Why Startup valuation is more of art than science?

Introduction

• More and more startups specifically in the technology sector are achieving the status of unicorn.Many of them had a successful IPO recently including Crowdstrike and Slack.
• The fascinating story of Stewart Butterfield who wanted to exit his failing mobile gaming startup by liquidating it and distributing the proceeds to its investors was discouraged strongly by Accel Ventures - The VC firm which did not take back the money offered and encouraged Stewart to explore other opportunity, struck gold when Stewart came up with idea of Slack - A corporate chat software that was recently valued at ~$19B in IPO is well known.
• Such great stories are few and far between as around 70% of the startups fail and close before the 2nd year of its start and only 1% of startups achieve unicorn status.
• Hence valuing a startup is extremely difficult for a VC firm when compared to a matured business.The startup business do not have a past track record or historical earnings to show and neither there is an assurance that the business idea will become profitable and generate expected future cash flows for the investor.Hence valuing a startup is more of an art than science as qualitative factors are given more importance than scientific method.The entire basis to value a startup is built with realistic assumption and detailed projections followed by using multiple valuation models to arrive at best possible decision.

Stages of Startup and Investments

Typically every startup goes through the following stages:

• Bootstrapping/Seed capital - At this stage, the entrepreneur has a business idea to come up with a product/service that can solve a pain point in the market.Generally this idea will be in a fast growing industry with few or less competitors.In other words, this will be a Blue Ocean strategy.The entrepreneur puts his own money for this idea or borrow capital from his friends or relatives. In some cases, an Angel investor might support the business idea by investing capital in exchange for an equity stake in the business.In this stage, the equity stake invested generally does not exceed 10%.
• Series A Round - At this stage, the entrepreneur would have come up with a prototype of its product/services that validates market/customer requirements.At this stage, the entrepreneur can look to raise capital from Venture capital firm.This money would be used by the business to pay management salaries and to come up with the final product that can be launched in the market after testing.
• Series B Round - In this case, the product is launched in the market and startup also has managed to sell its product to few customers.The fact that customers are paying the startup for the product shows the value the product is giving.The startup can further refine its product by taking regular feedback from its customers and then incorporating those in its final product.Now the startup would look for additional funding from VC to scale the business by investing on Sales and Marketing.More resources would be hired to further scale and expand the business geographically.
• Series C Round - In this case, the startup would have gained a substantial market share by investing most of its funding on sales and marketing.The VC firm or the existing investor might want to invest additional round of money for inorganic expansion like acquisitions or Strategic alliances.This funding would increase the size of the startup after which the VC might look to exit from his investment either through IPO/ M&A route.

Startup Valuations Approach

• The most critical question for an entrepreneur before approaching for an investments is to determine what is the value of his startup before funding.This valuation is called Pre-Money value and after additional investment from the VC, the final valuation would be the Post-Money Value of his business.

Pre-Money Valuation of a Startup = Post-Money Valuation - Investment

• The entrepreneur approach would be to maximize the pre-money value of his business and look for additional investment only when needed in order to retain his controlling stake in the business
• VC approach would be opposite where it would look to minimize the pre-money value of business and increase his investment in order to gain additional equity in business.
• This difference in approach could change the Pre-Money valuation of business while Post-Money valuation will be same.
• In case of Single Round Financing, the entrepreneur would look to get money at stages rather than at one time.This would reduce the investment value of VC due to Time value of Money.For instance, if the Startup intends to raise $10M round of funding, then it would ask for $5M in Year0 and 5M in Year1.When the hurdle rate used for discounting is 30% then Present value of total investment by VC at Year0 is 8.7M rather than 10M.The VC on the other end, would prefer to consider all investment to happen at Year0 even when the money is invested at stages.According to VC, since this is a committed investment, it would not be able to invest in other instruments where as startup argument would be that VC can reinvest the excess money at hurdle rate somewhere else.
• The Post Money valuation approach used will be same by Startup and VC.The VC would look to exit its investment at Year 3 or 4 at multiple of earnings or revenues to achieve the required IRR or return.

Hurdle Rate for Startups

• For a matured business with historical revenues, customer base and sustained cash flows, the hurdle rate would vary between 12-15% looking at the risk of the investment.The hurdle rate in other cases would also the WACC that include the weighted rate of debt and equity.
• As startup business do not have historical revenues nor its growth projections accurate, the probability of the startup achieving success affect the hurdle rate.The probability factor takes into account at what stage the investment happens.
• For instance in case of Series A round, the probability of success for a startup to be profitable or attain target revenues growth can be as low as 25% which means a hurdle rate of 13% can turn out be 52%(13%/25%).This means that startup need to grow its earnings or revenues more than 52% in order to get funding.As the business matures, the probability of success increases.So probability for Series B round of financing can be 70% and for Series C round can be as high as 95%

Exit Strategy of VC

Most of the VC decides when to exit based on whether the investment is able to achieve the target returns or multiple that was projected.Hence the two important metrics for VC to exit its investment is IRR and Cash on Cash

• IRR - The Internal rate of return looks at what stage the VC would exit its investment and what would be the multiple.The valuation multiples is based on Income or Earnings. In cases where the startup is still burning cash or not achieved profitability, the income multiple is used.The value for the multiple would be arrived at comparing the startups with other startups within the same industry and stage of maturity in its business life cycle.The multiple is then discounted by VC as this investment is illiquid and cannot be easily sold by the VC.After arriving at the discounted multiple, the terminal value at exit is determined If the IRR is greater than the adjusted hurdle rate then the VC would look to invest.
• Cash on Cash - Here the final terminal value of investment at exit year is compared with initial investment to arrive at ROI for the investor.

Single Staged Round vs Multiple Rounds of Financing

• The startup would prefer to have multiple rounds of financing subjected to achievement of certain milestones. At every milestone achievement, the valuation increases which would help the startup to raise money at attractive hurdle rates and ensure that share dilution does not happen.For multiple rounds of financing, the startup can raise money from the same investor or reach out to other investors.
• To prevent share dilution, the entrepreneur can additionally raise capital through mezzanine debt from VC itself.The VC on other end would also like to increase its stake in the startup as it becomes more profitable.They can also use different types of securities like Convertible Preferred stock to common stock to Participating Preferred stock to protect them from any upside in risk.By being a preferred stock holder, the VC would be entitled to the proceeds before it is distributed to common stock holders.In addition, it is also entitled to receive dividend payments.The accumulated dividend payments needs to be deducted from the post money valuation after which the proceeds are distributed to VC based on their ownership.

Qualitative factors for Startup Valuation

The startup needs to valued by VC qualitatively depending on the following:

• The quality of management team and their expertise would be a critical factor for VC to invest.If the management is matured or have credibility, then it is easier to get funding.
• The product/service should have a great market fit which means that the product offered by startup should be have high addressable market with few available competitors.
• If the startup has already come up with a prototype for the product, then the technology/implementation risk is low.If the product is well received by the customer, then this would further encourage VC to fund the investment.

Conclusion

• Funding a startup requires a keen eye and a sharp mind from VC.The success rate of startup is 10-30% and the VC funds would know that only 10% of their investments is going to be successful and those 10% should offset all losses from their other investments.
• It is also important that VC funds are entrepreneurial in nature and not solely focus on financial returns or valuation.The best example is Elon Musk who invested his funds on Tesla and PayPal as he was convinced of the business idea and the market potential for these products.Further he was able to add value to these business by his business acumen and industry expertise to scale the business to billion dollar valuations.