The most common ways on how to evaluate early-stage companies

Startup-valuation

If you ever wondered how founders, investors, venture capitalists and seed fund managers come up with a valuation of early stage companies, you are not alone. The three most used methods to evaluate those companies are described in this article.

Private company valuation is primarily built from assumptions and estimations. As long as taking the industry average on multiples and growth rates provides a valuable number for the accurate value of the analyzed company, it cannot account for extreme one-time events that have been affecting the comparable public company’s value. Thus, analysts tend to normalize and adjust the rates to a more reliable value with expelling the results of such rare one-time events that may have taken place.

Valuation can be as simple as negotiating for ownership of 15-20% of the company aside of the investment amount. The investor at this stage typically wants see the company’s ability to generate a 10x return in five to eight years. The main question remains: Can this company grow to $ XX in revenues based on its market size and impact, the team and the product itself? The analysis will change considerably if the founder is a successful serial entrepreneur – and the value goes up as a collateral effect.

Once a company starts generating revenues and cashflow, the valuation analysis becomes easier, more technical and robust. Usually investors look for valuations based on comparable transactions within the sector and industry the target company belongs to. Any obstacles before the expected exit or equity sale along the period of 5 to 8 years are taken in account.

It is important to observe that the valuation of startup ventures usually change with competition and with recession. Some sectors have more capital interested in closing deals than others, and investors are less inclined to sign checks if the general scenario is going through a recession or has one coming around the corner. The first case, as an abundance of capital, drives valuations up through and the second case, as a recession scenario, drives valuation down.

For an early revenue stage company, the investor might be looking for a 5-10x return on their money and for a growth stage one (financial revenue companies growing 20% or more yearly), the investor may be looking for a return of 2x – 3x the amount he/she invested in the operation.

The investor will make assumptions about the company’s growth over the next five years and calculate an exit value to see if they can meet their IRR (Internal Rate of Return) and return multiple. The investor will look at the sales of comparable companies and public company valuations in the same sector, use exit assumptions based on the metrics used for this, like revenue, annually or monthly recurring revenue and EBITDA multiples and then determine the valuation metrics to use.

Generally, the investor will have a list of comparable transactions showing the companies, their operating metrics at the time of acquisition and the valuation. Take the mean/median of this comparable set and use this as a data point for valuation.

Therefore, in many valuation methods for early or seed stage companies, the starting point for determining the valuation of seed stage ventures is that of comparable deals. The analyst must consider the same business segment and local operations and companies funded in the recent past, and the amounts they generated in the sales / exits.

So before talking about 3 of the most popular methods for valuation of early stage companies, we need to know what determines a startup value and we need to know about the investment stages of a company. There are positive and negative signals to be considered when making the valuation of a company, with the main ones listed below:

Positive Signals

  • Traction – Does the target startup have customers? If the startup has been growing its customers portfolio, you have a good chance at raising US$ 500 to US$ 1 million.
  • Prototype – The existence of prototypes show that the company has already a certain level of execution and achievement for the go—to-market phase. This makes a positive impression on investors.
  • Present Funding Supply and Demand – If there are more business owners seeking money than investors willing to invest, this could affect your business valuation. This also includes a business owner’s desperation to secure an investment, and an investors willingness to pay a premium.
  • Distribution Channels – Distribution is one of the most important and also one of the most underrated points in a startup strategy. When the target company has distribution channels in place and working reasonably, the startup valuation will certainly be higher than one without them.
  • Revenues – Revenue streams are very important for companies which main product has a B2B and a B2C audience and when the target company has recurrent payments from clients, the more robust the valuation will be.
  • Reputation – Does the founder or his team have a track record of good ideas and executing them up to market adoption phase? Does the product already have a good reputation? A startup is more likely to obtain a higher valuation with those particularities, even when there isn’t any traction yet.
  • Timing of Industry – In case the target company belongs to a booming or popular (like mobile gaming or fintech) industry investors are more likely to pay a premium when buying equity. This means that the target startup will be worth more if it falls in in vogue industry and sector.

Negative Signals

  • Poorly performing sector – If a startup belongs to a sector that recently showed bad performance, investors tend not to be interested in the whole sector. That is not a rule of thumb, as some investors profit from the low tides to make their bets in poorly performing sectors.
  • Incapable management team – When If the management team of a startup has no track record or reputation, or key positions are missing.
  • Competitive and saturated markets – Some industries have a lot of competition and saturation already. A startup that might be competing heavily with established players or entering a market that is already too crowded may be a turn off for investors if its business model or product is not disruptive.
  • Defective product – If the product still doesn’t work well or the market seems not ready for it. Also, when the product is illegal or close to illegal and has no traction at all.
  • Low Margins – Usually companies with low margins need more cash reserves to avoid risks of non-payment and legal battles, as profit and reinvestment are scarce. Some industries like wholesale are known for low margins and high capital immobilization, which makes startups in those sectors less attractive for investors.
  • Lack of financial planning – The founders go to the funding market when they need the money fast and soon, almost running out of capital, instead of planning the approach to investors and VCs. For most investors, this is a mandatory red flag.

The funding stages startups typically go through allows the company and investors time to perform and to evaluate their moves. The typical funding stages are:

  1. Seed Funding – This stage usually has the money coming from an angel investor or friends and family, besides the owners. At this stage, typically up to 20% is sold to the investor, with funds raised in the level between $250,000 and $2,000,000.
  2. Series A Investment Round – This is the favorite stage for venture capitalists to get involved, as the startup already developed a solid sense of their market, product and business model. Highly likely the startup also launched the product before this phase and began acquiring clients. The Series A either aims at establishing a product in the market and take the business to the next level for scaling or it corrects and adjusts shortfalls of the startup not being able to generate profit yet due to regulatory or prototyping requirements. Funds raised usually stay between US$2 and US$15 million.
  3. Series B Investment Round – The startup is already a established player and needs to expand geographically and locally growing through mergers and acquisitions, and new staff hiring and product portfolio diversification.
  4. Debt Funding – When a startup is fully established it can raise money through a loan or debt note that it will pay back in the future, or through a credit line from a traditional bank, which is not always advisable due to heavy conditions and interest rates in comparison to alternative debt financing sources.
  5. Mezzanine Financing and Bridge Loans – Many times it becomes the last round of funding before an IPO. Bridge financing is used where loans are placed in the run up to an IPO, acquisition, management or leveraged buyouts. Bridge loans and mezzanine financing are usually short-term debt that uses the proceeds of the IPO or buyout for paying it back.
  6. Leveraged Buyout (LBO) – A Leveraged Buyout is the purchase of a company with a significant amount of borrowed money in the form of bonds or loans, instead of deposited cash.
  7. Initial Public Offering (IPO) – An Initial Public Offering happens when the shares of a company are sold on a public stock exchange. The prices the shares reach in IPOs are many times set with the assistance of investment bankers who help to lock the sell prices. Being listed in a stock exchange has its pros and cons, but in terms of investment volume, one might just think that anyone can invest in listed companies, making the access to capital easier and broader than in previous stages.

So now that we have seen all the points above, we can list and exemplify three of the most used methods for early stage investment in startups. There are many different methods used in deciding on a startup’s valuation, but many investors will use the Venture Capital Method, the Risk Factor Summation Method and the Scorecard Valuation Method.

1. Venture Capital Method

The Venture Capital Method (VC Method) is one of the methods for showing pre-money valuation of pre-revenue startups. It was first described in 1987 by Professor Bill Sahlman at Harvard Business School.

It uses the following formulae:

  • Return on Investment (ROI) = Terminal (or Harvest) Value ÷ Post-money Valuation
  • Post-money Valuation = Terminal Value ÷ Anticipated ROI

Terminal (or Harvest) value is the startup’s targeted anticipated selling price in the future. It is estimated by using reasonable expectation for revenues and earnings in the year it will be sold.

If we have a software business with a terminal value of US$2,000,000 with an anticipated return of investment of 10X and they need US$50,000 to get a positive cash flow we can do the following calculations.

  • Post-money Valuation = Terminal Value ÷ Anticipated ROI = $2 million ÷ 10X
  • Post-money Valuation = $200,000
  • Pre-money Valuation = Post-money Valuation – Investment = $200,000 – $50,000
  • Pre-money Valuation = $150,000

2. Risk Factor Summation Method

The Risk Factor Summation Method compares 12 elements of the analyzed startup to what could be expected in a fundable and possibly profitable seed stage using the same average pre-money valuation of pre-revenue startups in the area like in the Scorecard Valuation Method. The 12 elements are:

  • Management
  • Stage of the business
  • Legislation/Political risk
  • Manufacturing risk
  • Sales and marketing risk
  • Funding/capital raising risk
  • Competition risk
  • Technology risk
  • Litigation risk
  • International risk
  • Reputation risk
  • Potential profitable exit

Each element is assessed as follows:

  • +2 – very positive for growing the company and executing am excellent exit
  • +1 – positive
  • 0   – neutral
  • -1  – negative for growing the company and executing an excellent exit
  • -2  – very negative

The average pre-money valuation of pre-revenue companies in the startup region is then adjusted positively by US$250,000 for every +1 (+$500K for a +2) and negatively by US$250,000 for every -1 (-$500K for a -2).

3. Scorecard Valuation Method

The Scorecard Valuation Method uses the average pre-money valuation of other seed/startup businesses in the sector, and then judges the startup that needs valuing against this benchmark using a scorecard.

  • The first step is to find out the average pre-money valuation of pre-revenue companies in the region and sector of the target startup
  • The next step is to find out the pre-money valuation of pre-revenue companies using the Scorecard Method to compare. The scorecard is as follows,
    • Strength of the Management Team – 0-30 %
    • Size of the Market Opportunity – 0-25 %
    • Product and Technology – 0-15 %
    • Competition – 0-10 %
    • Marketing + Distribution Channels + Strategic Partnerships – 0-10 %
    • Need For Additional Investment – 0-5 %
    • Other – 0-5 %
  • The final step is to assign a factor to each of the above factors based on the target startup and multiply the sum of factors by the average pre-money valuation of pre-revenue companies

As a conclusion, using multiple rational valuation methodologies does not prevent other investors from offering a term sheet with a higher and more generous valuation. This depends on the investors knowledge of the market he is investing in, the accountability of the execution made so far by the founder team and the investor’s appetite for risk. Startup owners must balance the conditions in each Term Sheet with the amount offered by the correspondent investor and make up their mind for accepting the deal, negotiating a few points in the Term Sheet or passing the offer and search for an investor who can make a more worthwhile offer and bring smart money to the table, not only cash.