Finding the next Facebook or Airbnb before they reach success is the dream of many investors. Getting in on these deals during the startup’s early stages is a great way to make money on an investment. Finding that next success story isn’t easy, however.
Investors need to use some type of method to evaluate early-stage companies. Valuation is typically based on estimates and assumptions. The question that they want to answer is this: At what growth rate will this company be able to produce in 5 to 8 years?
The methodology that investors use to answer this question will vary. Sukhi Jutla, Co-Founder & COO of MarketOrders says “In my experience of a founder raising investment, you need to show investors strength in two key areas: The quality of the team and the traction to date.”
William Cannon from Signaturely asks four key questions when evaluating an early-stage startup:
- How the team is unique in the niche against their competitor?
- Has the team worked together before?
- Does the targeted market provide long or short-term success?
- Are the audience eager, happy, or average when it comes to the product/service?
Others are looking for areas of distinction that are different from the rest of the market when evaluating an early-stage startup. Malte Scholz, the CEO, and Co-Founder of Airfocus believes in this approach. “This is really hard in today’s world which is why I advise businesses to experiment with aspects other than innovation. Some businesses may have a very unique marketing plan that will set them apart from the competition. Other businesses perhaps have better subscription plans. It’s enough to have one good element for a business to position itself in the industry.”
How do Investors Qualitatively and Quantitively Valuate Startups?
The valuation analysis becomes easier later on when the company starts to generate revenues and cash flow. The numbers are then based on real numbers. When a startup is at its starting point, many analysts will look at comparable deals as an indicator of where to start.
The operating metrics when the company is acquired and its valuation will be used as data points. Finding the average of these numbers from comparable deals can serve as a predictor of the early-stage startup’s potential. Looking at these comparable company sales can help make assumptions of how much an investor may get as a return. If these assumptions over the next five years match the investor’s expected return, they may decide to move forward with an investment.
To determine the valuation of a company, the methods can be put into qualitative and quantitative categories. Let’s look closer at specific methods that are used by VCs and investors who are interested in an early-stage company.
Qualitative Considerations
With early-stage companies, the qualitative considerations are just as worthy to evaluate before funding decisions are made. Here are some of the key qualitative items that are typically looked at.
Team’s Founders
Alberto Rizzoli, the CEO of V7 believes that it’s the prior entrepreneurial experience of its founders. “Well, factors such as the market size, the initial traction, or timing of the industry matter only if there’s a clear indication that the founders will be able to take advantage of them in the long term.”
Investors will hear pitches every day from startups, but it’s the team that is often the differentiator. The founding team should have the right mix of skills, team dynamics, and previous success to catch the attention of investors. These are the qualities that VCs look for specifically:
- Experience – What type of background the team has.
- Talent – Having the skillset from a technical perspective to be successful
- Passion – A team that possess the attitude to survive through the ups and downs
- Adaptability – The willingness to pivot or change when necessary
Startup’s Mission
This is an area that investors are increasingly becoming interested in. The social impact of the company’s product or service can make them an appealing investment. Having a clear mission also shows that the startup has a direction they are looking to go.
Founders who are able to share how their mission fuels their company culture can give investors a view of how well the team works. An engaged staff that’s passionate about driving their mission is more likely to succeed.
Competitive Advantage
When a startup has multiple competitors it is a sign that they are in a viable market segment. But the startup must demonstrate how they are unique in their approach to addressing the customer’s wants while being more affordable and efficient. Reviewing a startup’s competitive advantage will provide this understanding.
Matt Paulson, founder and CEO of MarketBeat, shared why he looks for competitive advantages in the hundreds of pitches he hears every year. “I want to see actual sales and user growth in addition to a minimum viable product. I also evaluate how the startup sees the problem and opportunity and whether they can describe both quantitatively.”
Crunchbase is an example of a tool that can be used for this research. Trends and changes across industries can be studied to see what the competitor landscape looks like from both direct and indirect sources.
Market and Company’s Momentum
Having a solid customer base and addressable market that can move the product or service further is another factor that early-stage investors may look for. Customers should seem excited by the startup’s product or service.
“In my experience, investors are looking for a clear statement of problem, solution, market, and traction.”, says Eloise Skinner, the founder of two businesses: The Purpose Workshop and One Typical Day. “ She goes on to say “Market and traction are an opportunity to show your research – on competitors, potential for scale, etc. traction also gives you the chance to showcase your progress so far.”
To show this traction, there are growth indicators that would need to be shared. Financial performance and user numbers are among those data points that would solidify this. It is also a good sign if the startup has been able to gain significant revenue on its own.
Quantitative Methods
The quantitative valuation methods that are typically used are the following four:
- The Discounted Cash Flow (DCF)
- Venture Capital Method
- Risk Factor Summation Method
- Scorecard Valuation Method
These are explained in greater detail below.
Discounted Cash Flow
This valuation method is a way to look at future cash-flow actualization. DCF works under the assumption that money from tomorrow is worth less than it is today. This is due to inflation and risk. Using DCF, you can understand the value of your money today by looking at the risk of earning that money in the future.
The DCF method is really just a formula that represents the value of all future earnings (the free cash flows), that are adjusted for their current value (present value of the net cash flows). Here is the formula:
DCF = CF1/(1 +r)1 + CF2/(1+r)2 + …..CFN/(1+r)N
CF = Cash Flow
r= discounted rate
There are 6 steps involved in determining the valuation of a startup:
- Create financial projections of the firm.
At least five years of future financial performance should be taken into consideration. A financial model or plan will need to be created (includes revenue streams, costs, expenses) and the Key Performance Indicators (KPIs).
- Calculate the future “free cash flows”.
This will include the EBIT (profit before interest and taxes are deducted), subtraction of operational taxes, investments (property, plant, and equipment), depreciation, and investments in working capital.
- Figure out the discount factor.
This is the value of the money with future money being world less than it is today. The discount factor is calculated by using the Weighted Average Cost of Capital (WACC). Discount factor = 1/(1 +WACC%)^ number of time period
- Calculate the net present value of all future cash flows.
Add up all the present values for all the years that are part of the forecast. Then find the “terminal value”, which is the value for the cash flows that are generated in the years after that time period. This calculation is found by multiplying the growth rate with the last year’s projected cash flow.
- Aggregate your calculations’ results
Adding up the net present value of all future cash flows and the terminal value will get you to the final value of the startup usin this method.
- Create other scenarios and analyses
The DCF method is sensitive to the input variables so creating different scenarios and analyses is important. Run through different possibilities to get an idea of possible valuation results that may occur.
Venture Capital Method
Another money valuation that is used among investors is the Venture Capital Method. It is used to show pre-money valuation of pre-review startups. Bill Sahmlan, a professor at Harvard Business School described this method first in a case study in 1987.
The concept of this method says the following:
Return on Investment (ROI) = Terminal (or Harvest) Value / Post-money valuation
Post-money valuation = Terminal Value / Anticipated ROI
The Terminal Value is the selling price (also called the investor harvest value) that’s anticipated for the company at some point in the future. This selling price is estimated with possible revenues that will occur in the year of the sale. Estimated earnings in the year of the sale can be found using industry-specific data.
Here’s an example to show you how that may work. Let’s say that we are looking at 5-8 years after making an investment in a tech company. During that harvest year, we expect them to have revenues of $10 million and an after-tax earning of 20 percent which is $2 million dollars. We determine the Terminal Value by looking at the Price/Earnings ratios in the same industry. If we have a 10X P/E ratio, then our estimated Terminal Value would be $20 million.
Risk Summation Method
There are 12 elements that are analyzed with a startup to use the Risk Factor Summation Method:
- Stage of business
- Management
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising the risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential profitable exit
The Risk Summation Method will then take each of these elements and assess them. They will receive the following assessment:
+2 – Very positive for growth and executing a great exit
+1 – positive
0 – neutral
-1 – negative for growth and executing a great exit
-2 – very negative
This average pre-money valuation of pre-revenue companies are then adjusted positively for $250,000 for every +1 it receives and a negative $250,000 for each -1 that’s noted. I.e. +2 = $500,000 and -2 = -$500,000.
Add up your total for each of these elements and you receive your startup valuation calculator.
Scorecard Valuation Method
The last quantitative method of startup valuation that will be explained is the Scorecard Valuation Method. This uses the average pre-money valuation that’s found from other seed or startups in the sector. Using these valuations, the startup is then valued against the benchmark that’s found from using this scorecard.
To use this method, you must first find other pre-revenue companies in this sector and see what the average pre-money valuation is for each of them. Then you score the Scorecard Method of comparing these companies to the startup. The scorecard includes the following:
- Strength of 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%
Each of these factors must be assigned to the startup, then multiply the sum of factors by the average pre-money valuation of pre-revenue companies.
Angles to Consider
Whether an angel investor uses a qualitative or quantitive approach to determine whether they will give cash to a startup, ultimately depends on their preference. There is no approach that is superior to another and each investor’s experience shapes how they may go about it.
Looking for specific signs when considering a startup’s valuation is also important. Here are some positive signs that the startup may have a promising future:
- Prototype – Having a prototype will show that the founders have shown initiative that they are moving towards a go-to-market phase.
- Distribution channels – When a startup already has some distribution channels that are working well, this is a great selling point for an investor.
- Industry timing – When the industry that the company is involved in is very popular or growing fast, the startup will tend to be worth more. That also means that investors will be paying a premium price for equity.
- Revenue streams – Getting steady payments from customers or clients is a very important aspect for a company. Valuations will be greater for those that demonstrate this capability.
With the good, there are also the bad signs to look for. If your notice some of these things from a startup, proceed with caution:
- In a low-performing sector – Industries and sectors that are not performing well should generally be avoided.
- Competitive and saturated markets – When there is already a lot of players present, it makes it more difficult for a startup to enter.
- Low margins – Startups that have low margins can’t provide much for profit or reinvestment. They also tend to need more cash reverses for possible issues such as the risk of non-payment.
