In an earlier post, I suggested that high impact entrepreneurs wondering how much their startup was worth – how much of the company they will need to give up in exchange for how much capital – should start by looking at the comparables. How much are more or less similar startups getting in the market? And how more or less similar are those startups in terms of team, market, technology and, alas, location (all other things equal, the further a startup is from a major venture capital center the less it generally will fetch). In this post, I am going to try and suggest a valuation model for those who insist on a more quantitative approach.
First, it’s important to remember that the finance theory gold standard for valuing a business is discounted cash flow analysis. It’s pretty simple in theory – put together a model of how much cash goes in and how much goes out over a period of time, assuming at some point a handful or two or three years out the number becomes a constant positive from year to year, and then pick a suitable discount rate to reflect the risk (at least 30-50% for a startup) and figure out the “net present value” of that cash flow stream on day one.
Alas, this is one of those cases where theory and reality don’t get along very well. For a variety of reasons finance theory just isn’t used much when the pros try and value a high impact startup investment opportunity. First, there are just too many variables involved; many of the variables are very hard to pin down even within a fairly wide range (how big will a market that may not even exist when the investment is made get, and how fast); and some of the variables are binary (e.g. maybe the technology just won’t pan out at all). Further – and you will have to trust me on this (or email me for a further discussion) – for a variety of reasons mostly related to the structure of venture capital vehicles (closed end funds that draw down capital over time and distribute investment proceeds to their own investors more or less as realized) the timing of returns on a given investment – which plays a huge role in the classic discounted cash flow analysis – just doesn’t matter all that much to early stage venture capital investors. (Don’t get me wrong, here; everyone would rather get their return sooner rather than later. It’s just that venture capitalists, and the people who invest in them, are not by and large market timers – or at least that is not how they are evaluated. Rather, they tend to focus much more on how much capital is returned on each investment, typically measured in terms of a multiple of the cash invested, then the timing of the return, at least assuming the return is within ten years of the investment.)
Fortunately, there is an at least plausible quantitative approach to valuation that has some utility in the startup context. Fittingly enough, it is often referred to as the “Venture Capital Method.” While various practitioners have their own versions of the Venture Capital Method the basic idea is simple. First, figure out what cash-on-cash return you need on your investment in a given deal. For a startup high impact business, figure at least 10x. Roughly 3-4 times what the typical early stage venture capital fund in a “normal” market might want to earn on its entire portfolio. Then figure out how much the company will be worth at a plausible exit. (Take a look at what comparable companies are being sold for currently, usually in terms of a multiple of revenue or in some cases profit.) Now, figure out what percentage of the exit value the investor will need to get that much out at the exit and, voila, you know the percentage of the company they need to own when they make the startup investment. And if you know that, and the size of the startup investment, figuring the pre- and post-money valuation is a very simple algebra problem.
Of course, it’s usually not quite that easy. Figuring out how much capital, in how many rounds, will be needed after the first round investment can be tedious – though in the age of the spreadsheet not all that tedious. (Remember as well that assuming the deal is working those downstream investors should be taking progressively less risk, and thus expecting progressively smaller cash-on-cash return multiples.) And don’t forget any future dilution from other events, such as increases in the employee pool.
The Venture Capital Method isn’t perfect. But within the context of early stage venture capital investing it seems to bring at least some measure of theoretical discipline to the otherwise black art of valuing high impact startup businesses. So long, that is, as everyone realizes that at the end of the day, a startup is worth what a willing investor will pay, and any sane willing investor is likely going to pay more attention to market comparables than fancy formulas.© MICHAEL BEST & FRIEDRICH LLP