisons. Valuation derived from Discounted Cash Flow.
Founders generally do not sell any equity at this point. Founders have limited scope to liquidate their stake. High scope of liquidity for founders.
Investors have virtually zero liquidity of stake. Investors may have around 25% discount on valuation while exiting. Investors have high liquidity meaning no discount during exit.

What does it mean to secure seed funding?

Even though seed funding only takes care of the initial stage of a startup’s growth, securing seed funding may indicate long-term viability of the growing business. A seed VC will not invest in a startup if it is uncertain that a Series A VC would be interested in funding it in 12 to 15 months. And the same goes for Series A VCs. They would not fund a startup unless they know a Series B VC would be ready to fund the business later on. So when a startup secures Seed funding, it goes around as a signal in the industry that this is a promising startup that will be available to Series A investors in 15 months or so.

On the contrary, if a seed VC does not play for its follow on round or goes on to sell its stake, that is a negative sign for the startup. In fact, each action of a venture capital is a signal, a coded telling of something, to the founders whether it is intended or not.

How does multiparty staging differentiate from other methods of valuation?

According to Professor Aswath Damodaran, a Professor of Finance at New York University, VCs largely use four methods to value a company including recent pricing of the company, pricing of similar private companies, pricing of public companies with some adjustment and forward pricing. Among these methods, he marks the last one, forward pricing, to be applicable to startup valuations.

This method, according to Prof Damodaran, involves the forecasting of different operating metrics out to two, three, five years. Based on these metrics and application of a pricing multiple derived from the market, venture capitalists use a target rate of return. This target rate of return incorporates not only conventional going-concern risk but also survival risk and fear of dilution. This rate also plays a role in negotiation.

However, from our experience, determining this target rate of return is not a common practice in startup valuation. In fact, we have not heard of any VC who plays at the same stage as us using this method. Rather, it might be more popular among hedge funds.

Professor Damodaran also mentions that venture capitalists want to enter cheap and raise the value at the time of exit. From a common knowledge perspective, this assumption makes sense and this is what happens in the public market. But in the venture capital world, it is not that simple.

Venture capital is a concise and well-connected industry where VCs playing at different stages of a startup are familiar with one another. On one hand, we know microVCs and angel investors who refer startups to us. On the other hand, we have a network of Series A investors whose values align with us and we refer companies to them often. On top of that, as we operate in the space of tech-enabled businesses, we know many of the founders in this industry quite well. This only means that when you are a part of the venture capital field, you have no anonymity. Everything you do and every decision you make is observed and analyzed by others in the field.

All this means that when a VC intentionally lowers the price of a startup while funding and pushes it up later on, a few things may happen.

  1. Founders in the industry start talking among each other about the VC that it intentionally estimates lower value for a startup and is not honest or generous about the funding process. This eventually leads to less deals.
  2. It goes around the industry as a red flag and founders try to stay away from the VC in discussion.
  3. Next stage VCs understand that the previous firm boosted the valuation up too high and they can not get a good enough profit. As a result, they may stop taking referral from the seed VC in discussion.
These circumstances combined together creates a negative reputation in the long run that far exceeds the short-term bump on that one deal. The consequences can be high, the brand might be damaged. That is why, VCs are generally quite careful about the signal they send out, making sure that they seem founder-friendly and professionally responsible.

While the methods mentioned before may work for hedge funds and listed companies, none of the techniques is a perfect fit for startup valuations. The flexibility and collaborative approach of multiparty staging, on the other hand, is far more suitable for unpredictable and high-growth companies like startups.

How can DCF be related to high-growth startups?

DCF is not really a general tool. It is more of a valuation technique for low growth environments. Although well-suited for listed companies with predictable growth, DCF is not a useful tool for evaluating early-stage startups. However, throughout the years, startups have needed to defend their valuation process because of the popularity of DCF – making it look like any deviation from DCF is not ideal and needs to be justified. This method has been interpreted as the benchmark, even when it is not suitable for the business.

DCF and value investing were both formulated around the time of the Great Depression when capital was much more scarce than today. Today, money flows around easily and the startup industry has grown. Frameworks formed in the 1930s are not suitable for today’s high-growth startups.

Today, if one group of investors implement DCF and value investing on large businesses of predictable growth, another group of investors should implement venture investing and long-term multiparty staging on young startups with high unpredictable growth.

Conclusion

Venture capital business is subject to brutal power law where more than half suffer from failure. This article by Benedict Evans explains that 60% of venture returns come from 6% of investments. For top VCs, this phenomenon is even more prominent as almost all of the returns come from the winners for them.

For a venture capital, unlocking the potential of these ‘mega winners’ is the most significant leverage point. Once a VC gets a few hits, the ball starts rolling. Promising new startups start to acknowledge and seek funding from said venture capitalist resulting in a rapidly growing reputation and more winning investments.

To sum it all up, we must now recognize that valuation techniques used by public market investors are not applicable to young, rapid-growth startups with unpredictable revenue. Instead, long-term multiparty staging games have shown up to be more ideal to take a company from ideation stage to IPO. This method has grown and evolved like markets do. It has iterated itself into one of the greatest financial innovations of the 20th century, almost as much as credit cards and microfinance have!

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