Startup Valuation In The 21st Century

Startup Valuation in the 21st Century An Introduction to the seed and early-stage valuation practices: setting best-practice methods and standards for the future.

Olivia Passoni, CVA October 2020

© 2020 Valithea OÜ. All rights reserved.

Table of Contents 





How to Use This Book 1.

DISCLAIMER / COPYRIGHT

2.

ABOUT THIS BOOK

3.

SERVICES AVAILABLE

4.

GLOSSARY

Chapter 1 - Introduction to the Startup Valuation Market 1.

DO WE NEED TO VALUE STARTUPS?

2.

WHAT IS A STARTUP?

3.

MUST STARTUP VALUATION METHODS BE DIFFERENT?

4.

HOW MAINSTREAM VALUATION METHODS APPLY TO STARTUPS

5.

A TECHNICAL FINANCIAL APPROACH TO STARTUPS: GOOD OR BAD?

6.

CHAPTER 1 – RECAP

Chapter 2 - Fundraising Implications 1.

FINACING & STRATEGY

2.

PRE-FINANCING MUST DO’S

3.

FUNDRAISING & VALUATION BASICS

4.

FUNDRAISING MILESTONES

5.

FINANCING INSTRUMENTS

6.

SOURCES OF FUNDS

7.

HOW THE FINANCIAL PROJECTIONS HELP SET THE STRATEGY

8.

THE BASIC STARTUP VALUATION

9.

SHARES AND CAP TABLE CALCULATION

10. THE EXIT STRATEGY 11.

VALUE MAXIMISATION

12. INVESTMENT READINESS 13. CHAPTER 2 - RECAP

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

2

Table of Contents 2



Chapter 3 - The Financial Plan 1.

FINANCIAL PLAN STRATEGY

2.

DRAWING THE BUSINESS MAP

3.

DEFINING THE MARKET

4.

MARKET SIZING & EXPANSION

5.

OTHER CUSTOMERS

6.

CUSTOMER ACQUISITION COSTS

7.

REVENUE PROJECTIONS AND DIRECT COSTS

8.

INDIRECT COSTS

9.

THE FINANCIAL PLAN

10. BOTTOM-UP APPROACH 11.

SCENARIOS

12. CHAPTER 3 – QUICK RECAP





Chapter 4 - Principles of Markets & Valuation 1.

WHERE DO UNICORNS COME FROM?

2.

WHAT ROLE DOES HYPE PLAY?

3.

THE LOCATION CONUNDRUM

4.

THE VALUATION-FUNDING LOOP

5.

VALUATION AS A TOOL

6.

CHAPTER 4 – QUICK RECAP

Chapter 5 - Startup Valuation 1.

SEED MARKET METHODS

2.

EXIT VALUE

3.

THE INCOME APPROACH

4.

THE DISCOUNT RATE

5.

THE HYBRID INCOME & MARKET APPROACH

6.

VENTURE CAPITAL METHOD

7.

FIRST CHICAGO METHOD

8.

ALTERNATIVE VC METHODS

9.

PRICE OF RECENT INVESTMENT

10. COST APPROACH 11.

VALITHEA METHOD

12. ADJUSTMENTS 13. COMPARISON OF VALUATION METHODS 14. VALUATION RESULT 15. VALUING A STARTUP WITHOUT A FINANCIAL PLAN 16. CHAPTER 5 - QUICK RECAP

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

3

Table of Contents 3





Chapter 6 - Special Situations 1.

LATE STAGE STARTUPS

2.

EXIT VALUATIONS

3.

EXIT OF FOUNDER

4.

SALE OF INTELLECTUAL PROPERTY

5.

STARTUP SHAREHOLDING VALUATION

6.

ESOP

7.

ICOs

8.

CHAPTER 6 – QUICK RECAP

Chapter 7 - Conclusion 1.

REPORTS & NEGOTIATIONS

2.

COVID-19 AND BEYOND

3.

THOUGHTS ON THE FUTURE

4.

CHAPTER 7 – CONCLUSION

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

4

Introduction

How to use this Book DISCLAIMER / COPYRIGHT 

By accessing this e-Book, you indicate that you accept these terms of use and that you agree to abide by them.



With effect from the date of your accessing this book, we hereby grant you a non-exclusive and royalty-free licence to use the content of this Book, but only in accordance with the provisions of these Terms. You may only use the content of this Book to assist in your valuation, investment or financing work, for internal purposes only. Any use of the content of this Book should include the following reference and link: ‘ “Startup Valuation in the 21st Century”, Olivia Passoni, 2020, www.valithea.com’.



This Book is not intended to amount to advice on which reliance should be placed. Whilst we take every reasonable precaution and care in relation to this Book, the information here is provided without any guarantees, conditions or warranties as to their accuracy. . To the extent permissible under applicable law, we therefore disclaim all liability and responsibility arising from any reliance placed on this Book, or by anyone who may be informed of any of its contents: we accept no liability for any losses, whether direct or indirect, including loss of income or revenue, loss of business, loss of profits or contracts, loss of anticipated savings, loss of data, waste of management or office time or for any indirect or consequential loss or damage of any kind however arising from your use of this Book or any part thereof, whether caused by tort (including negligence), breach of contract or otherwise, even if foreseeable.



We may update this Book, and its content at any time. If the need arises, we may suspend or stop access to this Book. Any of the material in this Book may be out of date at any given time, and we are under no contractual obligation to update such material.



You must not distribute copies of this Book to third-parties, modify the paper or digital copies of this Book in any way, and you must not use the Book in any manner which is misleading, inappropriate or use any part of the Book out of context or in any manner which is objectionable or offensive, or which would damage or dilute our goodwill and current or future Trademark.



You must not use any part of the materials on the Book for commercial purposes without obtaining a licence to do so from us.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

5

ABOUT THIS BOOK 

About the Author: Olivia Passoni is a financial consultant who first worked in advisory companies in London and Vienna for 7 years, covering different roles in financial research, valuation, financial due diligence, mergers & acquisition and restructuring, and subsequently founded her own online consultancy around 5 years ago. As a specialist in the valuation of private companies and as a Certified Valuation Analyst, she seeks to reconcile standard valuation practices with the world of private financial transactions such as startup fundraising and mergers & acquisitions, improve communication and understanding between the valuer and the business owner, as well as link financial planning with operational strategy. You can access her services and work via her global online consultancy: www.valithea.com



For now, valuation examples of real startup companies have not been used in this book, but these may be added in the future.



In some chapters, we discuss some valuation theories in length. For those who want to know only the key principles of each chapter, Quick Recaps will help navigate these chapters quickly without missing important points.



This book is aimed at investors, founders or valuation professionals. Many concepts discussed in this book are advanced and more suitable for startup finance professionals, but founders can also find key information about the fundraising process and startup strategy at seed stage. However, learning to value companies correctly requires practice and judgement.



This is the first edition of this book, which we aim to update regularly. You can offer your contributions and opinions, which can be included in future editions.



Some of the methods used in this book are not widely approved, they may experimental, work-in-progress or require subjective judgement – the aim is to present all possibilities to bridge the gap between a startup world where standard valuation practices are almost non-existent.



We may use words interchangeably, such as value, valuation, fair market value, and other commonly used definitions related to startup investments, which may differ from the definitions used in accounting standards or valuation standards.



Many of the statements in this book are opinions and observations based on personal experience. I do not claim that the content of this book represents undisputable facts or observations of statistically relevant sample sizes.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

6

SERVICES AVAILABLE This book can be thought of as a work in progress that can be used to collect theories about the startup investment market and the most used and relevant valuation methods for startups. As we discover new methods and tools that help professionals in the early-stage investment market, valuation professionals as well as founders that deal with the same uncertainty, we will update this guide to reflect new information, discoveries, and correct any mistake found. If you are a subscriber to our newsletter, you will receive an email every time a significant update has taken place.

Your contributions, experiences and queries will also be very helpful to clarify the methods used. You can get in contact in the following ways:

If you have QUESTIONS about the content and want to receive additional written valuation guidance,. different consulting options are available.

If you wish to receive a more

IN-DEPTH CONSULTATION on startup valuation

methods and related topics, you can schedule a call here.

If you wish to CONTRIBUTE with specific know-how or case studies that are not yet included in this book, you can get in contact at olivia@valithea.com.

If we include your contribution in this book, we will mention your name.

Additionally, you can VISIT our website to explore additional resources, calculators, templates and professional services.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

7

GLOSSARY View the International Glossary of Business Valuation Terms for a more complete list: most terms can be found here.

Additionally, an explanation of Equitable Value, Fair Value, Market Value can be found in the IVS Glossary. 

Bootstrapping - starting a business without external help or capital.



Business Angel – an individual who provides capital for a business enterprise



Cap Table - A capitalization table (or cap table) is a table providing an analysis of a company's percentages of ownership, equity dilution, and value of equity in each round of investment by founders, investors, and other owners Source



Employee Stock-Ownership Plan (ESOP) - An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares

Source 

IVS – International Valuation Standards by the IVSC (International Valuation Standards Council)



IPEV - The International Private Equity and Venture Capital Valuation Guidelines



IPO – Initial Public Offering, the very first sale of stock issued by a company to the public



Liquidity event - the merger, purchase or sale of a corporation or an initial public offering



Market Value of Equity – the current market price of a company’s total equity or stock



MVP – Minimum Viable product



PE – Private Equity



Pre-money valuation - refers to the value of the company before the investment



Post-money valuation - refers to the value of the company after the equity financing has taken place



ROI – Return on Investment



Run rate - The run rate refers to the financial performance of a company by using current financial information as a predictor of future performance, typically used for revenue by multiplying the latest monthly revenue by 12 to arrive at the revenue run rate



Runway – it measures how long the available money will last at the current cash burn rate.



VC – Venture Capital

Source

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

8

Chapter 1

Introduction to the Startup Valuation Market 1.1 DO WE NEED TO VALUE STARTUPS? Business valuation is not an exact science, nevertheless it is a very useful tool to regulate investment flows: it helps us understand and differentiate between different companies or investment assets and gives us information about the performance we can expect in the future.

Business valuation dramatically reduces uncertainty in the investments that take place every day and therefore makes our economy work better and more transparently.

The practice of business valuation has come a long way since it first emerged in the 19 th century. It is still partly a science under development as it evolves through the opinions of leading valuers, changing regulations and standards, and what we can observe on public and private markets, especially since the information we have available is constantly improving.

In many circumstances, there is leeway in how standards can be applied, also because valuation is forward-looking, meaning that the return that can be expected from an asset in the future has greater weight than what has been achieved in the past: the past gives an indication of risk and potential but not certainty about future growth. Estimations into the future can be probable but never certain: valuation is therefore prone to error. Valuation is a product of future profit, growth and risk. This makes judgement and experience some of the most important indicators of a good quality valuation, and that is why we often say that valuation is an art as much as it a science.

Unlike other valuation practices, startup valuation does not have set standards. What we rely on in practice is leading methods and practices. These are often very generalised methods, with few details. The later the stage, in theory, the more reliable a valuation can become as we can tell what the company’s future earning power is with a decreased risk or error. However, many are still clueless as to how to value startups, especially pre-revenue.

But do we have to value pre-revenue startup? Can’t we just leave it up to negotiations?

It’s not strictly necessary to value a pre-revenue startup. I am not here to argue that you need to have your financials in order before you have even validated your business model, or that an investment process without a valuation is incomplete.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

9

1.1 Do We Need To Value Startups?

However, what most people are not aware of is that in the negotiation process, the negotiating parties are implicitly relying on some valuation know-how. When you decide on the stake to give away during an equity transaction, or when you determine the cap on your convertible debt, you are making some valuation assumptions. These implicit assumptions are based on the market environment and prevalent practices: the return expected in specific markets is what determines how you can sell those instruments to investors. Founders and investors might agree on an implicit value without carrying out any complex financial calculations, but they are still relying on prevalent market knowledge based on implicit valuation practices. When the parties involved are not knowledgeable about the market where they operate, these assumptions will fail to take into account the true potential of the company by overestimating it or underestimating it.

For instance, why not give away 0.1% to a leading VC investor instead of 10%? Because the VC would not earn a return based on what we expect from the market. Why not give away 90% instead of 15% to a business angel? Because the founder would lose control over business decisions, complicate a possible exit, and increase the risk in the company, which would dramatically reduce its value, also making future rounds of funding almost impossible.

This book is an introduction to where we are today in the practice of startup valuation, how leading methods and practices in valuation help us understand the market and how you can apply them to a startup valuation as a founder or investor. This is an attempt at bridging the gap between startup valuation practices and professional valuation standards. By illustrating both common and new hybrid methods, we will therefore look into a variety of non-standard methods and subjective assumptions that are an important part of valuation of new ventures. We will explore both simple and complex methods, as well as ideas, suggestions, and future expectations on how the current methods can be improved.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

10

1.2 WHAT IS A STARTUP? Early-stage businesses operate very differently from later-stage companies, SMEs and corporations, but early-stage businesses can also differ widely from each other. Not all young businesses are startups, but there isn’t a clear-cut point to differentiate normal businesses from startups.

Startups are usually considered fast-growing and scalable business models, focusing on growth rather than profits in the early-stages. Some people would define startup businesses as only those companies heavily based on new technologies. However, this could be because technology is what enables scalability, especially when a business is marketing a business model based on the latest trending technology, for reasons that we’ll discuss later. Now, most new businesses that start out with the idea of growing fast in the future are technology-enabled.

It is also not clearly defined when a company stops being a startup. You could say that it could happen between year 5 and 10, when they are acquired or become public, but we still describe many companies having disruptive business models as being startups even after 10 years of operations in some cases. This is likely because they are still growing fast, as well as being continuously relevant in the startup world by acquiring or bringing to the market the latest trending technologies.

When assessing valuation methods to use for early-stage businesses, I would define startups as companies with a specific financing story, that are expected to go through multiple rounds of funding before becoming established, and where an exit, in the form of an acquisition or IPO, is an expectation. This defines whether using typical startup valuation methods is preferred, or whether to perform a standard valuation.

However, this is highly dependent on the startup story, which indicates what the company wants to achieve and how it wants to grow. Most entrepreneurs would define their new company as a startup, but not all of them have a suitable and believable startup story to go along with it. Many also tend to be unsure of whether they want an exit at all, which puts their future fundraising at risk and changes future potential as well. At the same time, some entrepreneurs start their company as a normal business, and then find a path to fast growth later on.

In conclusion, it is difficult to clearly distinguish a startup from a normal business at the onset, especially when the founders do not yet have a clear startup story. Companies that plan to raise funds from venture capital funds and similar early-stage institutional investors in the future, and that fit into the typical company profile sought by VCs and experienced business angels, can be valued using startup valuation methods. This is because a valuation is highly dependent on the transaction for which it is being prepared.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

11

1.3 MUST STARTUP VALUATION METHODS BE DIFFERENT? Startups have little to no past financials to account for in order to predict the future, their failure rate is very high, but this can apply to normal businesses during the early phases as well.

Nevertheless, even when comparing different types of companies at the same stage, the valuation of startups require different methods. There are many more reasons why valuations in these circumstances need a different approach, besides early-stage risks.

1.

THE ADDED UNCERTAINTY OF STARTUP BUSINESS MODELS:

• New business models or technologies have no reliable data on possible future exits and likely fundraising path; • Very successful startups may even create new markets that disrupt older business models, therefore changing underlying market assumptions; • Exit timing and multiples are fast changing as technology trends change fast in the startup market.

2. THE PRACTICE OF STARTUP NEGOTIATIONS, FINANCING AND PORTFOLIOS: • There is a gap in expectations between what founders may promise or think they can achieve, and the probability that these expectations will materialise, and this gap in expectations is usually known and accepted by the investor, which leads to a financial plan often representing the best-case scenario; • The portfolio strategy and structure of VC funds, which invest early and rely on long-term exits, requires large winners to achieve a satisfactory return on the fund, as the very high risk afflicting the majority of early-stage companies needs to be balanced with a very high return. This makes normal businesses unsuitable for VC funding and leads many founders to overinflate their possibilities to fit into this model, or to propose a strategy that purposely fits into this hyper-growth model; Many early-stage funds are known to have earned a great part of their return on investment from unicorns, and therefore the main successful strategy has been to get a stake in the most prized investments with unicorn potential. Fear of Mission Out (FOMO) drives many startup investments, as funds seek for these rare opportunities, rather than for many opportunities for discreet returns; • Multiple rounds of funding lead to a high dilution of early investors, which needs to be accounted for; • These fundraising transactions often have very particular rights and clauses attached, sometimes also with different rights held among different investors, which are not reflected in the official valuation; • The only liquidity event from which an investor can earn a return is an exit, and therefore no return is earned from dividends in the typical shareholding contract;

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

12

1.3 Must Startup Valuation Methods Be Different?

• Since an exit is often a must, the conditions to enable a successful exit are usually planned from early-on, including a favourable shareholding structure; • The valuation scope, as it relates to a venture capital or similar round of funding, is different from the valuation scope of other transactions, as multiple rounds, sometimes very close to one another, are expected, and are taken into consideration when estimating a suitable price. Multiple factors need to be taken into account. Also, the VC investor has a strong role in facilitating future rounds of funding, by introducing the startup to industry experts, and pushing for a fast growth and exit, which even differ from the typical practices of private equity investors.

3. BUDGETS AND ASYMMETRIC INFORMATION: • Considering that market information on rounds of funding for startups in certain locations are more readily available, this data is used as a benchmark, while non-startup companies have fewer comparable benchmarks to draw from.

• At the same time, available budgets to outsource valuations to experts are lower, and a strong weight is placed on negotiations, which often also see the founders as having little negotiating power and know-how during the early-stages; • This links up to the fact that founders without extensive entrepreneurship experience may be unaware of or not take into consideration how difficult it is to turn a fast-growing startup company into a profitable one, or how investors achieve sufficient portfolio returns to satisfy Limited Partners’ expectations, with asymmetric information held by the two negotiating parties.

4. THE BASIC ASSUMPTIONS ARE INCONSISTENT WITH THOSE USED BY VALUATION PROFESSIONALS: Early-stage investments operate in a different framework to other types of investments, as we have just seen. Valuers should therefore apply different assumptions to startup valuations.

Based on these different practices, how can valuers reconcile these differences?

• For startups, the disconnect between expectations and reality result in the valuer relying more on judgement and experience, rather than science and valuation techniques. Expert opinions and standards to rely upon are lacking or almost non-existent, whereas only prevalent practices are followed. Additionally, mathematical models used in traditional valuation methods were created and became more sophisticated thanks to the availability of stock market data and observable market risks, which do not apply well to the illiquid and intransparent startup market.

• In case the company fails, there are no assets to be recovered (or almost none, as the IP often does not have a significant value that can be recovered) and therefore the liquidation value is likely zero. The downside risk is therefore higher as a value of 0 is a very real possibility.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

13

1.3 Must Startup Valuation Methods Be Different?

• The Standard of Value (fair value, market value, investment value, etc.) depend on the role and rights of the investor, and on the transaction in question (called Bases of Value in the International Valuations Standards 1). Investment Value (or possibly equitable value) with entity-specific factors (according to the IVS definition) would be the suitable standard of value for many startup valuations done during a round of funding. The reasons for this is that only specific lead investors can extract the value indicated during a startup funding transaction, so it would not apply to any market participant without startup expertise and market power. Equitable Value is also to be taken into consideration here, even though it is not often used in valuation, as the valuation decided in negotiations also aims at satisfying the interests of founders, such as the need to keep control over the company until exit and to pursue their chosen strategy under certain conditions as well as to keep the motivation high. The variety of clauses sometimes present in the term sheet are a demonstration that value, in this cases, is subject to a variety of interests on both sides of the negotiating table.

The value of a startup at exit, instead, is likely a synergistic value or market value.

• When we are valuing an existing startup portfolio asset, fair value or market value can apply, depending on the circumstances and liquidity of the asset. In fact, The International Private Equity and Venture Capital Valuation (IPEV) Guidelines 2, which set out best practices to value funds and their holdings, refers to Fair Value as the standard of value to use for such assets within a portfolio.

• As for the valuation report that can be prepared for startups, the valuer can prepare a Calculation Engagement according to the standards they follow (e.g. NACVA Professional Standards 3), but a Valuation Engagement is not recommended for early-stage startups due to the high risk of error and lack of verifiable data. Also, many of the prevalent startup valuation methods in use are not studied, tested and approved by leading valuation experts or learnt in formal settings, and therefore they would not pass the quality standards of a Valuation Engagement, despite the fact that an adjustment to these stage-specific standards is needed for startups.

• The investment marketability can be high or low, sometimes very high for the latest technology trends, but the liquidity of the investment is very low, sometimes having to wait for over 10 years to cash in on early-stage investments. However, we do not add discounts or premiums to reflect this. The higher marketability, when present, is reflected in rules of thumb methods or in the best-case scenarios projections, whereas the lower liquidity is typically reflected in a higher expected return on investment or in the term sheet clauses surrounding the investment.

Sources 1. “International Valuation Standards”, IVSC, 2017 2. “The International Private Equity and Venture Capital Valuation Guidelines December 2018 Edition” 3. Professional Standards, National Association of Certified Valuators and Analysts®, 2017

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

14

1.4 HOW MAINSTREAM VALUATION METHODS APPLY TO STARTUPS In valuation, there are three main methods for measuring a company’s value: the income approach, the market approach and the cost approach. Each of these methods has a variety of different applications and sub-methods. Let’s briefly look at the main differences between how these methods are applied for traditional companies and startups, and what adjustments are necessary for startups.

The income approach typically involves discounting the future company’s cash flows by the cost of capital. It is possible to discount different cash flows (free cash flow to the firm, FCFF, or free cash flow to equity, FCFE) by the relevant discount rate (Weighted Average Cost of Capital, i.e.

WACC, or Cost of Equity). Additionally, with the APV (Adjusted Present Value) method, we can also discount financing benefits on the cash flows, with the appropriate discount rate for equity and debt. There are a few reasons why the income method differs for startups, thus if it is applied, it requires some adjustments: 1.

First of all, startups at the early-stages are unlikely to have DEBT on their balance sheet, therefore these methods are equal and lead to the same result. In the absence of net debt and high cash reserves, the WACC equals the Cost of Equity and the FCFF equals the FCFE. Additionally, the low or absent profits result in little to no taxes for some years into the future.

Initially, startups are often financed through convertible debts, but under a going concern scenario, and the best-case scenario for the instrument, investors expect to convert this debt into equity: therefore, for valuation purposes, we assume that this instrument will be converted into equity, and no debt calculations are necessary for the typical startup scenario.

Debt becomes more prevalent at later stages, but the future leverage of the company is difficult to predict at the onset, as average D/E ratios for different sectors are only available for public companies and these figures can change as financing trends change.

2. As mentioned earlier, DIVIDENDS are not usually paid out for startups, and the only return usually takes place during a liquidity event. However, the income method discounts cash flows, not dividends, even in the event that these are not paid out: the assumption here is that these cash flows, if not paid out, are reinvested and build up the company’s value or cash reserves. This has little weight for startups, as cash flows are low, equity injections for the expansion strategy are high and recurring, and the company is not seeking to build up cash reserves but rather to speed up growth. If the financial plan displays high cash reserves and they materialise, these are likely reinvested to grow further and push up the exit value as expected by investors. The conclusion is that again, a DCF can be applied to startups, but it becomes irrelevant, since high free cash flows are unlikely to take place until a liquidity event. When leaving high cash-flow reserves in the financial plan, the underlying assumptions of the financial planner is not that these will materialise, but rather that the new growth strategy on which these cash flows will be reinvested is not yet known. In fact, investors do not want to see a complicated strategy unfolding 5+ years into the future in the financial plan, but rather only the short- or medium-term strategy. However, it is very useful to calculate cash flows for early-stage liquidity purposes.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

15

1.4 How Mainstream Valuation Methods Apply To Startups

3.

One of the most important elements of the DCF approach is the correct calculation of a TERMINAL VALUE. As mentioned, carrying out a traditional DCF for a startup is not suitable, or rather is a futile exercise when considering how low the short-term cash flows will be.

However, assuming that a company also aims to produce a profit in the future, longer-term cash flows will be higher, even though this rarely happens before an acquisition for the typical startup. Calculating a terminal value is useful in some cases: it helps compare the terminal value to the exit value and understand the effect of synergies; when a sector is at its infancy and an exit value cannot be calculated reliably, a terminal value with added synergies can be calculated instead. The problem with calculating a terminal value for a startup is that the financials should be projected until the company displays a sustainable level of growth, ideally under 15%: this requires gross approximations and it will therefore not be precise. It is a great tool to ensure that the estimated exit value is not too low, and if it is too high, that the exit figure can be justified. However, it should not be used as one of the main valuation methods for startups.

4.

As mentioned previously, the financial projections for startups are unlikely to represent the most likely or base case scenario. This is also true of SMEs and other companies, as often the PROJECTIONS serve to set goals and aim for a positive-case scenario: however, they are achievable and the margin of error is considerably lower. It is the valuer’s job to negotiate lower projections with the management or to (when possible) increase the discount rate to account for the added risks involved (where this is acceptable). For startups, whereas financial projections should in theory be realistic and achievable, the probability that they will materialise is low, as the failure rate of startups is high (which includes also the failure to implement certain strategies and survive without materialising the expected potential). The failure rate in this case also includes the scenario in which the company does not achieve the exit that was envisioned. Securing an investment without illustrating the best case scenario is much more difficult, since startup investors are looking for potential future unicorns.

Therefore, the solution to value startups’ cash flows correctly is to either: i.

Create a secondary base-case financial plan only for valuation purposes;

ii.

Create different scenarios and weight them according to probabilities;

iii.

Use the best-case scenario with a high discount rate, without following the rules of the Capital Asset Pricing Model (CAPM).

5. In fact, because of the high risk of startup financial projections and of the exit value not materialising, the M-CAPM (Modified CAPM as sometimes used for SMEs) is usually replaced by an expected return on investment for the high risk assumed, adjusted by the expected risk of failure. This usually follows the expectations of every different fund. Another reason why the cost of capital is difficult to calculate is that the industry risk for new sectors cannot be calculated on the stock market, as well as the fact that there are a variety of startup risks to add to the company-specific risk premium, which SMEs are not subject to. This would make the calculation of the discount rate under the M-CAPM rules mostly subjective. Additionally, the CAPM assumes a fully diversified investor, whereas a VC is not.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

16

1.4 How Mainstream Valuation Methods Apply To Startups

The market method involves calculating the potential exit value of the company, today, based on the valuation of comparables. i.e. comparable transactions or comparable stock-listed companies, which can be used to calculate multiples. For startups, there are a few differences: 1.

Since, when we calculate the current value of an early-stage startup, we are doing this mostly for fundraising purposes, the current fundraising market value can be calculated only based on similar stage rounds of funding, for which market data is lacking and therefore some gross assumptions have to be made. When using these methods, different rules of thumb are applied.

2. The market method is not used to calculate an exit value as of today for early-stage startups, as that would be unrealistic. It would instead be used to calculate a future exit (instead of a terminal value) and then discount the figure to arrive at the present value of the exit cash inflow. This would be a combination method of the income and market approach.

3.

Market data is scarce for comparable startups as well, particularly for comparable transactions, for which only few (if any) financial figures are released. Even when a valuation is published, often a comparison figure such as revenue or users is missing. In this case, additional sector-specific multiples can be considered. Additional non-traditional multiples can be chosen such as users, locations and much more, as profitability is secondary for these acquisitions

4.

Additionally, the type of comparable transactions and comparable companies selected are very different from those chosen in the application of the traditional market method.

The cost approach involves estimating the value of a company though the sum of its assets minus its liabilities, to put it simply. This is typically used in real estate or similar businesses, where the value of the assets on the balance sheet reflects the future prospects of the company, and when these assets can also be considered valuable and durable as stand-alone assets. There are two types of cost approach appraisals: the reproduction method and the replacement method. In any case, for startups, few assets are present, mostly of intangible nature, and they are often not correctly displayed on the balance sheet. Anyway, this value will be very low and will only serve for comparison purposes with other startups: it cannot give a close indication of the market value of the startup.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

17

1.5 A TECHNICAL FINANCIAL APPROACH TO STARTUPS: GOOD OR BAD? The general opinion about using more advanced techniques for the financial projections and for the valuation of startups, particularly at the very early stages, is prevalently a negative one. There are also positive opinions, but let’s explore why the native opinions arise, and what are some of the statements I came across so far, as well as my motivations behind using a technical approach: •

“It’s not possible to create reliable financial projections for startups”: it is true, but projections are always wrong in any case, since we cannot precisely predict the future, what changes is the margin or error. However, we can come as close as possible to the most likely future according to the information we have, with different levels of risk. Many underestimate the usefulness of all the information, both quantitative and qualitative, that we have gathered to date and how the most experienced valuers are able to use them to decrease the risk in future financial projections and exit values. Financial plans and valuations do not eliminate uncertainty, but they can certainly decrease uncertainty if done well. Additionally, deviating from the financial projections gives us a lot of information about what has gone wrong and how the founders can learn from that: ignoring financial projections completely is a lesson lost.

Unfortunately, the vast majority of financial plans of startups today have little connection with reality and are carried out for the sole purpose of presenting some passable figures to investors, which devalues the usefulness of a financial plan to stress-test the strategy.

•

“I do not trust a founder who presents complex financials”. From an investor’s point of view, I think this translates more of less into: ”I want the founder to have a hands-on approach, be fearless, try out different strategies, instead of being someone who strives to perfection, who is too attached to data or too detached from reality”. Indeed, perfectionism is not a sought-out personality characteristics by VCs, at least not when it comes to the leading team member and CEOs, and for good reasons. A startup needs to go fast, sell effectively and grow by trial and error.

Nevertheless, the lean startup approach is not a rule that everyone goes by anymore, especially as many in the startup world have learnt what errors to avoid during the early startup phase. Today, a more hybrid approach, combining the lean startup approach with an effective validation before market entry, is gaining ground. This investor attitude towards financial plans is likely sector-specific, as some business models need a more precise approach than others. While it is true that a more perfectionist type is more likely to choose a complex financial plan, this is not the case in all circumstances, and this does not discount the usefulness of the financial plan. It should not become an excuse for some founders to shy away from doing the selling work and ignoring their entrepreneurial instinct. It should instead be used for setting goals, monitoring metrics when needed, getting to know the market, and adjusting the business or revenue model. It is in fact an absolute positive to be able to explore revenue models early on, as introducing or completely changing the revenue model later - a mistake that many startups made in the past - is complicated and sometimes inefficient or expensive.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

18

1.5 A Technical Financial Approach To Startups: Good Or Bad?

•

“The only thing that matters about startups is the team”: see the two points above. The need and importance of a team is not an excuse not to carry out the background work on the business model and market. While the team is indeed the most determining factor when no milestones have been achieved yet, the truth is that, when we select a team with the right ‘startup genes’ that is because we are trying to select: 1) someone who is reliable, has the prevalent winning traits for a startup founder, and therefore someone who we can assume to have done all the background work before asking for money, 2) someone who has the business experience to recognise good opportunities as well as the instinct to capitalise on those opportunities. Reliability is crucial and it is the hardest aspect to observe and assess for new founders. Other personality traits are becoming easier to spot, as psychological analysis has started to be introduced into some investors’ practices. A due diligence can look into the background work done and the market potential, but for lack of budget and time with smaller investments, investors have to count on the founders’ reliability. The reason why many support this statement is that investors often pride themselves for having the instinct to recognise the hidden potential in early-stage investments, as this is a major responsibility in their job.

While this is certainly true, and some investors do have an eye for the right investments, the way they take these decisions is by subconsciously selecting the same underlying assumptions that make a good investment in the financial world. While judging someone’s reliability cannot be substituted with technical analysis, and early-stage investments are still very much a people’s business, the two approaches are not in contrast with one another. A hybrid approach is needed, and the high failure rates of startups at all stages due to a lacking strategy and validation, suggest that leaving room for a better due diligence and financial planning may not be a waste after all. It is not a black or white situation: the financial plan and valuation help support and justify the investment decisions. This last point is also relevant to the common statement “everything depends on negotiations”.

In summary, using financial techniques to assess early-stage startups is not a replacement for how investments are assessed, but instead they complement and strengthen the process. The main benefits of creating a financial plan and carrying out a valuation are not the financial plan and valuation themselves, but rather the information they provide, as they help: •

assess the likelihood and timing of an exit and adjust the strategy

•

measure the market size, competition and tweak the revenue model accordingly

•

the founders highlight and understand their strengths and weaknesses

•

avoid overfunding sectors or companies that have little scalability potential.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

19

1.5 A Technical Financial Approach To Startups: Good Or Bad?

Creating correct financials is also a trial and error exercise that can improve over time. In the case of startups, it becomes extremely difficult, as the only real success can be measured when an exit takes place, which happens years later. The feedback loop is too long to be effective and much of the key information to improve decision-making by investors is lost or outdated by the time a new fund is started or new similar investments take place. Only few have the chance, as founders with multiple startups or as investors with multiple funds, to create a systematic approach that works. A better systematic approach that helps recognise good or bad investment decisions is underdeveloped. Can we identify which investments will succeed with a financial plan? Probably not, but we may be able to identify those companies without unicorn potential, those with a failing strategy and use investments more efficiently.

Is it cost effective to create sophisticated financials and valuations for all early-stage companies? In many cases it isn’t, but it is worth doing it for those companies that truly fit into the startup growth model, and whose potential can be maximised.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

20

Chapter 1 - Introduction to the Startup Valuation Market

Quick Recap 

Business valuation dramatically reduces investment uncertainty. It is still a science under development as markets change and more information becomes available.

Since valuations are forward-looking, the practice still involves a high degree of judgement.



Startup valuation is based on leading practices rather than set standards. Most earlystage valuation decisions take place during negotiations, nevertheless they are still based on implicit valuation know-how.



Early-stage businesses can be very different from one another. Startups are typically defined as companies with a scalable business model, focusing on a fast growth rather than profits, often technology-based.



Another effective way to define startups is through their financing story: startups rely on multiple rounds of funding to grow, aiming at a high and short-term exit or IPO. In fact, the transaction defines the valuation methods to be used. Whether a company fits into this description depends on the startup story.



Lack of past financials and the failure rate is not the only reason why startup valuation must be different, as these features apply to other early-stage businesses as well.

Startup valuations have added uncertainty, different practices in negotiations and financing instruments, and the assumptions used rely on a specific portfolio strategy.

Additionally, asymmetric information and negotiating power change how valuations are decided.



Startup valuation methods rely more on judgement than science, due to the disconnect between expectations and reality, the lack of valuation standards and the intransparent data. A liquidation value is usually close to zero. The standard of value may vary depending on whether we are valuing a startup for a new round of funding, a startup portfolio asset, or a startup exit. The low liquidity is usually reflected in other valuation assumptions, without the need for premiums and discounts.



The income approach, the market approach and the cost approach are the three methods for valuing a business.



The capital structure of startups is usually absent of debts, taxes are low, and convertible instruments are assumed to convert into equity, simplifying income valuation methods. Using a typical Discounted Cash Flow method is possible, but cash flows are unlikely to be relevant before the liquidity event. In the case of startups, the exit replaces the terminal value: however, calculating a terminal value can help for comparison purposes.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

21

Chapter 1 - Introduction to the Startup Valuation Market

Quick Recap



Since securing an investment for startups involves illustrating a best-case scenario, carrying out a valuation for startups involves producing additional scenarios, or using high discount rates not consistent with the CAPM (Capital Asset Pricing Model). Even when using a base-case scenarios and the Modified CAPM, startup cash flows are subject to typical startup risks that SMEs are not subject to: this subjective cost of capital is then replaced by the fund’s expected return on investment.



Considering that the exit replaces the terminal value, combined income and market methods are common for startups. The market method is in fact used to calculate a future rather than a current possible exit. Another market method used for startups is a rule of thumb method, and involves the analysis of similar stage rounds of funding with subjective adjustments. The lack of financial data for early-stage companies leads us to consider different types of transactions or companies, and to include sectorspecific multiples and other adjustments in the market method.



The cost approach, instead, for startups is unsuitable for financing transactions, but it can be used for other purposes and for startups comparison.



Many are against using advanced financial techniques for early-stage startups. Some say that it is not possible to create reliable financial projections: however, when considering quality financial plans, we have enough information available to decrease uncertainty. Some investors interpret a complex financial plan by a startup team as the lack of a hands-on approach, whereas the financial plan should be used for goal and strategy setting, rather than as a substitute for a hands-on approach by either the investor or the founder. Whereas it is crucial to assess the founders’ reliability when significant milestones have not been achieved, the team is not the only thing that matters, and therefore the financial plan helps to justify and clarify the investment decisions made. Financial plans and valuations provide important information about the market, strategy and financing possibilities: they do not provide a sure way to recognise investments that will fail, but they can classify the type of investment and avoid overfunding companies with little market potential. Using financial techniques is therefore recommended for all companies that fit under the ‘startup’ definition, whereas they do not provide the same value to those early-stage companies that do not fit this description.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

22

Chapter 2

Fundraising Implications 2.1 FINANCING & STRATEGY Planning out the financing strategy is something that many founders overlook. Funding possibilities for early-stage companies are limited, thus many founders have to accept a less than ideal financing source when this is available to them. Only few companies have the privilege to be sought out and to gain higher negotiating power.

Since the success of early-stage and fast-growing startups depends on receiving sufficient financing, knowing when and where the funds originate, and under which conditions, is fundamental. There are many mistakes to avoid regarding financing, which have put an end to many businesses, and there are ways for founders to prepare and to be more efficient at finding the right financing route earlier. Also, a start-up or small business investment, to some degree, comes from personal interest and experience, so many are unlikely to invest in sectors that they are not familiar with, unless the business can generate a short-term return and provide synergies.

The reason why it is important to know the company’s direction and which choices are available to the founders is that different strategies create different valuations, and very different financing possibilities. Some early-stage investors, as mentioned, tend to invest only in potential unicorns only, based on a fast-growing strategy.

A good startup story is important to get the attention, but it also needs to hold in terms of numbers. Demonstrating that the assumptions are realistic with data and validation will help founders gain trust.

The ideal financing strategy is closely connected to the company’s milestones.

The reason why we will look into the startup financing strategy, is that a deep understanding of the fundraising market is a premise for carrying out startup valuations, as trends and negotiations need to be understood to correctly value the companies involved in these transactions.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

23

2.2 PRE-FINANCING MUST DO’S For a startup, in order to increase the possibility of getting financed, there are some factors and potential risks to review when the business is founded. Reducing perceived risks would also increase the valuation.

VC investors typically prefer a founding team with diverse specialties, and they also prefer the company‘s core skills to be within the team instead of being outsourced. More homogeneous founding teams can still bring successful businesses to the market and can find the missing knowhow, such as technical, marketing, business or other industry-specific know-how, externally, but that makes the company much riskier as an investment. In the same way, being a solo-founder is associated with a very high risk, as the fallout from a solo founder becoming incapable of carrying on with the business, for whatever reason, signifies the loss of the entire investment. It is still possible to raise early-stage funds being a solo-founder, but only in some circumstances, with a fantastic track record or very safe business model, with good advisors backing the company or through some familiar financing sources. Also, being able to work in a team communicates to investors the ability to lead and cooperate when the company scales.

It’s important to be prepared for any risks materialising within the team: a strong shareholder agreement among founders, with clauses that determine what happens if a founder leaves or no longer actively participates in the business, is a must. Founders should ensure that any shares can be bought back cheaply if a founder leaves. Many startups have had to close down because of teams falling out and the inability to find a solution for the departing founder‘s shares. Remember that VCs will likely not invest if a major or controlling stake is in the hands of a founder (or business angel) who does not participate in the company‘s management and strategy, or in some cases even causes damage to the company. If fact, this would complicate a potential exit and therefore the value of the company would almost be nullified, unless someone has the ability and will to buy out the stake.

In the same way, all founders should be appropriately compensated for their work and involvement in terms of shares, as the motivation and stability of the company depends on it.

Founders can decide whether to have an Employee Stock Ownership Plan (ESOP) in place for the first employees: depending on the country, this may be expected or not, and provides investors with an indication of how much shares will be diluted in a liquidity event.

If Intellectual Property is present, this IP would need to be held in the company‘s ownership. An IP that is in the founder‘s ownership, or that is held in a subsidiary or associated company poses a great risk, especially if the company‘s success relies on it.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

24

2.2 Pre-Financing Must Do’s

It‘s important to measure the current monetary resources: depending on the chances of raising early-stage finance, founders should consider their ability to bootstrap and grow the company with their own money for longer periods of time, and know how long it will last (Run Rate) to avoid problems with investors and customers due to the sudden lack of money. It‘s advisable to have a timeline to stick to in terms of product development, validation and market entry, together with the funds necessary to go forward and reach each milestone. Calculating the run rate and time to raise the first round, which takes the longest, means that founders will be less pressed to raise funds and have higher negotiating power with investors. Desperate pleas for money, if successful, are usually raised at low valuations.

In addition, it’s important for founders to be committed to their company and strategy, to seek a cooperation with investors and share decision-making. A startup is not a lifestyle business and success may take many years of hard work to achieve. Sometimes, investors look into how much of their own funds the founders have committed, as they would want founders to be ‘all in’ and share the risk that investors are taking.

Fundraising trends, amounts, grants available and type of sectors financed can vary widely, therefore if financing is important for the company‘s survival, entrepreneurs can plan the business model, operations and location to ensure that it enables them to raise funds in the short-term, according to what investors are seeking ta the time. Unfortunately, this aspect needs to be considered on some level, as I have seen companies with great potential failing to secure funds because they did not tick some important boxes in terms of investment requirements.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

25

2.3 FUNDRAISING & VALUATION PRACTICES We established earlier that the transaction heavily influences the valuation practices used. This is one of the most important assumptions when carrying out a qualitative valuation.

For early-stage startups, valuations serve to determine the stake acquired by investors in a round of funding, or to potentially determine the valuation cap or discount of a convertible debt. In reality, the earlier the stage, the less likely that a valuation is carried out and that precise figures are requested or analysed.

It is very common for a valuation to be assumed without any formal calculations. Investors’ expectations vary depending on their experience and common practices: some business angels and VCs carry out their own valuations according to their preferred return on investment and do not expect the founders to carry out one. The assumption here is that it is unlikely that founders have the knowledge to estimate one, and it is common to underestimate risks of one’s own business: on the other side, not doing any internal calculations leaves founders with less negotiating power. Some investors, instead, may ask for a valuation figure very early on, and then discuss the valuation and financing conditions during negotiations. The aim here is often to arrive at an agreed value through negotiations rather than detailed calculations. Usually, only basic valuation logic is required.

It is good for founders to be prepared and to know that different investors may operate differently, which also depends on the type of investor (business angel vs VC). Valuation rules of thumb vary in different circumstances, but there are some general well-known recommendations and practices: •

The company value is clearly expected to increase as you grow, and therefore will be lower at the beginning when the risk is higher;

•

The rounds of funding are likely to increase over time;

•

Limiting the rounds of funding to only what is needed, while the valuation is low, ensures that you do not give away too many shares in any one round;

•

Having a high valuation is positive, but it should also be realistic. Having a down-round, when the valuation of the company decreases from one round to the next, is problematic for investors, therefore a high valuation is not necessarily a positive;

•

Some recommend giving away a maximum of 20% of shares in any one round and a minimum of 5%, with most transactions falling somewhere in the middle of this range. Many startups fundraising rounds that I observed on the market during various valuation projects, when valuation information is available, varied between 10-15%;

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

26

2.3 Fundraising & Valuation Practices

•

It is important to reward both founders and investors with a fair transaction. Founders are expected to keep a certain control in terms of shareholding and/or decision-making over the company in the long-term to ensure stability and to simplify an exit, taking into account the number of funding rounds potentially needed, and therefore it is not in the investor’s interests to ask for a very high stake;

•

It is possible that business angels investing at pre-seed may ask for a higher stake: however, a higher stake is only justified when the person can exercise significant influence and contribute to the company’s success with industry clients, future financing and exit strategy;

•

The valuation should be roughly aligned with other valuations in the same market, and any significant deviations are expected to be justified;

•

The interests of investors and founders should be aligned towards the same type of success (e.g. maximising an exit), since that requires an active contribution from both parties.

Debt instruments, including convertible debt instruments do not necessarily require a valuation of the company. It is however useful to value the company being financed, as it allows the financiers to assess whether the level of finance sought is proportional to the market value of the company, as the leverage can indicate whether the owners are asking for too much money, compared to what the company can achieve, and whether this would complicate funding rounds. Convertible loans are sometimes a way to postpone the valuation discussion, as the expectation is that the loan is converted into equity in the near future. However, the conversion can be set based on a cap (maximum valuation), a discount (the percentage by which the valuation at the next round is lower), which puts some constraint on the valuation at which the convertible debt is converted and allows convertible debt owners to ensure that their ownership is not too low. In order to set the cap and discount, and to ensure that the convertible debt amount is appropriate, the negotiating parties use some valuation assumptions, and therefore carrying out or estimating a valuation can also be appropriate in this case.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

27

2.4 FUNDRAISING MILESTONES We established earlier that the value of the company typically grows with time, as the risk of failure and uncertainty decreases. This means that different milestones and stages of the company will be associated with a different valuation. Milestones can also be linked to specific VC rounds of funding.

Milestones are essential to determine the current value of a company and its financing possibilities, but how these milestones are determined and how they affect valuations and fundraising rounds changes in different circumstances.

There can be different milestones to identify based on company type, number of rounds of funding for a certain stage, length of development and time to exit. The main milestones we can identify are:

Early Growth

Idea

Prototype/ MVP

Late Growth & Expansion

Market Entry/ Validation

However, there are still a variety of factors that affect the valuations of companies at the same stage, all else being equal. In addition to milestones, the factors affecting valuations are: •

Financing Trends

•

Location

•

Sector

•

Strategy

•

Competition

•

Timing

•

Investor role

•

Financing Source

From idea to prototype of Minimum Viable product (MPV), to product and market validation and then to early and late growth, the financing process and expectations change. Typically, the stages are defined by the type of rounds, from venture and angel financing, to pre-seed, seed, Series A, B, C and so on. These financing stages were defined by VC practices at different stages.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

28

2.4 Fundraising Milestones

There are companies raising many rounds, up until Series E or F, before starting to raise funds from Private Equity and Public Markets. This takes place thanks to the availability of private risk capital, which was previously available for large rounds only on stock markets. At the same time, this led to the specialisation of VCs and other funds on specific early or later stages. This also led to the creation of a wave of unicorns, which are private companies reaching 1 billion dollar in valuation, as companies are now able to grow without public capital. This hints at how important Financing Trends are in defining valuations: just like the market for private financing has developed to benefit from the life cycle of a startup, as this life cycle changes, fundraising trends can keep changing over time. In fact, thanks to the availability of capital and the ability to earn an easier return from later stage financing, over the course of 2018 and 2019, VCs have upped the size of Series A financing in many locations, so we also see large seed rounds, as large as previous Series A rounds. Startups at seed stage are already expected to show revenue figures, signifying an effective shift in how early-stage rounds work. At the same time, pre-seed rounds now tend to be more frequent and smaller, whereby founders would have to be constantly raising smaller rounds from different sources until they can effectively demonstrate market validation. 1 It is commons for Venture Capital firms, as they become more experienced, to shift to later stage financing, so this may well represent that shift, without a change in the terminology used for the funding round. This of course changes valuations for these stages, and it is important to consider these trends to avoid giving away too much equity during multiple seed rounds.

Something to remember is that these trends are not universal. In fact, these options are not available under the same conditions in all locations, and actually vary greatly from country to country depending on liquidity, knowledge of startup investments and the economy. Location is fundamental. The early-stage financing market, including grants, determines the number of companies that will be funded, the sectors, and the stakes given away, and ultimately determines the success of many companies. Countries such as the US, UK and Israel, or other startup-hubs with a very active VC market, tend to have higher valuations at seed stage, as the ecosystem contributes to the company’s growth in many different ways. The sophistication of local investors and their legal property rights also contribute to the equity stake expected and the amount of funding available for risk capital. In fact, some countries lack risk capital and investors can earn a higher return from traditional investments: investing and managing an early-stage startup investment requires passion and know-how not present everywhere. Transaction costs, local business risks and tax breaks for investors also have a strong effect on investment flows.

Additionally, an active acquisition market (or the lack thereof) can make or break an investment.

Founders can also chose where the company will be based, to take advantage of these advantages, and many have indeed moved their HQs to startup hubs, taking a hike in their valuation. This could seem unfair or counterintuitive, but there are advantages in the location that make a difference in the expected ROI. As some startups are considered to be born global, and their reach extends beyond their own country, they can appeal to more sophisticated international investors (when located in a country with less advantages), thereby raising their valuation compared to the average in their country.

Sources 1. “Seed rounds are dead”, Elizabeth Yin, 2018

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

29

2.4 Fundraising Milestones

The Sector determines the funding amount needed for each expansion or for product development: for example, a hardware startup easily needs millions before entering the market. A platform requires less investments before market entry and can more easily bootstrap before raising money for growth and marketing. Businesses belonging to new trending sectors and technologies are able to raise large seed and Series A rounds when opportunities with high potential are identified. For this reason, monitoring the latest rounds in your sectors gives a good indication of the current possibilities a startup has to raise a large round. The life cycle of sectors from inception to maturity also change the size and characteristics of funding rounds over time.

The unique strategy of the company determines both the size of the round and the relative valuation: how big a company wants to grow, how fast and in which direction the founders want to expand, determines how much money will be needed.

Competition is not to be underestimated: to compete with well-funded companies, startups need a somehow comparable level of funding (or a fantastic competitive advantage that money cannot acquire).

Timing refers to how the different financing rounds are structured and prepared: one can choose bigger and more rare funding rounds, or smaller rounds, when the possibility to choose is available. Raising funds when founders have no money left, in addition, may force them to accept the first offer on the table at unfavourable financing conditions.

The investor role influences the financing strategy, depending on what type of investor is financing the company. Investors can help startups grow and influence future financing rounds, or push for a faster growth that would lead founders to adjust their strategy. When a startup seeks VC financing, what that entails for the future of the company is a fast-growth, wider network and status, when instead a passive investor outside of the startup environment, alone, would lead to a different path.

Depending on the startup stage, different financing sources will be available. Since financing rounds influence valuations, financing sources will too. We’ll look at the them and their implications in the next chapters.

For this reason, it's always important to observe your current market, the specific situation of your company, the financing trends and plan a financing strategy accordingly.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

30

2.5 FINANCING INSTRUMENTS There are different financing instruments available to early-stage companies.

The founders owns common equity in their company, which gives them voting rights. It is possible to give out common equity to investors, but sophisticated investors typically opt for preferred equity. Preferred equity, depending on the specific contract conditions, may hold less control over the company, but may have higher rights over the earnings from a liquidity event, among many other possible clauses.

Equity transaction costs are higher, while a convertible note allows a transaction with lower costs and can delay the need for a valuation, but a rough estimate of the company’s value now or at the next round can be beneficial. In the majority of cases, an investor expects to convert the instrument into equity at a future funding round. A convertible loan can have a valuation cap, interest and discount. A valuation cap on the convertible debt limits the valuation at which the investor in the convertible debt can convert the investment into equity. An investor would prefer a lower valuation cap to gain more shares, while a founder would prefer a high cap or no cap. The valuation cap can be thought of as being the assumed current valuation of the company. The debt typically converts into shares at the minimum of the valuation cap and the discounted valuation at the next round of funding, with the discount usually being in the 15-25% range, which may represent how much the valuation is expected to increase from one round to another. A convertible debt can also have interest that accumulates into additional value, which can be converted into equity at the next round.

A large loan, instead, is rarely issued to startups as the risk of default is too high, and may be more often granted to traditional and local business models.

Revenue-based financing and similar instruments are rare, as they are considered a hybrid of equity and debt, and therefore in some countries they might be difficult to structure. It involves paying a percentage of the company’s revenue to investors for a period of time, independently of the profits earned. The instrument has gained some popularity, but it is more suitable for SMEs than for fast-growing startups, as specialised investors want to gain from the upside of an exit as well to account for the risk taken.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

31

2.6 SOURCES OF FUNDS Before deciding on the right approach, let’s look at the main funding options available: Bootstrapping simply means using your own funds to finance your business. Getting as far as you can with your own funds is a great strategy, it shows responsibility and commitment and demonstrates how founders are able to invest their money wisely. It also prevents founders from giving away too many shares early on as that may complicate the company structure in the future.

In many cases it is the only option, as funds are difficult to raise at the idea stage. However, this depends very much on the sector – investors tend to invest in some sectors earlier than in others, depending on the risk and the capital needed for product development. It also depends on the competitors and on the market: even though some businesses are not in urgent need of funds, they may need to develop faster to prevent competitors from getting ahead, or to ensure that they take advantage of market momentum. If there is demand for the product now, it does not mean that it will be the same in a few years once new competitors, fuelled by VC money, have reshaped the market. When possible to bootstrap, achieving milestones without reliance on funding too

early-on may positively influence seed stage valuations.

Funds from Friends & Family – it is a good option to get some founders started, albeit only available to a few.

Grants and subsidies are available for research-based projects, sustainable businesses, some types of innovative businesses and other special interest sectors. These are often country- or region-specific, so if the business’s success will strongly depend on the availability of grants, founders can plan the company’s location ahead.

Incubator and Accelerators are varied, some may offer support in terms of business development and network, and some may help with limited seed funding to get startups to the next step. These are most suitable to potentially scalable start-ups. The aim here is to give founders the necessary tools to get started and develop the prototype or minimum viable product. Being accepted for a grant or into an accelerator, especially for renewed grants or

accelerators, would reduce the perceived risk, and therefore the valuation of new ventures.

Crowdfunding is the funding option of choice for many startups these days. It is potentially available to anyone and it can be faster than other methods. Some start-ups decide against it because they prefer privacy. It is important to know that crowdfunding is great tool for some companies and not suitable for others – and that focusing on effective marketing communication is fundamental for its success. Some sectors are ideal, as they present a concept or product that resonate well with the public – and even though there are all kinds of companies crowdfunding these days, if the business is very technical or very focused on B2B relationships, it will be harder to sell it to a crowd. Another important point to remember about crowdfunding is that it’s not enough to get the company listed on one of these platforms: depending on the campaign and the amount to raise, there may be significant work involved in mobilising investors and potential customers to participate in the fundraising process. As many already know, there are typically four crowdfunding models, with various platforms specialising in each of them:

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

32

2.6 Sources of Funds

•

Donation-based crowdfunding usually applies when donating money for causes without getting back any return.

•

Reward-based crowdfunding involves contributing money in exchange for a reward, usually a product or service of the company, that the crowd is backing. I personally would not consider this an investment, but rather an advance purchase of a company’s products. For this reason, the campaign here is mostly marketing-based. It is suitable when a company mostly requires financing for its inventory, but less so when considerable funds are needed to complete the product’s development, as late deliveries may damage the brand at inception.

•

Loan-based crowdfunding makes it possible for anyone to lend money to startups or projects and earn a fixed return. There are platform that specialise only in this type of instrument, and others that give the choice between investing in debt or equity. The repayment terms would usually be fixed by the platform. For start-ups this would commonly be convertible debt, which converts into equity at a future point in time.

•

Equity-based crowdfunding allows anyone to become minority shareholders, especially some platforms that have an increasingly low minimum investment. Early investors in a startup often earn a return only when the company exits or in some cases, at a future fundraising round.

Business angels can pursue a variety of investment strategies. Some may actively invest in startups, some may invest through crowdfunding platforms, some may contribute to a private investment round together with other business angels, and some may be able to contribute to a large investment round independently (the so-called super angels). Being an active business angel who invests directly into startups also means having an interest in and understanding of start-ups and the industry they are in – that leads to them sometimes taking an active role and contributing to the company’s early development or taking board seats. Other business angels may prefer investing indirectly through investment funds, syndicates and VCs. Banks are less commonly approached by start-ups. Mostly, they are able to invest debt in traditional and well-known business models and local businesses.

Institutional investors include venture capital, private equity firms, mutual funds, hedge funds and others. Venture Capital firms are by far the most common investors in early-stage start-ups among these (less so in pre-revenue startups), as they have the means and strategies in place to benefit from early-stage investments. However, they are not the only ones: occasionally, other institutions and funds invest in early and growth stages as well. This usually happens in particular capitalintensive sectors, or for start-ups in more traditional sectors that may not benefit from the typical VC high-growth strategy. The backing of experienced business angels and VCs would often open

the doors to a wider network, support and set higher growth targets that would lead to a higher valuation in the following rounds.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

33

2.6 Sources of Funds

Corporate investors are leading industry players. Many of them grow through the acquisition of startups, but in some cases they also acquire minority shares, usually when the startup is more established and the risk is diminished. In this case, the investment is highly strategic and the corporate investor may end up acquiring the remaining shares at a later stage. Some now have a corporate venture capital branch that helps them identify the hidden potential in risky companies and make earlier stage investments possible, and even invest outside of their typical core business. Whether this is a good option or not, it depends on the founders’ long-term strategy. In

some cases, the involvement of corporate investors or corporate VCs can create worries for the company’s future independence and intellectual property, but it may depend on a case by case basis.

Stock markets (Initial Public Offering) can be an option for growth-stage businesses as well, as listing requirements for growth capital markets are less stringent, and new early-stage stock markets are slowly emerging in different pars of the world. The availability of capital through VCs and Private Equity has made this option less popular, since an IPO can be very costly. However, it is still a good medium-term option for some types of companies in order to pursue a market leadership strategy through acquisitions. Multiples of companies during an IPO transaction or for

companies aiming for an IPO listing in the future are likely higher than average transaction multiples, because of the stakeholders’ interests as well as a higher growth potential.

ICOs (Initial Coin Offering) have been the new fundraising trend for companies, which peaked in 2017 and then fell in popularity to become only a viable option for specific companies, namely blockchain-related growth businesses. At first it allowed entrepreneurs to avoid regulations regarding the sale of securities, now regulations are tightening up and companies have found a way to circumvent the regulations by selling utility tokens instead of equity or security tokens.

ICOs have allowed companies to raise funds much faster and in higher amounts than in traditional fundraising processes, but with less attention to the company behind and the risk of the investment. The biggest risk is now establishing exactly the legal regulations around ICOs and the rights attributed to investors by the tokens – with special attention to utility tokens that do not give right of ownership in the company (and therefore do not require a valuation and are not to be considered a financial investment in the traditional sense). Often, the valuation of these

investments fail to consider the future market for tokens, the rights of the investor and a variety of new risks connected to blockchain-based business models.

Distinguishing between all these different financing sources is useful for new startup founders planning out their financing strategy, and it is useful for all as a reminder that some of these financing sources may or may not require a valuation depending on whether an equity investment is involved. Valuations can change or are carried out based on different assumptions in the case of different financing sources, as factors such as the negotiation process and negotiating power, interests, rights and sophistication of investors differ.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

34

2.7 HOW THE FINANCIAL PROJECTIONS HELP SET THE STRATEGY The development of technology is uncertain, new industries can be created by the market leaders, the commitment and implementation skills of the team are difficult to foresee, and therefore much of the investment decision comes down to negotiations. Considering all this, why make the effort to look into the numbers and planning in detail?

All of the factors that form part of a company’s potential can be measured, not precisely, but they are observable. Financial projections can help in a variety of strategic decisions, in finding investments or selecting the right investments.

The process of valuing the company, for example, provides fundamental information about the company’s future, when to plan fundraising rounds, and how to present return possibilities to investors. Identifying suitable investors also means figuring out what type of investors can recognise the value that founders see in their company. A rejection may depend on the business‘s low potential, on whether it‘s just too early for receiving funding, whether it’s not the right investor for the startup or whether it just depends on the sales pitch.

Understanding that a company’s value is a function of future profit, growth and risk (for the company or its future acquiror) can shift the founders’ attention towards validating future strategies and potential markets, and towards reducing risks, instead of focusing only on what has been achieved so far, or on how good the startup idea is: it creates more realistic expectations and can lead to fairer negotiations on both sides. Preparing the financials, first, helps founders have a more structured approach to the company’s development, avoid wasting resources earlyon and balance priorities, measure the validity of ideas and progress as the product is developed.

New ideas can be translated into numbers to measure their viability or to understand how to adjust new concepts to make them profitable or valuable to future buyers. In fact, some markets and some expansion decisions carry some risk that may deter some investors, so an option that might look positive in the short-term could potentially be detrimental to the long-term strategy.

The startup’s strategy is also relevant to the exit strategy, as founders can choose whether they want to focus on maximising profits or on an early exit. If owners plan to sell the company one day, they can prepare in advance by reducing risks, simplifying the company’s structure and therefore maximising the company’s value over time. In this instance, owners can analyse the company’s competitive landscape by determining the timing at which it is worth selling and by understanding how the valuation changes with time.

Competitors can be better understood by assessing whether they are building value with branding, users, technology or other processes, and by observing their financing or potential exit strategy.

Therefore, securing funds not only depends on showing how amazing a product or startup is, but also on turning the company into a great investment, by analysing the market, through a valuemaximising strategy, appropriate sale pitch and investor targeting.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

35

2.8 THE BASICS OF STARTUP VALUATION When we value a company, we value its equity (the Market Value of Equity or Market Capitalisation) to determine the price paid for a transaction (acquisition, financing or other) where the investor receives ownership, which is an equity stake. The valuation can take place also for information purposes for debt financing, but it is mostly relevant for equity transactions.

When we talk about startup valuation, we use different terms from those used in standard valuations, as we refer to the Enterprise or Entity Value and Market Value of Equity to indicate the value of a company with or without its net debt (and other adjustments).

With startup valuations for financing purposes, these terms are rarely used. Also, a startup is unlikely to have net debt or non-operating assets, and therefore the Enterprise Value usually equals its Market Value of Equity.

For startups, you will instead often see the terms post-money valuation and pre-money valuation.

Pre-money valuation refers to the value of the company before the investment. Post-money valuation refers to the value of the company after the equity financing has taken place.

The equity stake is calculated on the post-money valuation, which represents the Market Value of Equity in the traditional sense. The scope of using these terms, particularly the use of the ‘premoney valuation’ is mainly to calculate the correct portion of shares before and after a transaction, which we will see later.

The most basic and simple way to calculate the value of your startup, is to divide the investment needed by the amount of shares (or stake) given away to the investor, to arrive at the post-money valuation. This reveals the underlying or assumed valuation based on the investment that is at the basis of the negotiations:

Subsequently, we can also calculate:

Pre-money valuation = Post-money valuation – Investment

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

36

2.8 The Basics of Startup Valuation

The calculation of ownership is then illustrated as follows: Valuation

Ownership

Pre-Money Valuation

$ 4 million

80% (existing shareholders diluted by 20%)

Investment Amount

$ 1 million

20%

Post-money Valuation

$ 5 million

100%

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

37

2.9 SHARES AND CAP TABLE CALCULATION Calculating the number of shares owned at each round, pre- and post-money, is slightly more complex.

At each equity round, new shares are issued. The price per share that the venture capital investor is willing to pay is:

Per share price = pre-money valuation / total number of shares outstanding Pre-Money share price

$ 4 million

Total Number of shares outstanding Pre-Money share price

4 million $1

The number of new shares to issue is calculated as:

New Shares issued = New Investor Stake x Post-money Total Shares Outstanding New Investor Stake

20%

Post-money Total Shares outstanding

5 million

New shares issued

1 million

In the same way, we can calculate the post-money valuation as:

Post-money valuation = New Investment x (Total post-investment shares outstanding / Shares issued for new investment) The total number of shares outstanding is also calculated on a fully-diluted basis in the Cap Table: this means that the total number of shares will include all outstanding common stock plus all outstanding options.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

38

2.9 Shares and Cap Table Calculation

A Cap Table example is displayed below, with investment, pre-money and post-money shares calculated for each round, based on the pre-money share price calculated. TFD is the Total Fully Diluted amount, including ESOP (Employee-Stock-Ownership Plan) and other options not yet realised: the share price will be based on the fully diluted pre-money shares.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

39

2.10 THE EXIT STRATEGY When we speak of an exit, or liquidity event, we usually refer to the acquisition of the startup by another company or fund, or a stock market listing (IPO). This takes place when the investor will receive cash (mostly, or in some cases the stock of the acquiring company) in exchange for the shares held. In some rare circumstances, it may be possible for an investor to exit their investment at an earlier funding round and be bought out.

Why do we need to consider an exit for startups at such early stages? There are different reasons:

•

Value depends on future cash inflows, which can come in the form of dividends or an exit for existing investors. Value can originate from additional synergies with the acquiring company, which results in a higher exit value and therefore additional cash inflows to the investors of the future acquiring company.

•

Startup investors, typically holding preferred shares, do not have the right to receive dividends. They can only earn a return from an exit in most cases. Additionally, the investor does not have many other opportunities to sell his/her equity stake without an exit, as secondary markets are not yet sufficiently developed.

•

Startups focus on growth rather than profits, and therefore profits take place too far into the future to be relevant for the calculation of the present value. The value of a cash inflow in 5 years is more valuable today than the same cash inflow taking place in 15 years: the risk, expected return on investment and opportunity cost of holding the investment is higher, on a cumulative basis, the longer it takes to earn a positive return on investment. Every investment has an inherent risk: since this risk is considerably higher for startups, the difference in value between an earlier versus a later exit or later comparable cash inflow is much greater.

•

Additionally, the exit value is typically higher than the cash flows that the company could earn independently in the short-term, due to the effect of synergies and other factors that affect the exit size.

For this reason, when founders do not want to sell or exit their startup company, and instead want to operate it in the long-term retaining their decision-making powers, the company will not be highly valuable for investors, since a return on investment will be low or absent. Usually, only investors that invest in late-stage highly profitable companies can earn a satisfactory return on investment from dividends alone, or by investing in stock-listed companies, since reselling shares will be made easier thanks to low transaction costs.

There are many typical businesses that do not classify as a startup, which have great potential and can generate a significant return to the owner. So, not wanting to pursue an exit is not negative per se, but the company would not be suitable for a typical startup investor, and would therefore have to adjust its business model and financing strategy to achieve the set goals without large rounds of funding, focusing on achieving profitability early rather than on a fast growth.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

40

2.10 The Exit Strategy

Both sophisticated business angel and venture capital firms, or anyone who invests in equity at the early-stage for financial reasons, will take into consideration the exit potential of the startup when investing.

IPO $$$

Investors

$$$

Strategic Exit

Highly valued company, synergies to be created by acquiring other companies

Synergies can be created by being taken over by a corporate investor

$?

No Exit

(only potential dividends)

Company can be sufficiently profitable on its own

For some large and risky opportunities, investors may look for very high returns, even as high as 15-20x for early-stage startups, considering a best-case scenario. In reality, average returns on investment for VC portfolios are much more modest, averaging around 20-30% return per year for a well-performing fund. Higher returns are sought to account for the large portion of startup investments that will fail. Failing does not only mean the company’s failure, but also the failure to exit or to reach an exit size that meets expectations.

As the risk decreases, and the exit will become closer in time, the expected return on investment on a single investment will decrease, to fall to a typical expected return on late-stage private equity investments of 3-5x.

The actual ROI for an investment can be calculate as follows, whereby for startups it is sufficient to include only the return on the exit by excluding cash flows:

ROI = (Cash Flows + Exit) – Investment x Investor stake% Investment

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

41

2.10 The Exit Strategy

To illustrate in a very simple way what this means for your expected exit size: if you raise $250k giving away 12.5% of your company’s shares, your post-money valuation will equal $2 million. If the investor is looking for a 15x return on the investment, accounting for a 46% dilution from now until exit due to expected future funding rounds and options, the expected exit size will amount to roughly $56 million (earning a return for the investor of $3.75 million. Double-checking the results, this equals to a return for the diluted stake of 15x.

In order to plan an exit strategy it’s useful to understand why corporates acquire other companies. This may not be relevant at seed stage yet, but it will become more important the faster a company aims to achieve an exit. Excluding IPO exits, which also have the aim for the company to become investment vehicles and serve as a marketing tool, and acquisitions by financial investors that mainly have monetary aims to be achieved in the short-term, corporate investors acquire or merge with companies out of strategic interest, which is why we also call them Strategic Investors.

As many who work in Mergers & Acquisition know, acquisitions often do not completely depend on rational decisions. There are corporates that are more risk-averse and that prefer to develop innovations internally, and there are corporates that prefer to grow through acquisitions, which is what we call acquisitive companies. There are companies that invest in other companies only when necessary, and there are other companies that have an active acquisition strategy that involves being on the lookout for potential targets: the latter may also have a corporate VC to link to potential acquisition targets early on. Growth can be pursued for different reasons: it may be a necessity in order to compete, it may be a personal wish of the CEO, it may be linked to a reward, or it may be part of a company’s market leadership strategy.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

42

2.10 The Exit Strategy

The more companies exist that are acquisitive in a certain sector, the better the exit possibilities will be. Growth decisions of strategic investors when acquiring a company usually encompass one or more of these reasons and resulting benefits: •

Additional sales channels  additional profit per user

•

Technology integrated in company  technology savings or sector leadership

•

Know-how integrated in company  new product development and sales strategy

•

Market leadership (eliminate the threat of competition)  additional users, better retention of current users who require constant product development and additional profit per user

•

Consolidate branding and company‘s market position  additional users, retention of users

•

Entering new country/ region  new users, sales channels and cost savings

•

Centralisation of activities and economies of scales (e.g. marketing, admin)  cost savings

•

Control over supply channels  cost savings

The last two are unlikely to be reasons to acquire startups and are more common in later-stage acquisitions.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

43

2.11 VALUE MAXIMISATION Valuing a startup at exit can be different than valuing a normal business at exit due to the very different financing history. This financing history has also ideally led to a higher scrutiny of operations and the access to top consulting from VCs and the network they provide. The assumption is that, at exit, a company has a clean structure and can operate independently from its CEO or founding team. In many cases, unfortunately, this does not take place for startups even after large funding rounds have taken place, but the companies are typically large enough not to depend on its shareholders to find new clients, which increases the valuation multiples compared to more traditional businesses.

For startups, preparing a company for an exit and performing a valuation to uncover value drivers results in different issues being uncovered, compared to the value maximisation of a normal business. Planning and maximising the potential exit value, for startups, involves drawing different scenarios that can lead to different future exit values.

Because the exit will be the ultimate goal, any factor that facilitates an exit will also increase the valuation, including: •

A simple company‘s legal structure (subsidiaries with different shareholders become a complication)

•

Straightforward company‘s operations (spin-off recommended for activities in other sectors)

•

No shareholder that may cause trouble, or having legal protection from shareholders’ interference

•

If you are likely to have multiple funding rounds it would be ideal to give away a stake no higher than 15% for every round

•

Strong relationships with customers independently of the owner, an active customer base to capitalise on

•

Being independent from any specific customers

•

Unique and competitive technology or know-how advantage that cannot be replicated

•

Legal control over the company and know-how

•

Only financing from financial investors (a minority stake to a corporate investor may bring access to a valuable network but your know-how may be diluted and get transferred to the corporate investor)

•

Qualitative financial performance

•

Selling to a company with strong identifiable synergies

•

Presence of synergies with multiples companies

•

Successfully developing the products and company to be easy to integrate operations into active corporate acquirers

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

44

2.12 INVESTMENT READINESS It is difficult for founders to assess whether they are building a valuable business, what investors want to invest in, and what a founder needs to ‘tick’ all the boxes. Investors, at first sight, tend to give preference to certain general features, in the absence of certainties. Besides meeting the requirements expected for each milestone, high future revenue, low risk and high chances of acquisition push up the investability and value of a company.

The main factors that contribute to a startup’s investment readiness and attractiveness are:

•

An large potential market that the company can expand into (considering only serviceable customers);

•

An active customer base and any real market information to validate the offering and confirm a product-market fit, and most importantly also a product-solution fit, with the problem being important enough to justify the solution;

•

Having a first-mover advantage in the market or disruptive business model. Entering profitable markets before other companies have done so is a sought-out feature, as the company can establish significant entry barriers and market power before other companies enter the market. Disruptive business models can change industries or create entire new ones, resulting in a high potential revenue;

•

Receiving interest from different investors is a sign of trust for future investors. Also operating in a popular startup sector is important, as it pushes up the value as well as the demand from investors;

•

Having intellectual property or a proven technology can decrease the risk of technology and help capitalise on the company’s value;

•

An experienced and responsible team is fundamental as it reduces the very high risk inherent in startup ventures, as well as putting the company on the right track to capitalise on its future possibilities;

•

Ensuring that the Company in the future can be easy to integrate into a potential acquiring company and can become independent from its founders of course maximises the chances of the company having a successful exit;

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

45

2.12 Investment Readiness

•

Having a focused strategy, but with a variety of future expansion possibilities, is less logical for some, but a startup resources need to be very focused on one product, service or market at first. It is difficult to scale, and therefore momentum and speed are essential to meet milestones and achieve success. A startup with too many activities followed at once will likely be disregarded as having little potential and as being too complex to invest into for specialised investors. Too many resources will likely go towards validating different business lines at the same time, with an increased possibility of failure. On the other side, having a variety of future possibilities will arouse the investor’s interest, as long as the company is not pursuing a confusing strategy at the very beginning.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

46

Chapter 2 - Fundraising Implications

Quick Recap 

There are many mistakes to avoid regarding financing. Different strategies create different valuations: the startup story and the milestones achieved influence the financing possibilities available.



Having diverse specialties in the founding team, a strong shareholder agreement with a good compensation plan, an IP legally in the company’s ownership as well as having enough monetary resources to manage the business until the next round of funds, helps the startup secure funds. The funds committed by the founders and adapting to investors’ requirements also contribute to the company’s investment readiness.



Valuations are unlikely to be carried out at the very early stages, at least not by both parties. Specific rules of thumb and expectations apply to startup valuations, such as the amount of funds to raise, the range of stakes and the company’s future financing curve.



Milestones are essential to determine the current value of a company and its financing possibilities, but how these milestones are determined and how they affect valuations and fundraising rounds changes in different circumstances. The factors affecting valuations at different stages are: •Financing Trends •Location •Sector •Competition •Strategy

•Timing •Investor role •Financing Source



Preferred Equity and Convertible Notes are the financing instruments most used by startup investors.



Valuations can change or are carried out based on different assumptions in the case of different financing sources, as factors such as negotiation process and negotiating power, interests, rights and sophistication of investors differ.



All of the factors that form part of a company’s potential can be measured, not precisely, but they are observable. Financial projections can help in a variety of strategic decisions. Securing funds not only depends on showing how amazing a product or startup is, but also on turning the company into a great investment, by analysing the market, through a value-maximising strategy, appropriate sale pitch and investor targeting.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

47

Chapter 2 - Fundraising Implications

Quick Recap 

Pre-money valuation refers to the value of the company before the investment. Postmoney valuation refers to the value of the company after the equity financing has taken place. Pre-money valuation = Post-money valuation – Investment



The most basic and simple way to calculate the value of your startup, is to divide the investment needed by the amount of shares given away, to arrive at the post-money valuation. Funds raised $ : Stake % = Post-money valuation $



At each equity round, new shares are issued. The price per share that the venture capital investor is willing to pay is: Per share price = pre-money valuation / total number of shares outstanding



The number of new shares to issue is calculated as: New Shares issued = New Investor Stake x Post-money Total Shares Outstanding



In the same way, we can calculate the post-money valuation as: Post-money valuation = New Investment x (Total post-investment shares outstanding / Shares issued for new investment)



The share price will be based on the fully diluted pre-money shares.



When we speak of an exit, or liquidity event, we usually refer to the acquisition of the startup by another company or fund, or a stock market listing (IPO).



The reasons why startup investors expect an exit are:  Because the exit value is typically higher than the cash flows that the company could earn independently  Because the investor does not have many other opportunities to sell his/her equity stake without an exit and does not have rights to dividends  Because the cash inflow from selling the company comes sooner than future long-term cash flows



Higher returns are sought to account for the large portion of startup investments that will fail. Failure does not only mean the company’s failure, but also the failure to exit or to have an exit size that meets expectations.



The ROI for an investment can be calculate as follows ROI = (Cash Flows + Exit) – Investment x Investor stake% Investment



The main factors that contribute to a startup’s investment readiness are: a large market, an active customer base, a disruptive business model, interest from investors, intellectual property, an experienced and reliable team, high exit possibilities and a focused strategy.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

48

Chapter 3

The Financial Plan 3.1 FINANCIAL PLAN STRATEGY Preparing a financial plan for a startup helps in countless ways. Most importantly it helps to: •

Size the market

•

Test different business models

•

Lay out the future strategy

•

Determine the amount of funds to raise

•

Understand the exit potential

•

Estimate a more reliable valuation

Differently from companies with a longer history or for companies that plan a longer-term exit, for startups we do not need all the figures of the financial plan to extract a valuation. The Discounted Cash Flow Approach does not work well with startups, as we have seen before. However calculating cash flows is important to measure the company’s liquidity and financing needs.

Understanding how big the company can grow in the short or medium-term, and how to realistically reach the set goals, is a very valuable output that helps make crucial decisions. In this phase of the financial plan, because of the potential for high growth, details are very important. It is not expected that founders keep to a certain strategy, and actually, one of the greatest skills for startups is to adapt and change quickly, as validation is a constant exercise. However, the more strategy information is available, the better you can analyse what has gone wrong and what parts of the strategy need changing.

A short-term financial plan of 1-3 years will only measure your liquidity, but it will not give an indication of how you can develop your future strategy, the potential of the market penetration or exit. In this case, carrying out a complete valuation would be difficult.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

49

3.1 Financial Plan Strategy

Many high-tech companies and fast-growing startups display a fast growth during year 2-3, and then naturally growth starts slowing down, unless new markets are targeted. This is not a negative factor, but a natural development, as triple-digit growth rates cannot be sustained in the long-term.

Creating financial projections with a constant growth rate, or one that is not backed by any market figures, is rather futile. However, because a slowdown in growth can lead to some investors rejecting an opportunity, this in turn leads to many startups presenting unrealistic financials, or incorporating impossible strategies to boost growth on paper, without carrying out the necessary exercise of considering different strategical possibilities based on realistic numbers.

Ideally, the financial plan should have 5 years of projections, planned on a monthly basis at least in the first 2-3 years, due to the fast growth and liquidity that needs to be tracked. The aim is usually to reach a sustainable profit within than period of time, except for business models focused on hyper growth rather than profits. However, it is still too early to assess the potential long-term financing strategy and long-term costs: this can be analysed from competitors in some cases.

The most important figure in a startup financial plan is revenue, which gives an indication of the company’s size potential and can be used to calculate an exit, together with user-related or sector-specific growth figures. Potentially, revenue and user-related figures can be extended into the future, with simpler assumptions, until an exit can be calculated according to the prevalent exit timing in the industry.

The first step to take for the preparation of the financial plan is market sizing and customers projections.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

50

3.2 DRAWING THE BUSINESS MAP When planning out the company’s strategy, the first step is to have a clear view of the company’s business model. The Osterwalder Business Model Canvas 1 is a very useful tool to use to lay out the business model. Since for startups this is likely to evolve quickly, it’s important to consider preparing multiple versions or laying out how each factor changes over time, clearly distinguishing how the business environment influences the model chosen.

At the seed startup level, this does not have to be a detailed exercise, but it needs to consider all the basics before entering a market, which are too often forgotten. The business model canvas focuses on different parts of the business model: costs and revenue streams, influenced by

resources, key activities, partners, value proposition, channels, customer relationship and customer segments. 1 Additional important features and decisions to take to build a strong business model are pricing structure and product features, which likely determines the company’s competitiveness. Barriers to entry can influence different types of costs and determine necessary investments, constraints in the sales channels usable, product features demanded by the market, internal resources needed to compete, required legally or by the market. In the same way, competition determines the value proposition, as it needs to be formulated with regards to the current market offering, and all other parts of the business model, from prices, to resources used, to product features.

Substitutes should also be considered within the competitive environment, and in today’s globalised competition, positioning is more important then ever. Validation, too, can influence the product (technology) or market chosen, or other parts of the business model, such as channels used and their effectiveness.

Business model choices can be influenced by a variety of factors. Analysing the value chain can also help place the company at the right spot in the value chain, depending on where the company can offer more value, or it can occupy more links on the value chain (for example: production and distribution), or just focus on the higher value activities and outsource the rest.

The customer segments chosen should first be subject to a market sizing analysis. Trends also give information on how the company can shift customer focus in the future. For example, the company can use one market as validation, and then move on to another market where favourable trends are expected to materialise in a couple of years.

The expansion to new markets can influence future product development. Different or adapted products can be offered to different customer segments as the company expands, or the same products can be offered to different customer segments. In any case, a pipeline is fundamental for any company to be considered a worthwhile investment. This does not mean that a startup should focus on multiple markets and products at the same time – on the contrary – focus is expected of any startup team, but the future potentials should be visible to investors.

Sources 1. "Business Model Generation", Alexander Osterwalder & Yves Pigneur, Strategyzer, 2009

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

51

3.3 Drawing the business map

Different parts of the Business model Canvas 1 are illustrated below, including their causality and how they influence each other in the financial model that we’re going to create, while below are factors that can change the strategy and business model over time.

Cost Structure

Price & Revenue Streams

Resources Channels Partners & Suppliers

Product & Value proposition

Customer Segments Customer Relationship

Key Activities

Changes influenced by:

Validation Barriers to entry

Pipeline

Competition & Substitutes, Positioning, USP

Market size & trends Pricing Structure Expansion & market strategy Value chain positioning

We will start from the definition of customer segments, which is influenced by the chosen value chain positioning, changes in market size and trends. Different customer segments of markets will be targeted over time through a specific market strategy for each market. In turn, this determines the pricing structure chosen and the resulting revenue.

The other business model features mainly determine the costs and investments of the business. In order to reach and retain the chosen target customers, certain marketing and CRM strategies are used, which are used to communicate the value proposition of the product. The chosen sales strategy is influenced by the validation process and the competitive strategy. The product and its features may evolve over time as the pipeline develops. The creation of the product and its features involve the use of internal resources such as staff and tools, partnerships and suppliers, and are created and brought to the market through key internal activities. The requirements for these factors are influenced by the barriers to entry.

While the business model may refer to the business’s static features, the business map illustrates how these features change over time. In order to illustrate this, you can use any scheme or graphic of your choice.

Sources 1. "Business Model Generation", Alexander Osterwalder & Yves Pigneur, Strategyzer, 2009

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

52

3.3 DEFINING THE MARKET Trees grow in size by first extending their roots into the soil. Every specie of tree is different and it may need a different structure and acidity of the soil. Some need larger and deeper spaces to grow their roots to develop to their full potential, some need less. Different species grow at a different speed, have a different lifespan and different resistance to external agents. If the soil is occupied by other trees, there might not be enough space for another one to spread its roots and they will compete for nutrition and water.

The same applies to startups. Before setting the ‘roots’, founders needs to know what kind of startup they are building, what it needs to grow and become profitable and the market (‘soil’) that is available, as well as how many others are already in the market.

The market should be suitable to the venture that is being planned. If the company can only be profitable at a certain size and the competitors have also grown to a certain size, you will need a large enough market to grow. A niche company, instead, can become successful at a small scale, so a smaller but profitable market is what you need. If the market is overcrowded, developing means taking up the space of other companies and success means winning over some of their customers. Additionally, some companies are built to be resistant to economic cycles, just like some companies can be successful despite adverse market situations. These are things that can be researched and planned before ‘planting’ the roots of the company.

The way to start a financial plan for a startup is to define the market. It’s best to use numbers related to the company’s specific business, not the larger industry, as the latter doesn’t say much about the specific company potential. You may as well be in an industry that is billions of dollars in size, but if you only target a niche group among the customers in that industry, or if you take transactions of 0.01% out of the revenues in that industry, the total industry size gives you the idea that possibilities and earnings for the company are infinite, whereas these may instead be very limited. Looking into how much revenue the specific market and companies with a similar business model earn is a very good indication of potential.

How do we define the market? We may definite it in terms of number of customers, whether it is B2B, B2C, both or B2B2C: define who you are really targeting specifically. It can be defined in terms of market value, or yearly spending in that market: this is useful to determine how much your market share can really grow in the long-term, and it’s useful for some B2B sectors where the number of customers or the spending per customer is difficult to determine (for example advertising).

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

53

3.3 Defining The Market

To define your market, founders can ask themselves: who is the product really for? Who is the decision-maker? Who are they influenced by? How should they be approached? The ability to approach target customers also defines whether they can be part of the targetable market.

How customers use the product also defines the market and spending: how often is the service/product bought by the same customer? What is the retention rate, retention strategy or dependency on product add-ons? Is it possible to sell new products to the same customers or do they belong to a different target group?

What problems are you solving for your customers? Why is now a good time? As a founder, you will be asked these questions by investors many times as this often determines the success or failure of a startup, as well as how you validated your solution, with real-world examples, traction and partnerships further solidifying the reliability of your venture. Your validation possibilities can be: •

Personal observation

•

Market Research

•

Industry experience and knowledge of industry practices

•

Exact same product is successful abroad

•

Superior solution to an existing business model and deep knowledge of customer needs

•

Market validation

•

Customer traction & positive feedback

•

Existing partnerships

Validating the business model or idea also involves analysing the competition and substitutes.

Researching competing companies also gives insights into how fast they developed, their market penetration and what prices they charge. If the startup’s projections are more positive than the competition, there should be a competitive advantage to justify this.

The differentiation strategy can encompass one, or better, multiple elements: product/ technology, customer service, access to market/ resources, revenue model, marketing strategy, business model, etc. Is the competitive advantage sustainable and is it enough of a driver for customers to buy the product or switch from the competition? Are the competitors being financed by VCs or quickly gaining traction? If they are, bootstrapping may not be the best strategy.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

54

3.4 MARKET SIZING & EXPANSION The first step to take to build the financial projections, after the market analysis and validation, is laying out the expansion strategy with realistic figures by using the top-down approach. Startups operate in dynamic high-growth markets, and therefore this needs to be reflected in the way the market is evaluated: using only static data will not bring realistic results.

As your company grows and reaches new milestones, all of these features will expand and will require new investments:

We can break down the market size more precisely by defining: Total Addressable Market (TAM): Your actual target market. This will not be static and instead grow at a certain CAGR (Compound Annual Growth Rate, in size or value). Many startups typically target high-growth markets.

Serviceable Available Market (SAM): The portion of the target market that you can address and realistically target Serviceable Obtainable Market (SOM): The portion of the market that can win accounting for competition and the startup’s competitiveness over time.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

55

3.4 Market Sizing & Expansion

I have seen quite a few financial plans that just assume that the entire Serviceable Obtainable Market can be reached on day 1, and from then on, many simply apply a standard growth rate.

That’s not the reality of startups. It is best to consider SOM as a market that you can reach with your current business model, say between 5 and 10 years from day 0, and then determine how fast you can reach that market. Development is often very slow in year 1 and faster in year 2-3 for many tech startups. Another mistake is to project a too high market penetration: setting a maximum market penetration for the current product or service line helps arrive at a more realistic exit value. Since many startups don’t exit before year 5, and many may sell after year 10, it’s an exercise worth doing to assess a realistic exit size.

We start from calculating the Total Addressable Market (TAM). Depending on the sector, you can calculate this in terms of value, volume or number of customers. Value is the total spending per year in the target market, volume is the total number of products/ units sold per year in your target market, and number of customers relates to the number of people or companies carrying out transactions in the target market per year.

Market value is generally the easier value to find, but not the most useful. Most new ventures will have different pricing models and marketing strategies, therefore by using value, in many cases you will not be able to realistically project financials. Value, however, is a great figure to use for those businesses that earn income on a project-basis, where every contract may have a very different price point (B2B advertising income, for example may be difficult to project based on number of clients), or for transaction-fee businesses, where a certain percentage of an industry transaction value is earned.

Volume figures are recommended for those businesses where the number of products purchased on a per-client basis is difficult to determine. Calculating your projections based on the number of customers, is typically the most accurate option and helps greatly when measuring the company’s performance, particularly for B2C startups, as well as helping in the calculation of marketing and sales costs on a per-customer basis, which for some sectors is necessary.

There are some rules to remember when calculating the total market size: •

Be as specific as possible; if the company is in a niche sector, research its size or make some assumptions to reduce the market size to what is suitable to the specific company

•

Use values that are suitable to how the revenue will develop

•

For new disruptive startups, the market size may measurable but not straightforward, you can draw it from different industries where the future customers will come from

You can repeat this exercise, and the following steps, according to your expansion strategy, using your first target market, second target market, and so on. The market can be defined in terms of countries, regions, different customer groups, different product users within the same industry, different industries or a combination thereof. Be focused, by using only few expansion steps that are relevant to the business.

When it comes to a disruptive business model, this may be a little harder to calculate, as there is little or no market data to draw from. In this case you can use data from different industries together or make estimates based on macroeconomic data. In some cases, companies create new markets, or expand current markets: this, however, is not easy to do, therefore do not overestimate the company’s ability to influence the market. In any case, even with scarce market data, market sizes have a limit that can be drawn with a simple and free market research on other industries. In too many cases these limits are disregarded, and it results in startups claiming the ability to reach the entire market.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

56

3.4 Market Sizing & Expansion

The Total Addressable Market will also grow. Typically, VCs and other investors are interested in markets growing at a higher rate than the economy, otherwise growth will be impaired. Most startups, and even more so disruptive sectors or new technologies, are easily growing at double digits at the time of the first investments. Slow-growth industries would be interesting for investors only when targeting the industry with new disruptive products or services. You will then need to apply a CAGR (Compound Annual Growth Rate) to your Total Addressable Market to measure how it grows, and recognise that double-digit growth rates will eventually slow down after a few years.

A Serviceable Addressable Market (SAM) instead indicates that portion of the market that can effectively be served and targeted, by further cutting down your target market size. Even though the entire target market buys a certain product, when an innovative product is introduced, a portion of the market will not switch due to certain characteristics, demographics or habits, or they may not be targetable through typical marketing channels. Taking a clear-cut example of a developing country with lower internet penetration: the market for physical goods or offline services is of a certain size, but once the same services is offered on an internet platform or marketplace, it won’t be possible to reach the entire user market for that product; only those who will be able to access or know how to use the platform have the potential to be customers. The SAM and usage can also have a growth rate if the market is changing fast: however, ensure that you are not counting the same type of growth included in the TAM twice.

The Serviceable Obtainable Market (SOM) relates to that portion of the market that the company can effectively obtain as customers. This is hard to determine, but there are ways to do it more effectively. If the SAM only includes the market that the startup and its direct competitors target, the SOM can be divided into the number of competitors in the market. This will not lead to very precise values, but still more precise than most methods in use. You can divide, let’s say a 2 million customers market by 4 competitors, which results in a 500k target market for your company. However, what if the competitive strengths differ? You can adjust it by how much the startup’s competitive advantage can contribute to winning more or less customers, and consider how this can also grow exponentially over time. This exercise is very helpful in order to consider the company’s own strengths and competition, as many owners falsely believe that they can reach the entire market with only a slight competitive advantage.

What if the company has first-mover advantage? Regardless of the barriers to entry, if it’s a profitable market, the startup is very unlikely to remain the only competitor. Especially when it is easy to enter a new market, many founders believe that earning possibilities are endless, whereas low barriers to entry lead to too many companies entering new startup markets and leaving little earnings left. You can also consider consolidation, or in slow-growing markets, decreasing competition, when suitable. Again, future competition is hard to predict, but do not underestimate the power of using simple logic. If you are knowledgeable about the market on how it developed in the past, it’s possible to roughly predict how competition can develop, and in any case, it’s always a factor worth considering. So, don’t forget that, especially in new markets, competitors may increase every year: use a growth rate here as well.

The best way to realistically project the number of customers and growth for a startup will be to apply an initial low competitiveness, assuming for example that the average competitor is 5x more competitive on day 1, but that this competitiveness grows very fast to even exceed that of average competitors and their market share. Please set a maximum market penetration to ensure that your projection do not become unrealistic. By maintaining this market penetration, your company will still be growing through the market growth and the entry in new markets.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

57

3.4 Market Sizing & Expansion

What happens after this? Many falsely project, due to the lack of better financial tools, that the SOM will be obtained on Day 1. You can set the Serviceable Obtainable Market as a time-bound target, between 5 and 10 years, or possibly the same length of your financial projections. Then you can build up your market reach to reach 100% of your set SOM during this time-frame.

As complicated as this may seem, one of the most incorrect variables to use for seed or earlystage startups is the growth rate. Growth rates are important to analyse, but projecting them from 0 is pretty much impossible, or leads to many mistakes – we’ve all seen these financial plans.

Defining your target market and building up to its penetration goal is more correct.

Using these values results in the projected number of customers for the duration of the financial plan phase, for each of the target markets that you have used (or volume of products sold, or sales/ transaction volume, depending on the variables that you have used). You can then project retention which results in number of active customers.

There is a lot to research and validation work before a business model can be defined. Not all of these questions can be answered at first, but knowing that soon enough these metrics will be analysed helps plan ahead. When in luck, or thanks to deep industry experience of the founders, the metrics of similar competitors will be available and they can be used to validate or adapt the business model.

Below is an example of market sizing, in detail for Target Market 1, while for the other markets, only the result is illustrated: Assumptions

Calculations

2020

2021

2022

1,024,999 107,188 26

1,050,624 115,361 27

2023

2024

2025

TARGET MARKETS Target Market 1 February 1, 2020 Starts 1,000,000 Market Size CAGR 2.50% 10.00%

Serviceable Addressable Market

5.00%

SAM Growth

25 N° of Competitors 3.5%

Change rate competition

USP compared to current competitors Max penetration 4.5% years to reach all 5.00 available market Monthly retention 94.4% Change in retention 1.00%

10%

100.00% Target Market 2 October 1, 2020 2,500,000 5.00% 1.0% 25 Target Market 3 January 1, 2020 3,500,000 10.00% 3.0% 125 Target Market 4 September 1, 2020 5,000,000 5.00% 2.0% 50

Target Market 1 TAM SAM N° OF COMPETITORS PENETRATION

Growth Retention Active customers

1,103,812 133,625 29

1,131,407 143,837 30

1,159,692 154,804 31

0.68%

1.14%

1.93%

3.27%

4.50%

4.50%

725 133

1,319 506

2,401 1,401

4,369 3,422

6,473 6,365

6,966 6,966

SOM n° CUSTOMERS SOM gradual REACH

1,076,890 124,158 28

18.33%

38.33%

58.33%

78.33%

98.33%

100.00%

280%

177%

144%

86%

9%

56%

63%

71%

80%

91%

100%

109

378

1,035

2,625

5,001

5,416

2,562,499 128,444

2,626,562 132,972

2,692,226 137,659

2,759,531 142,511

2,828,520 147,535

2,899,233 152,736

1.01% 1,303 65

1.72% 2,281 570

2.90% 3,993 1,797

4.90% 6,989 4,543

7.50% 11,065 9,405

7.50% 11,455 11,455

3,587,499 369,512

3,677,187 390,113

3,769,116 411,861

3,863,344 434,823

3,959,928 459,064

4,058,926 484,657

0.47% 1,749 350

0.80% 3,123 1,249

1.35% 5,574 3,344

2.29% 9,951 7,961

3.87% 17,763 17,763

6.54% 31,709 31,709

5,124,999 257,947

5,253,124 269,684

5,384,452 281,954

5,657,040 308,175

5,798,466 322,197

0.17% 436 29

0.29% 771 206

0.48% 1,363 636

0.82% 2,409 1,606

1.38% 4,259 3,691

2.34% 7,528 7,528

Max retention

Target Market 2 TAM SAM PENETRATION SOM n° CUSTOMERS Target Market 3 TAM SAM PENETRATION SOM n° CUSTOMERS Target Market 4 TAM SAM PENETRATION SOM n° CUSTOMERS

5,519,063 294,783

Customers

577

2,531

7,178

17,532

37,224

57,658

New customers

577

1,954

4,647

10,354

19,692

20,434

Monthly active customers

481

1,910

5,284

13,269

29,593

Growth in active customers

2729.4%

297.1%

176.6%

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

151.1%

123.0%

48,074

62.5%

58

3.5 OTHER CUSTOMERS While we calculate customers’ projections, it’s important to remember that many companies, especially new startup business models such as sharing economy platforms, may have two sets of customers. The two sets of customers may need to be calculated in relation to each other, because they use the platform to interact with each other, and the number of one set of customers influence the decision for the other to sign up. For example, hosts would not be on Airbnb if there were no guests and vice versa.

So, if you have users and service providers as customers, you can first calculate the number of users, in this case your primary customers, and then project service providers based on the number of users.

The advantage with this approach is that you can set a separate customer acquisition cost for the second customer group, if you have very different marketing strategies for the two.

IN addition to setting a relation between the two, which allows the number of partners to grow with the number of users, for example, you can set growth or an economy of scale, a retention rate and a maximum number of partners to ensure that you don’t overestimate market penetration.

PARTNERS Users for every partner 4.00

equals to partners per user 0.25

Partners

119

448

1,177

2,808

3,500

New

119

329

729

1,631

692

-

Active

115

407

1,089

2,711

3,403

3,403

Total new users

696

2,283

5,376

11,985

20,384

20,434

Total active users

596

2,317

6,373

15,980

32,996

51,477

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

3,500

59

3.6 CUSTOMER ACQUISITION COSTS Once you have projected the customer base, you can calculate the marketing and sales costs and split these costs into the different channels used. By doing so, you can validate every channel and see if it is possible to realistically win that certain number of customers with your set marketing strategy and budget. This is also useful for the internal day-to-day company management and to measure marketing effectiveness.

For a more simple exercise, it is possible to research, in a few cases, the Customer Acquisition Costs (CAC) of larger competitors that have recently got listen on the stock-market. By measuring marketing costs vs. the number of new customers acquired during that period of time, you can arrive at the company’s CAC during that period. By doing some research online, it is possible sometimes to find a few general industry values, but it is generally important to know that B2C CAC is lower, let’s say from around $5-10, while for B2B this can be much higher, for example $150 or higher. The values depend on the specific sector and company, as well as the stage, with well-established large companies having lower CAC on average.

The marketing and sales strategy can include a variety of methods and channels. It is possible to establish the portion of customers that can be earned through each channel. These can include: social media, Adwords, media advertising, traditional advertising, referrals, direct sales, sales partners, trade fairs, shops (if they are an active part of marketing), and others. For example, you can project a sales or marketing funnel with costs, audience target, leads, and customers won over time. For sales funnels, you can then establish, based on capacity, how many sales employees you need to achieve your targets. This generates the expenses for each channel used, as well as the total marketing and sales costs and the average cost to acquire a customer.

In advanced financial plans, you can also include the cost to retain current customers, or the general marketing expenses that are necessary for both attracting and retaining customers, such as external PR or consultancy agencies, marketing materials and design, regular branding costs or launch expenses. Whichever type of expansion you choose, sales and marketing costs can grow in line with your expansion, preferably on a per user basis.

Calculating your Customer Acquisition Costs (CAC) should also be at the basis of the company’s financial management. For a healthy business, it’s usually recommended that LTV (Customer Lifetime Value) is at least 3 times the CAC, and that in any case, that the long-term revenue per customer is clearly in excess of the Customer Acquisition Cost.

In the next page an example of advanced customer acquisition costs calculation is illustrated. Not all calculations of other marketing costs and partners marketing are included, but you can see how the assumptions used for the customers’ direct channels lead to an estimation of capacity, total costs and CAC per customer.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

60

3.6 Customer Acquisition Costs

Customers

Direct Sales

Events (Trade Fairs/ Shows/ Presentations) 5.00%

90.00%

5.00%

February 1, 2020

September 1, 2020

August 1, 2020

February 1, 2020

Shops

Advertising

Partnerships & Referrals

Organic Growth

Assumptions % of users acquired through this channel

5.00%

10.00%

5.00%

1.50%

100.00%

100.00%

from date Monthly customer reach per unit (salesperson, event, PPC, etc.) per month Lead rate

7.50%

33.00%

10.00%

7.50%

100.00%

100.00%

Conversion rate

5.00%

5.00%

5.00%

5.00%

3,360

10

5,000

2,000

1

Change p.a.

Minimum staff or fairs or ads p.m.

1.00

9.00

50

25,000

2.50%

-

3.00%

131.75

Maximum staff or fairs or ads p.m.

50.00 5.00%

-

20.84

Cost per unit (per event, per monthly rent, per PPC, per referral)

150.00 3.00%

Cost increase p.a.

-

CAC

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

61

3.7 REVENUE PROJECTIONS AND DIRECT COSTS Working on your customer base potential is the first step to building reliable financial projections for startups. After analysing, sizing the market and projecting customers, you should have the following figures for every month or year of your expansion: number of customers reached, number of new customers and number of active customers: which ones of these figures you will need depends on your business model.

How you plan to charge your customers defines your entire business model. This include deciding when to start charging customers, how much, how and whether you want to sell different products or services to different customer groups. The revenue model itself can also provide a competitive advantage and defines the type of resources that you will need.

Many startups first decide to focus on a fast-growth strategy involving technology development and/or customer acquisition and only later define their revenue model. However, having a set strategy is becoming increasingly important for investors, because proving that you can generate revenue from your customer base becomes part of the validation process.

I identify eight main types of revenue streams for the purpose of our exercise: •

Sale of products

•

Sale of services

•

Subscription fees

•

Transaction fees

•

Licence fees

•

Rent Fees

•

Advertising

•

Safekeeping Fees

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

62

3.7 Revenue Projections

These revenue types are grouped based on the type of inputs that are needed in order to calculate each of them, but each of these categories may have very different subcategories depending on the sector they refer to. For each of these revenue streams you should determine the portion % of your customers that applies, as well as whether you will charge the number of customers reached, number of new customers or number of active customers. Most revenue streams apply to active customers, who may buy products or service repeatedly, but not all, and some revenue streams may be better split into two. For example, you may have a sign up fee for new customers and a subscription fee for active customers. By analysing the type of product and the customer base, you should know whether you are selling something that will only be bought once, and therefore that you can model only based on new customers, or repeatedly, meaning that you should model the revenue stream on active customers. Most companies have some repeat customers: clearly, acquiring customers to sell only one product can make for an unsustainable business model and not likely investable.

The customers/products matrix will help determine which customers will buy what:

3.7.1. SALE OF PHYSICAL PRODUCTS To start, we can analyse one of the most common types of revenue streams for businesses: the sale of physical products. We’ll review how to calculate products sold correctly, prices, volumes, customer preferences, inventory and other direct costs.

The sale of products is quite straightforward, as it involves the sale of physical goods that the company produces or distributes directly to the customer, but nevertheless many calculation mistakes are made. To plan this revenue correctly, there are a few factors and inputs to take into consideration:  How many products do customers buy per month or year? Determining how often customers buy a product and how many units they buy is not easy, but it is something that you are bound to measure during the typical business operations. You can also increase the frequency over time.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

63

3.7 Revenue Projections

 Unit price of each product. The unit price that will flow into the projections should be consistent with any unit used to determine costs. In addition, inflation should be considered, as well as the point in time when you start charging the normal price after a fast customer acquisition during market entry. Some retail businesses use a fixed mark-up on the cost of goods sold. Just like you determined how often customers shop, you can also determine the basket size each time the customer shops, instead of an average price for each product. How you do this, depends on the type of business. If the company sells a variety of different products, for example as a retailer, you should use basket size or value, while in other cases selecting the number of products if only a few products are sold (or including this figure in frequency) helps you determine direct costs more easily.  % of customers buying each product. After working on the customers projections, if you have multiple products or category of products, you should estimate the % of your selected customers that will buy each product by entering a sales split. The sum here can be more than 100% as some customers may buy multiple products in the product range.

You can project a revenue stream for each product, or estimate an average buyer spending. An example of physical products sales projections based on average spending are as follow:

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

64

3.7 Revenue Projections

New entrepreneurs make the largest errors with revenue projections, but costs projections are also rarely realistic. Most mistakes, however, originate with the calculation of fixed costs: direct costs are certainly more straightforward. Calculating costs for the sale of products, on the other hand, is quite complex for companies holding inventory, easier instead for drop-shipping companies.

Another complication could be carrying out net revenue adjustments, with warranty returns, resales and discounts, when these items apply to your business model.

Direct costs for goods sold would then include: •

Cost of materials and labour, calculated on a per unit basis according to contracts with suppliers, taking inflation into account

•

Product licence fees

•

Product packaging or labelling

•

Wholesale commission or third-party platform fees

•

Credit card or transaction fees

The following costs are instead calculated based on the inventory, which may involve calculating units ordered, units on stock, value ordered and value of inventory on stock: •

Inventory write-off

•

Freight-in and import costs, including, duties, freight, certificates of quality, product containers

•

Storage

•

Postage & Packaging to customers and distribution centres

Cost of materials involves less mistakes, but other costs are usually forgotten or grossly understated. The complexity of this business model is related to inventory, which is seldom calculated correctly and linked to the correct inventory figure.

Another problem with startup projections lies in the timing of payments. The advantage of a dropshipping business model, where the inventory is held externally, is not only a much easier calculations of cash outflows, but also fewer advance payments. The inventory on stock is otherwise typically paid in instalments, and especially for new companies, in advance. Suppliers have stricter terms for startups in terms of advance payments than for established companies, as they are more risky. To ensure that the company does not to run out of inventory, inventory levels and corresponding pre-orders should be planned. Pre-payments of inventory also lead to higher liquidity needed, which should be included in the amount of funds raised: the failure to estimate inventory payments correctly can lead to unexpected low liquidity for the startup.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

65

3.7 Revenue Projections

Based on the assumptions used for the revenue model, we can calculate inventory and related costs, with some assumptions based on inventory units, inventory value, number of products sold or revenue:

3.7.2 SALE OF SERVICES Compared to physical products, calculating the gross profit from the sale of services is much more straightforward, as there are fewer cost items to consider. In this category we can consider any service or digital product that is not sold as a subscription.

Just as in the calculation of physical products revenue, base on the market size calculated, which includes the number of customers reached, the number of new customers and number of active customers, you should decide the following: what is the proportion of your customers that will buy the services at any one time, in case there are other revenue streams, and whether the product is bought by customers once, which will apply to new customers, or at specific intervals, which applies to active customers.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

66

3.7 Revenue Projections

The sale of services involves the following factors and inputs to take into consideration:  How many services do customers buy per month or year? Determining how often the customers buy a product and how many units they buy is not easy, but it is something that founders are bound to measure during the typical business operations. You can also increase the frequency over time in the model. This would only apply to repeat customers.  Unit price of each service. For services this is sometimes hard to estimate, as you may have many different services and charge different prices to different clients, but you should try to estimate an average for each service category. In addition, inflation should be considered, which can also be understood as increase in average order value.  % of customers buying each service. If you have multiple products or a pipeline, you should estimate the % of selected customers that will buy each service. The sum here can be more than 100% as some customers may buy multiple products in the product range.

Direct costs for services are much simpler, as they can be easily calculated as a transaction fee (credit card fee, wholesale fee, other transaction fee) multiplied by the amount of services revenue that they apply to: this results in a the portion % of direct costs in relation to sales revenue.

Additionally, one of the major direct costs of services revenue is direct labour costs. When this constitutes an important revenue item, it would make sense to include this staff in direct costs, as often freelancers are hired to do these tasks as well. The labour costs can be calculated as hours needed per product and cost of labour hour including inflation: this results in the cost of labour per product. If you need to calculate the number of staff to hire to fill this task, you can select the number of monthly hours that 1 staff will take up, so that the financial plan can also be used for operational purposes as well.

2020

2021

2022

2023

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

2024

2025

67

3.7 Revenue Projections

3.7.3. SUBSCRIPTION FEES Subscription fees are one of the most common revenue types for startups: subscription fees, which is only likely to further expand in the future.

After analysing, sizing the market and projecting customers, you should have the following figures for every month or year of your expansion: number of customers reached, number of new customers and number of active customers. This distinction makes the calculation of subscription fees tricky, as we should use the number of active customers to calculate this revenue stream, meaning after incorporating a retention rate. I tend to calculate the number of active customers for the entire business, using a retention rate that applies to all revenue streams.

For this reason it is recommended to keep the retention rate rather high and consider lost customers as those that are unlikely to return, while incorporating the specific retention rate of subscription fees by using each subscription’s duration.

The main figures and assumptions needed to calculate subscription revenue are:  The Portion % of your total active customers that will buy subscriptions.

 The type of subscriptions that you plan to offer and their duration as well as how often you charge your customers. If you have discounts for yearly payments, it may be better to set it as a separate subscription type with a different price in your financial plan.  Customers split % with the portion of subscription customers who will buy each type of subscription. For subscription fees, the sum should be 100%: it certainly cannot be less than 100%, but it is also unlikely that a customer would buy multiple subscription fee packages, except in few circumstances.  Unit price of each subscription, monthly or yearly depending on the financial plan setup, as well as any price inflation over the years, or a price jump after the beta phase.

 Duration of each subscription, which should be accounted for in the calculations as not all active customers will buy 12 months of subscription. Additionally, some subscription fees are paid monthly and some yearly. There are two ways of doing this: you can set payments directly when they occur buy using more complex formulas in the revenue calculation, or you can set a weighted average monthly subscription fee charge based on the assumptions above, and then calculate an average days of receivables to calculate cash flows correctly. When calculating revenue for accounting purposes, it is usual in most countries to recognise revenue when a subscription is sold, and make cash flow adjustments later to receivables, prepayments and unearned revenue.

Directs costs to subscription revenue is instead quite easy to calculate, typical costs would include: •

Transaction fees, which would also include payments to any third-party providing the services included in the subscription, as these is usually calculated as a % of the fee

•

Data fees in case of technology-based services, where fees may be calculated as a % of revenue or based on a fixed fee per transaction or data transfer

•

Credit card or payment fees

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

68

3.7 Revenue Projections

3.7.4. TRANSACTION FEES Transaction Fees take place when you sell products or services of third-party providers through your business and it is a revenue model very common among sharing-economy startups or marketplaces. It is worth noting that this applies only in cases when the total value of products sold is not recorded as revenue and instead it takes place when sales can be processed on different payment gateways. This is only an accounting difference, so even if we refer to many marketplaces as earning a transaction fee, this would actually be accounted for as the mark-up or difference between revenue recognised, which equals gross billings, and payments to sellers: in this case please refer to sale of products or services revenue calculations.

Transaction fees revenue occurs when only the transaction fee is recognised as revenue. Here we need the number of active customers to calculate this revenue stream. Calculating transaction fees therefore involves calculating the amount of billings on your platform, unless the entire transaction value is registered as revenue.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

69

3.7 Revenue Projections

The main figures and assumptions needed to calculate transaction fees revenue are:  The portion % of your total active customers that will be involved in making transactions  The average value of a transaction and its increase in value per year, the sum thereof representing the total gross billings  The number of transactions per month/year and its increase per year

 The type of fees based on the company's business model  Customers split % with the portion of customers to whom the fee or fees apply, when there are multiple types. The sum should be at least 100%.  Fee amount % based on the portfolio amount as well as any price inflation over the years

3.7.5. LICENCE FEES Licence fees are royalties that you receive for the third-party use of your technology, brand or other IP that you own. Licence fees are typically paid on the wholesale value and are based on each end-customer sale. You might want to take into consideration, if the revenue model has not yet been validated, whether licensing the product to others would prevent you from having other revenue streams connected to the IP, as the licence may be exclusive.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

70

3.7 Revenue Projections

It is largely a different business model to transaction fees, as it typically involves a technology or other type of IP, but here we can also calculate the gross value sold by third-party wholesalers to estimate our licence fees.

To calculate this revenue stream you need:  The portion % of your total active customers that will be using your IP and paying a licence fee, provided of course that your customers include wholesalers in this case, and not retailers or end consumers  The average value sold or value of product sold and its increase in value or price per year, the sum thereof representing the total gross billings  The number of transactions per month/year and its increase per year, if we have used product value instead or total value per month in the point above  The type of licence fees based on the company's business model  Licence Fee amount % based on the total gross value Directs costs to usually include only: •

other Transaction fees

•

Credit card or payment fees

3.7.6. ADVERTISING FEES Advertising fees can be complex, as customers and users’ behaviours can flow into the projections, which means that this type of revenue can change from month to month in some cases. It is worth including advertising revenue in the financial plan only when it is a major revenue stream of the company.  The information that you can collect is based on the type of advertising that you receive:  Monthly featured content/ sponsorship: Price per month per advertiser, which is the most simple advertising revenue type  Pay per view: Price, Website visits, % of users viewing ad, Ad slots  Pay per Click/Action: Price, Website visits, Click-Through Rate, Ad slots The most simple was to include this revenue stream is to select the portion % of active customers that would buy advertising packages in any given period and the amount of monthly spending per customer, including inflation, and in case of multiple types of packages, the spending for each type of package and the customers' split % for each package. We recommend using this calculation for minor revenue streams, which can also more easily be compared to advertising income per customer of larger social media companies.

We can also carry out more complex calculations by using the website capacity, impressions, clicks, ad slots, which puts an upward limit for advertising based on the number of pages and ad slots, to calculate the price for the advertising packages.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

71

3.7 Revenue Projections

Direct costs for these fees are usually limited to transactions fees and/or credit card fees. Only when these costs are directly linked to revenue items changes, such as volume or value of goods sold, and for the most part change to a similar extent as revenue, they should be included in direct costs

3.7.7. RENT FEES We include rent fees here as they have similarities to subscription fees, being recurring monthly income streams, but this revenue type has its own set of assumptions. It is worth noting that real estate ventures would usually require a separate real estate specific financial plan, but in cases of mixed business models, when rent fees may represent a minor revenue stream or a larger business, it is worth including it in a simplified manner as a regular revenue stream.

As with subscription fees, here we need the number of active customers to calculate this revenue stream. In cases where there is a sign up fee, which can be included in a separate service-related revenue stream, this would apply to the number of new customers, as is the case with deposits, which would have to be then accounted for as payables in the balance sheet, but not as a revenue stream.

The main differences in terms of financial projections between subscription and rent fees are that we do not use the duration of rent for physical rent spaces in most cases, unless the business model demands it, but instead we include a limit by including the maximum number of units to rent that are available the usual occupancy rate per period.

The main figures and assumptions needed to calculate rent revenue then are:  The Portion % of total active customers that will rent, even though this figure becomes redundant when we use a maximum number of units to rent and an occupancy rate % that is lower than the number of customers selected  The types of monthly rent that you plan to offer for different types of spaces  Customers split % with the portion of rent customers who will buy each type of rent. The sum should be 100%, unless the business model allows the same customer to rent multiple spaces at the same time.  Unit price of each rent type as well as any price inflation over the years Directs costs to rent revenue include more items. Typical costs would include: Property costs, which depending on the business model would include rent/lease from other thirdparties, maintenance fees (but major maintenance may be included in investments instead) and service costs, that in some cases represent a large portion of rent •

Transaction fees, if they apply

•

Credit card or payment fees

•

Any property purchase cost would be included in investments.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

72

3.7 Revenue Projections

3.7.8. SAFEKEEPING FEES This is a rare type of revenue stream, but it involves unique types of assumptions that entrepreneurs should have to plan carefully. Safekeeping fees may include charges such as rent of a warehouse which is charged based on quantity stored, or non-physical safekeeping fees such as portfolio fees. Again, it is worth noting that in cases when this represents a major revenue source in a business model, it is worth structuring the entire financial model based on these assumptions and calculate this in much more detail: these assumptions are only sufficient when the safekeeping fees represent a minor revenue stream. Investment funds would have their own unique financial model.

As with subscription fees, here we need the number of active customers to calculate this revenue stream. In cases where there is a sign up fee, which can be included in a separate service-related revenue stream, this would apply to the number of new customers.

The main feature of safekeeping fees is that we need to calculate the volume of assets, whether they are physical or virtual assets, that every customer accumulates and on which the fees will be based.

The main figures and assumptions needed to calculate safekeeping fees revenue are:  The portion % of your total active customers that will pay safekeeping fees  The average value added to each customer’s asset for each transaction or per period and its increase in value per year  The number of transactions per month/year and its increase per year  The average value of assets sold per customer per month/year, which decreases the total asset value per customer, and possibly its change per year  The type of fees based on the calculated portfolio value, for example insurance and safekeeping/inventory fee  Customers split % with the portion of safekeeping customers who will buy each type of fee, when there is a choice. The sum should be at least 100%.  Fee amount % based on the portfolio amount as well as any price inflation over the years Directs costs to safekeeping revenue include: •

Property costs, which may include rent of a warehouse or the same type of fees charged to customers with a mark-up

•

Transaction fees

•

Credit card or payment fees

Any property purchase cost would be included in investments.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

73

3.8 INDIRECT COSTS Operating costs can include staff costs, marketing, R&D, Operations and Administration expenses.

Since the financial plan for a startup does not have to be identical to the financial statements prepared for accounting purposes, it’s best to divide costs in a functional manner that helps you understand where funds are spend on. For example, for early-stage startups, I prefer including sales staff & marketing staff within sales & marketing expenses rather than personnel, to better illustrate marketing costs to investors. I also use operations costs separately from administration costs to include all development expenses that do not classify as investments, as well operations costs for companies with high fixed costs.

Employees’ expenses are easily underestimated by startups. Since in the first few years, the ability to earn a high revenue per employee is high, many founders are lead to believe that this value can remain the same or even increase. Instead, a way to measure whether staff costs are realistic, is to gradually drive revenue per employee towards the average of the specific sector.

Each employee type or function can be projected based on what their hiring depends on, so for example customer service employees are based on number of customers, other functions might be needed at certain steps or milestones according to the development strategy, and others might simply grow with revenue size or customers. Using dates linked together to the different company development phases is the best modelling method, as the strategy timeline may change often, so linking all new cost items for a certain phase together means that you can easily update the financial plan when needed.

R&D is difficult to estimate in absolute terms, as it can be very industry-specific, but it becomes easier when estimating the number of R&D employees or external researchers involved.

Remember that innovative companies are unlikely to have falling R&D costs.

All customer acquisition costs and marketing costs calculated previously also flow into the indirect operating costs. We calculated CAC beforehand because it is one of the fundamental parts of a startup’s business model, and should be validated before proceeding to calculating other costs.

Other costs that relate to the company’s operations or the day-to day-administration can be hosting fees, calculated on a per user basis, recurring products or servicing costs, product set-up costs, expansion costs, licencing fees, materials required for operations and small equipment. If you are delivering physical goods, you can separate delivery personnel here, together with shop rent when this is not included in marketing, vehicle leases and fuel, insurance and maintenance, when these costs are not included somewhere else such as in direct costs or marketing activities.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

74

3.8 Indirect Costs

Administration expenses can include a variety of expenses that grow slightly with revenue or the size of the employee force: Office rent, Utilities, Repair & Maintenance, Security expenses, Business insurance, Memberships, Software, Virtual assistants, Telephone & Internet, Staples, Server costs, Accountancy, Legal, Business consulting, Travel expenses, Training, Bank charges and other office costs. Just like we did with other costs, all these costs should be timed, to ensure that start at different phases of the model, and should grow in line with number of employees.

Startups typically have few investments, such as hardware (on a per office employee basis), IP and only in rare cases investments for real estate or other large physical assets.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

75

3.9 THE FINANCIAL PLAN All the calculations that we carried out so far flow into the financial plan. I prefer creating a full 3 statements financial plan as is typical for larger companies, even though it is not strictly necessary for early-stage startups with a very simple capital structure. Some accounting or finance knowledge may also be needed to know where all income statement, balance sheet and cash flow positions are built up correctly. Early-stage startups may simply submit an income statement and total cash flows, which corresponds to the cash burn rate (the net burn rate includes revenue while the gross burn rate excludes revenue).

A balance sheet is not always necessary for a startup: it usually becomes relevant when the company owns significant assets, such as IP and real estate, when debt is present, and when there are significant accruals. To make things easier, some accruals can be avoided for startups as they may have a low number of days payable: for example, digital startups may collect revenue online through credit card, which involves only a few days to cash in. Most expenses can be set to be paid within 30 days. More major differences between startups’ income statements (when expenses are registered) and cash flows (when expenses occur) are related to inventory payments, when they apply, or to other longer delays in payments that are typical of B2B clients or more traditional business models. These timing differences can also be calculated directly into the cash flow, as investors may expect to see a balance sheet only for companies after 2-3 years of operations.

A direct cash flow approach, instead of an indirect cash flow method, usually used for larger companies and accounting purposes, helps more closely assess liquidity, and visually observe where cash comes in and out for startups.

The financial plan can give further validation to the business model. In many cases, a profit is expected to appear in the income statement in the first 5 years, even if strategic decisions taken later may delay profitability. A profit higher than 50%, and often even higher than 30%, is usually a sign that unrealistic assumptions may have been used. The competition’s margins will help determine what is possible in the sector, even though this data is often hard to find.

As a result of calculating cash flows correctly, we can estimate the amount of funds needed.

Investors expect to know how much founders will need, how long it will last (the Run Rate), the current Cash Burn Rate and where the investment will flow. Investors want to put their money where value is created, therefore in: staff for product development, partly in marketing, investments, and inventory depending on its risk. Raising enough to cover all negative cash flows is important: to calculate this, you can measure all inventory, operating costs and investments cash outflows over the chosen period of time. However, you may also want to ensure that the funds raised are in line with the amounts that similar companies are raising at the same stage, and that what you are raising is actually necessary to get to the next milestone. Ideally each round should have a specific focus and goal.

The cash flow provides additional hints: if significant funds are accumulated in a fast-growing company, whereby competitors are raising large amounts of funds in multiple rounds, you are very likely underestimating costs and investments, and/or overstating revenues.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

76

3.9 The Financial Plan

Cash flows also provide information on the time when cash is at the lowest point, which is why a plan on a yearly basis may miss this intra-year value, and result in companies raising amounts not high enough to cover liquidity gaps during the year. With a realistic strategy and research, the cash flows will give you a rough idea of the total funds needed until an exit takes place. Once you have this information, you can determine how much you will raise now, and how much you will raise later, taking into account that each funding round takes some time to complete. It is recommended to raise cash to cover negative cash flows over 6-12 months in the early stages, unless giving away a low stake in the company takes priority: in this case you can have lower and more frequent rounds.

How do we account for unpredictable business models? The expansion speed of hyper growth startups, the potential of truly disruptive business models with undefined customer groups, the size of large B2B contracts and custom prices are difficult to predict and model. In these instances, we can still project the market size and revenue model with the financial model explained previously, but market penetration and recurring revenue will be based on subjective assumptions. However, very few startup business models fall in this category, and the vast majority can have a defined market to project and a predictable revenue model that they can apply. Based on the statistics and typical trajectory of companies that can be defined as tech startups, it might actually be easier to create projections for them than for a new traditional business, for example a consultancy business, where the income may be defined by few large clients.

If a realistic financial plan is in place, the startup can potentially measure the remaining funds needed. Usually, however, even for more realistic financial plans, the amount of money to raise during the life of the startup can be grossly understated. One reason is usually the lack of transparency of competitors’ struggles that can lead to underestimate costs for new business models, and another is the growth drive that the company will undertake. In fact, the startup may be pushed to grow faster by VCs, because of new emerging competition or because competitors are raising more money, and also thanks to the high availability of money. As competition grows and the sector trends change, the startup founders may be pushed to accelerate or change the initial goals set. The current calculated remaining funds to raise therefore only apply to the current company strategy and are based on what is known of the sector costs that will be incurred in the future.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

77

3.9 The Financial Plan

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

78

3.9 The Financial Plan

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

79

3.10 BOTTOM-UP APPROACH The bottom-up approach is sometimes preferred by entrepreneurs. While the top down approach starts from the analysis of market size and penetration to estimate the company’s revenue, the bottom-up approach instead estimates the available resources to use and projects customers acquisition and therefore revenue based on this input.

The top-down approach is more suitable to companies that can gain a significant market share in the long run, while other companies that only gain a very small portion of a large market could benefit from a financial plan using the bottom-up approach. However, startups are usually expected to become a leader in their respective markets, or to disrupt old markets, and therefore a top-down approach is much more precise in this case. It allows us to easily measure when projections become unrealistic and market penetration figures become too high, and it allows for a better market segmentation. This happens quite often, as with the bottom-up approach founders tend to lose sight of what is feasible. By linking market penetration with the correct use of marketing expenses and other resources, the use of resources can be measured correctly with the top-down approach as well.

This is one example of the inputs and outputs of the bottom-up approach where we set a marketing budget, with resulting customers gained. The remaining parts of the financial plan are planned in a similar way to the top-down approach.

Marketing & Sales Budget Conversion rates

Total N° of Customers Acquired

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

Revenue Calculations

80

3.11 SCENARIOS It is typical for founders to want to present a best case scenario to investors. However, a best case scenario should not be a world domination plan. As mentioned earlier, for such high-risk opportunities, it is important to illustrate in the startup story what can be realistically achieved while at the same time excite the investor. Since venture capital firms tend to favour companies with unicorn potential, it is not wrong to present a best case scenario, but it is important to present the best possible realistic scenario. Feasibility analysis and validating the assumptions and business models are essential to serious investors. The goals should possible to obtain, even if the chance of the best case scenario materialising is slim, as typical for unicorns or high-value startup opportunities.

Usually, there is also a worst case scenario, and in the case of startups, this is 0, as the failure to exit or the difficulty to recover any value from the assets built means that there will be no return to the investors if the startups is not a success. For startups, this is certainly a likely scenario.

A base case scenario (or additional scenarios) is not typically presented to the investor, and instead might be calculated internally by VC analysts in the case of larger opportunities. A riskweighted base case scenario, usually representing the most likely scenario, would not be very exciting. When accounting for the startup failure rate, the likelihood of a successful exit, the typical exit in terms of size and timing, on average the startup would be unlikely to offer a satisfactory return on investment.

This is why, if we use a discount rate to calculate the value of startups, this is unusually high: we use high discount rates not only to account for the failure rate, but also for the planning uncertainty of the best case scenario, which is usually at the basis of startup projections. If we had to use a standard discount rate in compliance with the CAPM, we would need the base case scenario, with risk-adjusted projections and exit values.

Since the return for investors is determined by the exit, it is possible to only adjust the size and timing of the exit to create different scenarios for the valuation, as well as use different discount rates or expected return rates. This is in fact the method typically used in VC valuations.

For a more detailed approach and for operations monitoring, strategy planning and feasibility, it is possible to create multiple financial plan scenarios, which can lead to different exit value scenarios, which are defined by the time to exit, number of customers and revenue, which lead to different valuation multiples and resulting valuations. Creating different financial plan scenarios instead of only different exit values certainly results in more realistic values, as the number of customers, revenue and profits can be tested for reliability, whereas different exit values scenarios are simply assumed values where the inputs have not been tested.

Based on the probability of each exit value scenario, we can then calculate a probability-weighted exit value. Setting these probabilities may be a subjective exercise and therefore this exercise is better outsourced to a professional. We will look into these methods in more detail in the valuation chapter.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

81

Chapter 3 - The Financial Plan

Quick Recap 

Preparing a financial plan for startups helps measure the market, business model, liquidity and investment needs. A 5-year financial plan is recommended. Projections for revenue and user-related figures are used to calculate a potential exit value.



Before creating a financial plan, it is useful to draw the business model and how this can change over time.



Validation can have multiple levels and involve: Personal observation, Market Research, Industry experience and knowledge of industry practices, Analysing the same product successful abroad, Superior solution to an existing business model and deep knowledge of customer needs, Market validation, Customer traction & positive feedback, Existing partnerships



We can size the market using the top down approach, first by estimating a Total Addressable Market (TAM), its CAGR. The Serviceable Available Market (SAM), the Serviceable Obtainable Market (SOM) through an analysis of competition and development of competitiveness.



Once you have projected the customer base, you can calculate the marketing and sales costs and split these costs into the different channels used. By doing so, you can validate every channel and see if it is possible to realistically win that certain number of customers with your set marketing strategy and budget.



For each of these revenue streams you should determine the portion % of your customers that applies, as well as whether you will charge the number of customers reached, number of new customers or number of active customers. We can identify seven main types of revenue streams: •

Sale of products

•

Sale of services

•

Subscription fees

•

Transaction fees

•

Licence fees

•

Rent Fees

•

Advertising



For a startup it is possible to create the full 3 statements financial plan as it is also typical for larger companies, even though it is not strictly necessary for early-stage startups with a very simple capital structure.



While the top down approach starts from the analysis of market size and penetration to estimate the company’s revenue, the bottom-up approach instead estimates the available resources to use and projects customers acquisition and therefore revenue based on this input.



A best case scenario is usually presented to investors: this should be realistic. A base case and worst case scenario can be useful to calculate a valuation, whether these are prepared for an exit scenario only or for different financial plan strategies.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

82

Chapter 4

Principles of Markets & Valuation 4.1 WHERE DO UNICORNS COME FROM? What was once a myth and rarity is now an everyday story. ‘Unicorns’ are private startups whose valuations have reached $ 1 billion.

It is interesting to read into the mythological background of the unicorn: the King of Ethiopia claimed that “it is impossible to take this ferocious beast alive; and that all its strength lies in its horn. When it finds itself pursued and in danger of capture, it throws itself from a precipice, and turns so aptly in falling, that it receives all the shock upon the horn, and so escapes safe and sound” 1.

We could identify the horn of the unicorn as the funding received from Venture Capital firms and Private Equity, where all its strengths lie and which saves the startup from crashing when falling down. It may seem like a negative assumption but it’s not. Money and liquidity create value and they are necessary to create disruption, as long as we recognise which companies and deals create positive disruption, liquidity creates value along the value chain and for consumers as well.

The goal is to create a company that can eventually thrive and stay alive without its horn, i.e. the enormous cash injections. Many of these startups survive on large losses for years and years only thanks to the availability of cash. I’m not going to argue here about whether there is a bubble or not, it depends on a case by case basis whether a startup is overvalued or undervalued.

The term ‘unicorn’ for startups was first coined by Aileen Lee in 2013. The massive increase in billion dollar startups is also due to changes in the early-stage financing markets: the push for fast-growth, the availability of VC and PE finance that allow companies to raise large amounts of cash without the hassle of going though an IPO, and the willingness of these investors to finance them at high valuations. I also believe that investors are able to finance them at high valuations because of the control that many of them can exercise during a liquidity event or exit, which in the case of unicorns can often be an IPO.

Sources 1. ‘Mythical Monsters’, Charles Gould, 1884

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

83

4.1 Where do Unicorns Come From?

However, finance is not the only reason. Technological advances are becoming faster and the expansion possibilities of companies are therefore compounded. The internet has created completely new business models that weren’t conceivable before, allowing them to scale at massively fast rates, decrease prices thanks to economies of scale and by putting growth before profits. Globalisation trends such as a mobile workforce, the opening of global financial markets and corporate deals, as well as the immediacy of communication all help increase the scalability of these startups.

Many of these unicorn valuations depend on a story. Facebook and its success may still fuel the hopes of current tech startups, and how the first famous tech unicorn and the ones that came after it will keep developing, will likely influence current valuations as well. That’s because at the moment, for some business models, growth almost seems to have no limits. At the same time, this feeds higher entry barriers, as growth fuelled by capital and availability of the latest technology has become a pre-requisite to even operate in some markets, pushing up valuations and growth projections, as well as capital needs.

It’s also difficult to speak of failure, because once companies are able to raise funding rounds of hundreds of millions or more, they can acquire a variety of companies that in turn push up the company’s value, and create synergies with the current core business, increasing the value even further. These unicorns, in effect, can even become an investment vehicle over time, just like many tech giants such as Amazon, Alphabet, Alibaba, Uber, Facebook, Salesforce and many others are now maintaining their leadership by investing in all new potentially relevant technologies after IPO, and often setting up separate Corporate VCs to do so.

Synergies can be created with acquired companies in a variety of ways: by selling more products to the current customer base, by expanding the sales channels, by achieving market leaderships and buying up competitors, by enhancing brand recognition, fuelling the creation of new technology and know-how by sharing expertise, and also economies of scale, which however is not usually a motivator for early-stage exits.

The hype of some tech sectors certainly plays a role in the overvaluation of early-stage startups, but these may last for a few years, as the fast pace of technology also means that hypes quickly change as the attention moves on to the next big thing, and mostly creates positive returns from early-stage exits. However, the popularity of some startups, despite their losses and the backing of investors, make it easier for these companies to keep raising money, as in the former case the best way not to lose money on previous investments is to keep the ‘fire alive’ until a liquidity event can take place, doubling down on poorly performing investments in order not to lose the money already invested. Creating unicorns or pushing for early-stage exits has become a business model

by VCs, as VCs can also be considered disruptive businesses that can create great successes by using this strategy. Entrepreneurs become attracted to the startup culture and lifestyle, and want to take part thanks to the availability of capital and the VCs ability to help them achieve earlystage exits, often starting out with sub-standards ideas and products. One could argue that having more serious and experienced entrepreneurs would create fewer failures and could result in the capital being spread out more evenly among startups.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

84

4.1 Where do Unicorns Come From?

The way that seed and early-stage VC portfolios are structured also leave little room for companies without unicorn potential. If you have a portfolio of 10 companies, and according to many 6-7 will fail, while 2-3 may just about return the initial investment or a little more, then you will need 1 company to exceed all expectations, and you will want to use all resources at your disposal to ensure that this company provides the highest possible return. The risk of failure is so high at this stage for any company with little or no traction, that an entrepreneur will need to present a very high upside to investors to be of interest. Increasing our ability to recognise some bad investments from the very early-stages may leave more room for strong but less scalable startups, but how this can be achieved in practice is still unsure.

So where do unicorns come from? First, they the product of a pursuit of growth, as we can create growth in one sector by disrupting another sector. Unicorns are created by a cycle of availability of finance, avoidance of regulations, technology change, higher scalability and fast adoption, VC power and negotiation practices, the use of imprecise valuation approaches, synergistic acquisitions, popular startup culture, the story of successes of other tech giants, the availability of talent, increasing entry barriers and the makeup of a startup portfolio. All these trends are fuelling each other. These are the step in the assembly line in the unicorn factory, which can change over time as many VCs are constantly adapting their business models and their current focus to changing trends in the market.

The possibilities for unicorns during the first growth phase look almost infinite, as there are countless strategies to be applied in the future, a variety of revenue models possible and high hope of continuous technology changes to fuel the growth and future possibilities. The fact that we just do not know what the next big thing is going to be, also creates unicorns through this very idea that there can be countless different growth possibilities. Despite the pessimistic reports of some experts predicting that the bubble will burst, this hasn’t happened yet. There will certainly be ups and downs, but unless the fast technological changes stop, the cycle may continue, as new growth can be created in many ways. There will likely be some large unicorns that will fail and lead to more cautious investing and generally lower valuations. I doubt that the current large financing rounds can continue as they are. However, creating unicorns is part of VCs disruptive business model, so unless some other catastrophic event takes place to change market dynamics, this cycle is likely to change when new financing methods and investment trends will disrupt the VC market.

How can we explain the unicorn valuations? Many of these so-called unicorns have a value that is not only based on their potential cash flows. If many investor expect a certain technology of business model to be profitable in the future, this will drive up value for all investors, also because it becomes easier to achieve a successful exit in popular sectors, even when the market does not have enough room for all these market leaders. Investors will know that some of these companies will come out as winners and some will fail.

Another thing to point out about unicorns, is that their values are calculated based on the funding received by VCs. It makes a lot more sense to calculate multiples from a strategic exit rather than VC funding. Valuations calculated out of VC funding rounds are based on companies with little revenues who are given a chance to grow at an extremely fast rate. So first this level of liquidity creates value in itself when used correctly, and second, VCs often have preferential rights in case of liquidation and in case of exit, so valuations extracted from VC funding should be adjusted when comparing them to other assets.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

85

4.1 Unicorns

To summarise, a few factors contribute to the differences between potential unicorns and other startups or companies, as for unicorns: •

The company/product will be useful or profitable at some point in the future, but we don‘t know exactly when or with what revenue model

•

They have already developed a business model or brand recognition that cannot easily be replicated

•

There are countless different strategies that can be followed in the future

•

They have a very large potential market

•

The focus is on achieving critical mass and eliminate competition

•

The sector is currently very popular and growing

•

They bring a new, disruptive and scalable business model or technology to the market

•

They can become a vehicle for future acquisitions (through an IPO)

•

They have received the backing of trusted investors

•

The extrapolated valuations do not account for the superior contractual rights of VCs

So, should a founder sell their company as a unicorn? Business angels may prefer investing in businesses that bring short-term cash flows. Generally potential unicorns are what VCs are looking for, but not only. However, the growth story should be realistic and some validation should take place. Additionally, founders should be willing to reach certain ambitious goals and ensure that this is in line with their personal goals. The business model may in fact have more chances of success in non-VC settings and every company should decide on their growth story independently.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

86

4.2 WHAT ROLE DOES HYPE PLAY? The innovation that startups bring to the markets these days is unprecedented. New disruptive business models and technologies have changed our habits in the past ten years in a way that we would never have imagined: social media, the sharing economy, smartphones, mobile commerce and many more innovations determine how we do things everyday now. Many other technologies were expected to have a dramatic impact on our lives, but they did not, for example the Google Glass or blockchain technologies, or at least they have not had the impact that was expected impact of them yet.

These days, when working with startup, it might be more important to have a deep understanding of technology than economics, as for many companies the success relies heavily on the advancements in technology and its speed of adoption. Experts constantly speculate about what the next trend might be and how it’s going to change our lives. If you have worked in the startup field for a few years, you have already experienced a few trend cycles, with each trend being described as possibly world-changing, only to be replaced by a new hype a few months later. This happens not because these new technologies have not been successful, but because many have become mainstream quite fast. The startup investment market always investigates and pushes for new types of investments. Hype can create interest around the technology, which in turn increases the adoption of a technology and therefore its value.

In fact, many early-stage funds invest out of the Fear of Missing Out (FOMO). This naturally leads many startups that fit into the latest hype criteria to be highly sought after, because funds want to have a portfolio interest in the potential growth of the latest trending technology or business model. This pushes up valuations in fundraising rounds as the popular company has higher negotiating power, and future projections of market adoption of the new product or service skyrocket.

Once the company shows success, funds tend to keep financing the startup in order to maximise the exit value. Exit values also tend to be higher or tend to be easier to achieve for popular technologies and business models: in fact, conglomerates and large internet or technology companies that pride themselves of being innovative, are always on the lookout for the latest popular technology to integrate in their service portfolio or kick-start more innovation within their R&D department. In order to maintain their market leadership position, missing out on the next big innovation is not an option for the internet giants, which leads them to invest in a variety of different technologies, some of which will become redundant, while some will determine their future success.

Hype does not affect only the investment market, it also affects consumers. Popular startups receive more money for marketing, and therefore new technologies and business models are talked about everywhere: this leads to new demand being created. Of course, if the needs of the consumer were not met, new sectors would not be successful, but widespread advertising and early adopters lead to wider acceptance as well as creating FOMO in consumers as well. The result is that hypes also influence consumer choices and lead to higher valuations thanks to faster growth, higher number of users and higher revenue.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

87

4.2 What Role Does Hype Play?

This is how the market operates, a market in which startups, investors, corporate buyers and consumers are all affected by the ‘hype’ and consequently push up valuations during the entire lifecycle of the company, or at least the early-stage phase, up until the exit of the startup. This should be taken into account when valuing companies, as trends might initially fictitiously push up the value of companies with no concrete potential, but in the long run, this value can in fact materialise for both institutional and corporate investors.

Of course, as a valuer it is challenging to analyse the potential of a new technology. It is certainly necessary to have an in-depth conversation with the founders, and it is a plus to be able to speak to an expert in the field and to do some independent research. However, the main point to make in this chapter is that the investors‘ belief that a technology will be successful in the future, especially when the belief is widespread, and the valuer believes that this belief can be held until the exit, is just as important to determine the market value of a company.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

88

4.3 THE LOCATION CONUNDRUM Many startups are known for their place of origin and many companies from smaller or lesser known countries become the pride of their home country. In reality, however, many companies founded in lesser known markets move to larger startup hubs. In doing so, their valuations during rounds of funding also increase. Why does this happen and how can this be justified?

While this is not always true of bigger companies, it is known that startup valuations change according to location, when other factors are equal. It may seem unfair that a company can in some cases increase its market value by relocating its headquarters and offices, but this is not just a matter of image. The location determines many things that go beyond just the original business model of the company.

First of all, by incorporating the company in some Western countries, in many cases, the rights of the investors are different: some countries offer better protection to investors through laws, rule of laws, a more functioning or fair justice system or tax credits for investors. The exit process can be easier in some countries from a legal point of view, which can significantly impact the duration of the transaction and therefore it can ultimately determine the exit value of the company, or even whether the buyer decides to acquire the company or not.

The startup ecosystem naturally offers a great contribution to the development of startups: investors, accelerators and local know-how, close access to customers, government participation, industry involvement, which also heavily influences the likelihood of a local exit. Countries with more active exit markets, in fact, report higher valuations during the early-stages of startups. The location can also determine the proximity of similar startups and access to a trained workforce, as well as a local sector specialisation which further enhances the collaboration of different parts of the startup ecosystem.

Close proximity to investors is not only positive, as that opens up possibilities of networking and easily linking up with investors compared to less active funding markets, but it may also be a requirement: many investors focus only on specific markets, and may require a seat on the board, as well as a regular meetings with founders to ensure that the investment goes according to plan.

This may depend on the amount invested and the investor’s involvement: those holding board seats often invest in the same country or even city. In the future, this could change as online meetings remove this requirement, but as of today, this is still the modus operandi of many investors.

An active startup investment market also contributes to investors’ know-how: more sophisticated investors tend to know what it takes to manage a startup investment, they are familiar with the funding process which requires multiple rounds until exit (and therefore has no place for an investor requesting a very large stake), and the general risk tolerance of the investor for earlystage investment opportunities is higher. This creates more beneficial and more sophisticated transaction for both parties, the founders and the investors, in an active market, and facilitates successful exits.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

89

4.4 THE VALUATION-FUNDING LOOP In most circumstances, before a full market validation takes place and the startup earns sufficient revenue, professional valuations are not carried in the same way as they would be in a larger transactions. In most cases, no valuation is carried out at all. A potential exit value is rarely calculated at very early stages unless institutional investors are involved, therefore negotiations will automatically take market trends into consideration to agree on an appropriate value.

Whether any kind of research takes place into the valuation of comparable startups or not, some general knowledge about the stakes that are typically requested by investors for similar companies at a certain stage would flow into the decision process. What needs to be decided is how much stake the investor requires, or how much stake the founders are willing to give away.

The valuation is then an extrapolated value rather than a calculated value.

Exact data for early-stage funding is not easy to find, but observing the few seed-stage deals with valuation data made public, many rounds tend to involve a sale of around 10-15 % of the company’s equity. This can vary by country, sector, scalability and other features, but it is usually a fair estimation, and it represent a middle ground between what is a feasible return for the investor, and the goal of maintaining control for founders until an exit, considering multiple rounds of funding as well as ensuring a smoother exit. For non-public and smaller angel investments, as well as for companies that might not fall into the tech startup category, valuations may vary and follow different patterns.

What really is decided in the pre-revenue stages is then the amount of funding needed by to a startup until it can reach the next milestone. The stake then usually doesn’t move very far from the average stake of the market, except for particular transactions of funding in tranches. Once again, this depends on the stage and sector, and even if a company needs more cash injections during the life of the company, the amount raised at any given stage before Series B is usually proportionate to what other similar startups are raising.

This represents a loop in valuations and funding amounts, where the funds raised, the stake given away and valuations grow in line with similar startups and influence each other. The valuation is roughly determined by the category the company belongs to and the amount of funding needed, mainly based on the sector and location, and is therefore implicitly predetermined.

This might explain why some early-stage valuations seem high, when considering what has been achieved pre-revenue. Valuations at this stage are determined by market demand for funding and the expectations that the market has for tech startups.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

90

4.5 VALUATION AS A TOOL Can the valuation of a company also have meaning beyond just the numbers? Not often during the very early stages, but as the company grows and becomes more popular, in some circumstances, the valuation can become linked to the image of the company. Let’s take the example of unicorns, which received plenty of press coverage: landing in this group of private companies with a valuation exceeding $1 billion, even with uncertain revenue models and losses, brings a marketing push to startups, both in the face of customers and new investors. In this case, valuation can be used as a marketing tool to receive more press coverage.

Many founders start their ventures with the goal of achieving unicorn status, as if the mere value of the company provides some sort of recognition for them personally and for the company. In this case, valuation is also used as a proof of success.

At the same time, the value of the company is expected to grow over time along with the company’s growth and performance improvement. This is not always the case, as some companies can be overvalued in one round and experience a down-round when raising additional funds. This does not only hurt the image and possibly the trust in the company’s potential, it also becomes a significant problem in terms of shareholder structure. A down-round is considered somehow a failure, it is the indication that something has gone wrong and that the founders have not been completely transparent in communicating the company’s achievements in the previous round, which may push away future investors. This would hurt current investors as well, which is why interested parties would try to avoid a down-round whenever possible: in fact, some current investors are involved in setting the valuation when they want to avoid registering a write-off of assets on their books. In this case, valuation is both a marketing tool and a proof of success and reliability, as well as being a tool to plan out and optimise the company’s shareholding structure. In difficult times, when the company starts showing the first signs of crisis, the valuation becomes a tool to reassure everyone that the crisis has been averted and give the startup another chance to achieve the promised success.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

91

Chapter 4 - Principles of Markets & Valuation

Quick Recap



WE CREATED UNICORNS. First, they the product of a pursuit of growth, as we can create growth in one sector by disrupting another sector. Unicorns are created by a cycle of availability of finance, avoidance of regulations, technology change, higher scalability and fast adoption, VC power and negotiation practices, the use of imprecise valuation approaches, synergistic acquisitions, popular startup culture, the story of successes of other tech giants, the availability of talent, increasing entry barriers and the makeup of a startup portfolio. All these trends are fuelling each other.

Additionally, high valuations can be fuelled by hype and different investment clauses.



HYPE CAN INCREASE VALUE IN THE LONG-TERM TOO. Hype can create interest around the technology, which in turn increases the adoption of a technology by consumers and therefore its value. In fact, many early-stage funds and corporates invest out of the Fear of Missing Out (FOMO) and push up valuations of companies in high demand. For a valuer, the investors‘ belief that a technology will be successful in the future, can indeed facilitate the success of a technology and therefore will affect its long-term value.



MOVING THE COMPANY’S LOCATION CHANGES THE VALUATION. The location influences valuations due to the investors’ right, the ease of the exit process, the startup ecosystem, the proximity and sophistication of investors.



THE VALUATION IS DEPENDENT ON THE FUNDING AMOUNT AND THE FUNDING AMOUNT IS DEPENDENT ON THE VALUATION. The Valuation-Funding loop takes place where the funds raised, the stake given away and valuations grow in line with similar startups.



THE VALUATION IS USED AS A TOOL FOR STARTUPS. Valuation for startups can be a marketing tool and a proof of success and reliability, as well as being a tool to optimise the company’s shareholding structure and gift the company another chance during a crisis.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

92

Chapter 5

Startup Valuation 5.1 SEED MARKET METHODS For a standard valuation, applying the market method means extracting multiples from comparable transactions or comparable stock-listed companies to estimate the current value of the company being valued. This cannot apply to seed stage startups for obvious reason: •

No stock-listed company can be comparable to a startup

•

Multiples cannot be used at this stage as the company has little or no revenue, as well as few users, if any

•

By comparable transactions in a standard valuation we usually mean mergers & acquisitions transactions that involve the sale of a majority shareholding. The multiples are then applied to the company’s current figures, assuming the company is ready to be sold in the near future. We can use this method to estimate a future exit value, but not to directly estimate the current value of a seed stage startup, as the company would not be an acquisition target today, in the vast majority of cases.

However, we can apply an adapted comparable transactions method to seed stage startups by using comparable rounds of funding. There are a few related methods that can be used and that we can call seed market methods. These are usually called rule of thumb methods as well, since these methods are simplified and some approximation is necessary due to the scarcity of data and the lack of complexity and therefore precision.

One advantage of these methods is that no financial plan is required, while one disadvantage is that some figures used can be subjective or are not based on or proportional to observed market values. Another advantage is that it can be used in new emerging sectors where sector exit information is not yet available.

A way to conduct a valuation at the pre-revenue stage, in the absence of reliable financial information or projections, is therefore to observe similar rounds of funding. These methods were originally developed by Bill Payne, and then adapted by Ohio Tech Angels.

The one that I find to be the most useful is the Risk Factor Summation Method, as it accounts for more risks and features compared to other seed stage valuation methods.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

93

5.1 Seed Market Methods

How to use this method: 1.

Calculate the pre-revenue pre-money startup valuations in your area USUAL METHOD

This involves researching the average valuation of all pre-revenue startups in your country, which is a difficult value to find. Based on the last available median US value, you can estimate how the proportionate valuation in your area are. 1

OUR MODIFIED METHOD The country certainly plays a role in influencing the size of seed stage valuations, but the sector, in many cases, can be just as important, or even the most important factor for comparability.

Therefore, researching seed stage rounds of funding would produce the most comparable prerevenue pre-money valuation to apply this method correctly. In this case, it is very important that the chosen companies are truly at the same stage of the startup to be valued. In some cases, we are lucky to find the valuation of companies in the context of these transactions, but when these are not available, we can use the funding amount, which is also a very important figure. When the funding size is large, we can assume that the valuation also is, just as when the amount of funding is very low, the valuation will likely be low as well. To derive a value, we can use the rule of thumb stake value of 12.5%, which comes from observation and experience in seed stage transaction, except in cases where this value appears unrealistic. We can then estimate the median or average pre-revenue pre-money valuation.

Sources 1. Halo Report Seedrs Valuation Methods

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

94

5.1 Seed Market Methods

2. Then attribute a value between -2 (for negative characteristics) and +2 (for positive characteristics or absence of risk) for each of these risks, compared to the seed companies analysed. Then you sum up the points and for every point you add or subtract $250.000.

USUAL METHOD Every point is valued at + or - $250.000. However, this method was conceived at a time when seed stage valuations were different. It is also not dynamic, as it must be adapted in case seed stage valuations are much lower or higher than the average.

OUR MODIFIED METHOD This value should be preferably adjusted to the different valuation level, and currency, if the used currency is not USD. As comparison, we can use the estimated average seed stage value in point n°1, and compare it to the average seed stage value in the US: in this case the value changes from $250k to €130k due to the lower average valuations in the sector.This proportion should then be applied to the value of 1 point to calculate the Factor Adjustment.

3. Add the Factor Adjustment to the average pre-revenue pre-money valuation to arrive at the estimated pre-money value of your company. You can now add the investment sought to arrive at the post-money valuation.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

95

5.1 Seed Market Methods

The Scorecard Valuation Method 1 proposed by Bill Payne is a popular method used among angel investors, as it offer good flexibility and a wider range of values. The same principles used for the Risk Factor Adjustment Method are used here, as Step 1 similarly involves the estimate of the median pre-revenue pre-money startup, and the same modification I suggested can apply here. The following steps after Step 1 are: 2. After estimating an average pre-revenue pre-money valuation, we can compare the company to the companies used to estimate that average. The comparison factors can have different weights, depending on the importance placed on each factor, the sum thereof must equal 100%. Each factor can then be given a score lower than 100%, when the company performs worse in the given category compared to the average companies analysed in Step n°1, or higher than 100% when the startup is of higher quality. Each factor score then results by the Weight x Target Company Score, the sum thereof gives the Factor Adjustment.

3. The median pre-revenue pre-money valuation is then multiplied by the Factor Adjustment to arrive at the estimated pre-money valuation of your company. You can then add the Investment sought to arrive at the post-money valuation, as in the previous method.

The Dave Berkus Method is at the origin of the previous methods. It is very simple but also quite outdated. It considers different success factors with a fixed value appreciation. This however, does not take into consideration valuation trends and the weights of different factors, which can therefore be adjusted to the average sector pre-revenue valuation compared to the average pre-revenue valuation of all startups.

Sources & Versions of the Scorecard Valuation Method 1. Scorecard Valuation Method Seedrs Valuation Methods Angel Capital Association

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

96

5.1 Seed Market Methods

Since the startup investment market is dynamic and subject to quick changes, methods based on fixed values cannot stand the test of time. However, a simple method like this one can find future application if these values can be adapted to current trends through a multiple related to the sector and current market trend: in reality, this is more complex than it seems. This methods can therefore be used as a quick reference and preliminary valuation, before valuing the company with one or two additional valuation methods:

The Development Stage Valuation Approach has some similarities with the David Berkus Method as it relies on milestones and therefore holds the same weaknesses in terms of reliability and outdatedness. Just like the previous method, it can be adapted to today’s trends and to the sector, and it is useful when used as a quick reference.

All of these methods produce the pre-money valuation, which even if it is used vastly in the startup investment world, is less relevant than the post-money valuation, since the money raised by the company is actually an important feature of the startup and its valuation. The funding amount is not simply something to add to the valuation as it is typically proportionate to the valuation. Ideally, the practice should be to compare and publish startups’ post-money valuations rather than pre-money valuation: nevertheless, these values can easily be calculated from published funding rounds information.

Seed market methods can also be used to construct a speculative valuation timeline. Base on the expected size and number of funding rounds of a startup in a particular sector, the gradual growth of the startup‘s valuation and timing of the funding rounds can be mapped, up until an exit value.

This valuation timeline would be speculative and it would only be used for internal goal setting and for investors‘ communication.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

97

5.2 EXIT VALUE In order to value a company that is an acquisition target, or that can be potentially sold in the near future, we use the market approach, which involves analysing comparable transactions and comparable stock-listed companies. In the case of early-stage startups, as we have seen by analysing the seed market methods, this market approach cannot be used as the company is too young to be sold. However, the exit value is fundamental to apply early-stage valuation methods: we need to calculate the future exit value of the company to apply the venture capital or similar methods. In the next few sub-chapter we will analyse how this value can be used to arrive at the value of the startup today through different valuation methods, starting from an estimate of the exit value.

The first step is to analyse comparable transactions or companies. This exercise is different from the standard market approach, as the type of transactions and companies that we take into consideration are very different. I recommend using Crunchbase for the analysis. It is not easy to find valuation figures as these are often private, so in some cases the analysis may have to rely on related but not closely comparable companies. When researching comparables, I recommend prioritising the following: •

Transactions or values not older than 5 years, preferably even as recent as 2-3 years

•

Companies in the same sectors with a similar revenue generation model, business model and risk profile, a common target region and without a large debt

•

Preferably do not include Unicorns, unless your company follows a similar growth strategy

•

Focus on Exit Multiples rather than Early-stage Funding Multiples or Multiples of stock-listed companies

•

When sufficient Exit Multiples are not present, it’s also appropriate to use Late Stage Funding multiples or values of Recently Stock-listed Companies

•

When there is a choice, deals mostly paid in cash and in full are preferable to deals paid in stock or with an earn-out.

What can aid you in the analysis is also knowing what types of companies would be interested in acquiring the startups and what will be the main acquisition motives: you can view examples thereof in the exit strategy analysis.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

98

5.2 Exit Value

EV/Revenue multiple

In startup valuation, the multiples that we calculate also differ, as profit multiples are often not available, or not comparable to our startup.

EV/EBITDA multiple

For startups we prioritise Revenue or User multiples, or alternatively other sector-specific growth measures:

EV/EBIT multiple Equity/ Net Profit

• EV/ Sales outlets •

EV/ Number of products

•

EV/ Years of operation

•

Other sector-specific figure

The result of the research and analysis would be a table like this one, illustrating the minimum amount of information to include:

The analysis will provide very valuable information about other companies’ performance, but most importantly, about the typical exit timing for your sector and multiples to use.

When no reasonable exit multiples are found, it is possible to select an EV/Revenue multiple between 2-6x: the more popular the sector, the higher the multiple that you can use within this range. There are cases, especially for new emerging sectors or for non-US transactions, where comparable valuation data is scarce or non-existent. In this case, to demonstrate to investors an active and acquisitive market, you can demonstrate the sector popularity or you can show examples to potential investors (e.g. number of companies recently funded or sold, even if the valuation, revenue or user figures are not available) to prove the validity of your chosen exit multiples, when reliable figures are lacking.

To calculate the startup exit value we usually assume the absence of future net debt, and assume that the Enterprise Value equals the Equity Value.

At this point, you can calculate the exit value based on the startup figures, extracted from the financial plan, in the estimated exit year with the following formula, in this case relative to revenue: Revenue (during your Exit year) x EV/ Revenue multiple = Future Exit Value

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

99

5.2 Exit Value

The calculation would lead to a range of values, which you can average or weight according to their reliability.

It would be ideal if values extracted from different multiples come very close, which signifies that companies with similar business models have been used and that the financial plan of the company is proportionate to the market.

The exit value represents the potential future fair market value of the startup: in order to calculate the value of the company today, at time 0, we need to apply valuation methods that involve either discounting this value based on the company’s risk or using a multiplier based on the investor’s return expectations.

A mistake that often takes place is the use of multiples on future plan figures without discounting. This is a practice that leads to overvaluing startups. By using researched multiples based on the financial figures of a company at or before acquisition, these multiples cannot be used on the startup’s next year projected figures, especially when the achievement of these figures is highly uncertain.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

100

5.3 THE INCOME APPROACH The income approach is the most popular valuation method among valuers, as it is more precise, forward-looking and company-specific than the market or cost approach. It is widely used in standard valuations: it is also more complex and can easily lead to mistakes when not applied correctly, which results in non-valuers and entrepreneurs preferring to use the market method when valuing a company internally.

The income approach involves valuing the expected future cash flows of the company: simply put, this can take place by capitalising the current sustainable cash flow or through the discounted cash flow (DCF) method, by calculating the net present value of the future income streams. There are a variety of sub-methods that can be applied based on the situation and company.

At the same time, the income approach is the most unpopular valuation approach for startups and early-stage investors. It’s usually because it adds an additional element of complexity and requires precision, so it is at odds with the speculative situation it is applied to: it makes little sense to apply advanced methods to such high-risk investments, when this risk cannot even be measured correctly. There are many more reasons for this, which we have analysed in the Chapter 1, but one that I find particularly relevant is the fact that an investor only earns a return from an exit, and therefore putting effort into valuing other cash flows is futile, as well as it being unlikely that a startup can accumulate significant cash flows before an exit takes place.

However, the income approach to valuation provides some key information into understanding why the market value of startups changes at different stages. The Discounted Cash Flow method involves discounting future cash flows with the following formula:

Cash Flow/ (1+ Discount Rate) ^ n° Year

The basic concepts to learn from this for non-valuers are: •

The higher the expected cash flows expected, the higher the company value will be, all else being equal

•

The discount rate is a measure of investment risk, therefore the higher the discount rate and therefore risk (or expected return), the lower the valuation

•

The higher number of years and therefore the further into the future the cash flows occur, the larger the denominator becomes as the risk is compounded: this therefore decreases the weight of the cash flows. This means that the further in the future a cash flow takes place, the lower its value today will be.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

101

5.3 The Income Approach

Understanding these basic concepts gives us information about early-stage valuations and the large differences among startups at different stages:

CASH FLOWS €M

20 10

2

5

10

12

14

0 -2

-10

-1

-4

90%

100% 75% 50% 25% 0%

DISCOUNT RATE %

60%

Year 1

45%

Year 2

Year 3

35%

30%

25%

20%

18%

Year 4

Year 5

Year 6

Year 7

Year 8

Let’s assume that these are the expected yearly cash flows for a start-up company and below is the assumed risk of the company’s cash flows at the start of every year. For every valuation point on the curve, only one discount rate usually applies (except in advanced valuation methods), as the lower risk of future cash flows still depends on the previous years’ failure rate. Over time, assuming the expected future cash flows stay the same, the risk decreases and therefore the value increases. This is why at the early stages the value of startups is lower than at later stages.

At the idea stage, sometimes the risk is so high that the value would revolve around 0, making the company a non-ideal investment.

C OMP A N Y V A LUE A T DIFFEREN T S TA GES €M 50.00 40.00 30.00 20.00 10.00 (10.00) Value

Year 1 (1.42)

Year 2 (0.28)

Year 3 2.19

Year 4 6.47

Year 5 10.60

Year 6 17.60

Year 7 30.70

Year 8 39.32

This is illustrated as many of the valuation methods used for startups are hybrid valuation methods that include both elements of the income approach and market approach. In fact, the exit is a cash flow that is paid to the owners of the company at a single point in time in the future (not accounting for an earn-out). This expected cash flow is then discounted to the present by using a startup-specific discount rate or divided by a multiplier, which is effectively derived from the discount rate as it accounts for the risk-return profile of investor, the probability and the timing.

This is why we can consider different versions of the VC methods to be an hybrid of the income and market methods.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

102

5.3 The Income Approach

We have analysed the exit strategy in a previous chapter and determined that there are 3 main choices in future strategy: 1.

The choice not to exit and therefore the indefinite continuation of the current ownership

2. The sale of the company to a corporate of institutional investor 3.

An IPO

There is also the possibility, in some cases, to sell the shares to other investors during a future funding round, but this is not a given, and in any case the valuation in this case would rely on the future exit possibilities of the startup.

Choice n°1 would not be an option when looking for VC funding, and when this takes place it would usually represent a failed investment. A startup does not necessarily need to decide exactly what their exit possibilities will be, but in many cases it would become a logical exit strategy based on the startup story.

In a standard valuation, when the company’s cash flows become sustainable, we calculate a terminal value: this can be done when no precise exist strategy exists and would require a DCF valuation. However, using a terminal value for a startup would be very challenging as a sustainable cash flow would materialise too far into the future, or imprecise/high growth rates would have to be used. For startups, we can replace the terminal value with the exit value when the startup will be presumably ready to be sold or to list on a stock exchange.

To bridge the gap between the two values the following comparison can help: a terminal value will represent the value at year X of all future cash flows the startup will generate from year X and onward, while the exit value represents the same value of these cash flows, plus synergies that the acquirer can generate from the target company from year X onward in the form of additional cash flows. We don’t have the data to calculate these synergies, and therefore the exit value is calculated from market values, which represent how much the acquirer is willing to pay based on how much they expect to gain from the company. These values will then have to be discounted back from Year X to the present to arrive at the present value. Even if we will not go through advanced DCF calculations in this guide, here below is a comparison of the Terminal Value and Exit Value calculation and discounting.

Present Value of:

TERMINAL VALUE

EXIT

Future Value at Year X

(SUSTAINABLE CASH FLOW YEAR X x (1+ growth%) ) : (Discount rate –growth%)

EXIT VALUE YEAR X (Calculated from multiples)

Present Value at Year 0

TERMINAL VALUE at Year X : (1+ Discount rate) ^Year X

EXIT VALUE : (1+ Discount rate) ^Year X

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

103

5.4 THE DISCOUNT RATE What discount rate can we use for startups? What is sure is that we cannot use the Capital Asset Pricing Model used for standard valuation in its current form, mainly because: 1.

Market risk for startups is not observable on public markets. Any additional discount or premium would therefore be subjective, or better it is a perceived risk;

2. The discount rate not only refers to the company’s risk but also to the risk of its cash flows, therefore the practice of presenting a very positive scenario to investors must lead to a proportional increase in the discount rate.

The only risk that we can observe is the typical failure rate of startups at different stages, but even these statistics are rare, sometimes outdated or not available for all geographies to be completely relied upon. However, as some statistics claim that the failure rate for seed stage startups can reach 90%, we can more confidently use higher discount rate for the early stages. Over the years, as the reliability of projections increases, the risk decreases as well as the failure rate, and the discount rates used will increasingly come close to those used for a standard valuation. In any case, only after an exit or in special circumstances it becomes appropriate to use the DCF approach instead of prioritising an exit value.

Also, the way we value startups must be in line with the expected return on investment of the VC investor, who typically has specific return expectations, is not a completely diversified investor and therefore is exposed to higher risk, whereas the CAPM assumes that the investor has a diversified portfolio with assets belonging to different risk classes. We can use different methods to estimate a discount rate for startups.

DISCOUNT RATE METHOD 1 The discount rates that can be reasonably applied for different stage of startups are as follows: Stage completed

Minimum

Maximum

IDEA

75.00%

90.00%

DEVELOPMENT

70.00%

85.00%

PROTOTYPE/ MVP

60.00%

75.00%

MARKET VALIDATION

50.00%

65.00%

MARKET ROLL-OUT

40.00%

55.00%

GROWTH

35.00%

50.00%

EXPANSION

30.00%

45.00%

LATE GROWTH

20.00%

35.00%

None of these discount rate are based on market observation but rather on general practice. The stage is extremely important to determine the risk for startups, as execution is fundamental to foresee a company’s potential rather that the idea alone.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

104

5.4 The Discount Rate

It’s recommended to use this method only with companies that have at least completed the idea stage and are currently investing in the company’s development, assembling the team and that have begun investing into the company’s products and assets. Before this stage, the risk would be so high that it would difficult to estimate a potential exit: in this case, it is better to user a rule of thumb method by analysing local market valuations at the idea stage.

To more precisely estimate the discount rate to use within the range of the startup’s completed stage, we can analyse small business risks (in blue) and startup-specific risks (in red), when these risks are not already included in the valuation. Again, these are not risks that can be quantified by observing the market, but rather they are perceived risks based on judgement, which can be weighted according to the importance placed by the investor.

This is a proposed approach for estimating the additional risk of a startup within the 15% risk range of the company’s stage, which can be added to the minimum discount rate for the relative stage:

The Startup Premium is then added as follows: There is another method that we can use as a way to bridge the gap between the startup valuations and discount rates and the CAPM. By using the Modified Capital Asset Pricing Model with a custom risk premium to independently asses different risks.

Stage completed:

Minimum

Maximum

PROTOTYPE/ MVP

60.00%

75.00%

Startup Premium

4.50%

Expected ROI

64.50%

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

105

5.4 The Discount Rate

DISCOUNT RATE METHOD 2 Another method that we can use to calculate the discount rate is by applying the investor’s Required Rate of Return, which usually ranges between 15%-25%. However, investors know that this figure will not be returned by all investments as the risk of failure is not accounted for.

We can therefore add the risk of failure for startups for different stages or sectors. Some statistics are available and are illustrated here. 1 These statistics 2 refer to the portion of startups that were still operational after 4 years, while others report that 75% of VC-financed startups fail. 3

We can then add the Required Rate of Return to the expected failure rate to arrive at the Discount Rate to use:

Sources 1. Statistic Brain Research 2. Failory 3. Review 42

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

106

5.4 The Discount Rate

ALTERNATIVES These methods, as mentioned, serve as an estimation of startup risk or expected return, but since this risk cannot be observed on public markets, they are not scientifically proven. They rely on judgement and experience, but nevertheless they are very useful in highlighting the different risk profile of different startups.

There is another version of method n°1, that involves a more highly customised risk premium based on the subjective assessment of each risk, involving the estimation of probability and the amount of cash flows that are affected by the risk, should it materialise. Just as in method 1, we can add the risk premium to the base discount rate for the stage:

Additionally as a way to bridge the gap between the startup valuations and discount rates and the Capital Asset Pricing Model, this can be used with Total Betas, taking into account a nondiversified investor. This would considerably increase the discount rate used in most cases, but it doesn’t take into account the stage of the company, and therefore we will not go into the detail of the CAPM here.

Moreover, if you are not sure whether to use method n°1 or n°2 for the estimation of the discount rate, you can average the two, provided that both methods are relevant and the values are not Expected ROI 62.8% different from each other, as we have done here:

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

107

5.5 HYBRID INCOME/ MARKET APPROACH After estimating an exit value and the exit year and now having established a discount rate, we can now calculate the present value of the company by discounting the exit value as of year 2020. The result for the hybrid income/ market approach can be illustrated as follows:

Here we assumed the lack of debt and non-operating assets.

This is not yet the final valuation for this method. Differently from the seed stage method that already incorporates market values and the expected dilution of early-stage investor, the exit value does not incorporate the dilution of early-stage investors. The dilution can be estimated based on the additional expected rounds of funding that the company will likely need before an exit, based on the market observation of the sector and comparable companies: we don’t know the stakes sold at each round of funding in the future of course, but we can estimate a value between 10%-15% as typically observed in the market.

The value of the company will then be reduced by the expected future dilution to arrive at the post-money valuation of the startup with the following formula: Post-money valuation x (1 - Dilution) = Adjusted post-money valuation

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

108

5.6 VENTURE CAPITAL METHOD The Venture Capital method has different versions and has varying degrees of complexity and adjustments that can take place in a different order. In its most simple form, the VC method involves estimating an exit, and dividing it by an anticipated total Return On Investment (ROI), which will be higher for high risk and early-stage companies such as the one used below, and lower as the company progresses.

This Anticipated ROI or Target Multiple of Money may be usually between 3-15 depending on the stage, characteristics of the fund and expected exit timing. This would be the fund’s total required return for Limited Partners, including the costs of the fund. Its use should be comparable to the use of a discount rate used in the hybrid income / market approach, even if the calculation methods differ.

We have seen how can we can calculate an exit value, after preparing a financial plan and applying researched multiples to the company’s figure in the estimated exit year. Some VCs may simply estimate an exit value by weighting 1-4 scenarios for a future revenue and exit timing (here the timing refers to the exit starting from the current investment year, not from incorporation) and apply a standard multiple that is acceptable for the stage. Of course, without a financial plan, the revenue becomes much more speculative.

If we want to break down the Expected ROI, we can calculate it as a function of the expected fund’s yearly return, which usually ranges between 15% and 25%, the n° of years to exit, increased by the risk of the opportunity: 1 Target Multiple of Money: (1+ r) T / p Where: r = Expected yearly ROI of investor per year T = Years invested from time of investment until exit p = probability of success Adjusting the expected return by the probability of success is very important, as most deals are known to fail. In fact, actual VC return are known to range mostly between 10%-20%, with many VCs having returns on the lower range. This depends on location, maturity of the fund and concentration on early or later stage deals: comprehensive and precise recent statistics were not found. This post 2 illustrates how returns for VCs work and how fewer than 5% of funds returns more than 3x the initial investment. This can only take place if we take into consideration the failure rate within the required return we apply to the valuation.

Sources 1. Metrick/ Yasuda (2011) 2. The meeting that showed me the truth about VCs

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

109

5.6 The VC Method

We can create a table of multipliers to choose from, based on the calculation just illustrated:

Now that we have a more case-specific multiplier, we can apply the venture capital method. It is also typical to adjust the value by the expected dilution. Then based on the investment sought, we can estimate the required investment.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

110

5.7 FIRST CHICAGO METHOD The First Chicago Method is another method typically used by VCs. As we mentioned, we can’t calculate the discount rate for startups with traditional methods, because what typical startup projections and exit values represent is not the base case scenario but rather a best-case scenario or a positive one, but not the most likely scenario. These projections represent a goal. If we want to bridge the gap between standard valuation and startup valuation by using the discount rate according to the MCAPM, it is possible to do it, but only if we account for different scenarios and weight them according to probabilities, thereby calculating a weighted base-case scenario.

To calculate scenarios, we can, for example, follow the exact same procedure by calculating financial projections, an exit value and timing for each scenario, and then weight the different scenarios according to probabilities. Creating a second scenario based on the change in a specific value, for example market size, or product range or growth helps understand your realistic range of possibilities. Or alternatively, after calculating an exit value, you can simply take an minimum, maximum and average value to create 3-4 scenarios: bear in mind that a scenario analysis for a startup would include a 0 worst case scenario, as the probability of failure is high.

In this case we calculate the Net Present Value of the company by either discounting this value using a standard discount rate, dividing it by a multiplier as we have seen in the VC method, or by using the yearly expected ROI of the fund. What is important to take into consideration here is that the risk of failure should already have been accounted for when weighting probable scenarios, if this exercise has been done correctly, and therefore it should not be accounted for twice. Both the Discount Rate, Target Multiple of Money and ROI can therefore be lower than those we use for the best-case scenario only.

There are actually a variety of different way to carry out this method, therefore here we analyse the method that I use the most for startups, which is to use the ROI, but other similar approaches can be just as valid: view the Alternative Methods for the key sources for the First Chicago Method.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

111

5.7 First Chicago Method

We can then assign a probability for each scenario, and the weighted average will represent the company’s valuation, according to this formula: Exit / (1 + ROI) ^year x Probability Each scenario will have a probability that should sum up to 100%. The sum of the above calculation for each scenario results in the NPV. We can now adjust this value by the expected dilution as we did with the previous method.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

112

5.8 ALTERNATIVE VC METHODS Venture Capital Methods are the most used for startups as VCs are the drivers of the startup investment market. Since investors have different backgrounds and there are no official guidelines for VC methods, as a consequence there is a wide variety of applications of these methods. The application of VC valuation usually involves the estimation of an exit value and the use of a discount rate or multiplier to arrive at the current fair value of the company.

Many other details can vary. Some alternative calculations involve the following:



The use of 4 instead of 3 scenarios.



The dilution can be applied before, to the exit value, or after, to the post-money valuation; the result should be the same or similar.



In the same way, probabilities may be applied to the exit value, the time of exit and at different valuation steps separately for the different scenarios, instead of at the end. 1



Sometimes negotiations take place before a valuation has taken place, so there might be a proposed stake under consideration. In this case the proposed investment can be compared to the required investment stake that would meet the VCs return expectations. This is not a different method by itself, but rather it is the use of the VC method for decision-making purposes.



Some may use cash flows plus an exit value in the First Chicago Method instead of just an exit value. Some may calculate a weighted future value from different scenarios and then discount this value to the present.



Some investors who come from a traditional finance background use the DCF method with a Terminal Value. Of course this does not produce a realistic value for companies who expect a very fast growth.



The Options Method also exists but is rarely used.

Other useful resources that discuss startup valuation methods are: 1. “How to Value a Start-up”, Shelly Hod Moyal, iAngels, 2017 2. “The International Private Equity and Venture Capital Valuation Guidelines December 2018 Edition” 3. “A guide to help evaluate Early Stage investments”, EBAN, 2011 4. "Valuing Young, Start-up and Growth Companies: Estimation Issues, and Valuation Challenges”, Aswath Damodaran, 2009 5. "How does the venture capital method value a business?", Venionaire Capital

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

113

5.9 PRICE OF RECENT INVESTMENT This method is analysed in the “The International Private Equity and Venture Capital Valuation Guidelines December 2018 Edition” so I invite you to read the guide for venture capital valuation theory. The IPEV mentions that:

“After considering individual facts and circumstances and applying these Guidelines, it is possible that Fair Value at a subsequent Measurement Date is the same as Fair Value as at a prior Measurement Date. This means that Fair Value may be equal to the Price of a Recent Investment; however, the Price of a Recent Investment is not automatically deemed to be Fair Value.”

The price of a recent funding round for a startup is extremely important, as the value of the company usually grows in line with its funding rounds. This value can be used as a basis to arrive at today’s valuation, provided that the price of the company is considered correct and no extraordinary influences that no longer apply have affected the transaction and fair value placed on the company, for example the special interest of the investor. Depending on how large these influences or bias are, the valuer can decide whether to calibrate and adapt this value or to scrap it altogether for being unreliable.

When the Price of Recent Investment is usable, there are two main adaptations that I recommend applying: 1.

Remove bias identified in the price of the recent transaction, particularly special rights of investors and other clauses that affect the liquidity event and ownership in the future

2. Use the discount rate to bring the past value forward to todays value, provided that the company has met its recent milestones and progressed in its planned path 3.

When the company has exceeded expectations with regards to increased revenue, users or development, additional upward adjustments can be applied (or inversely, when the company has underperformed).

The quantification of these adjustments will be at the discretion of the valuer. There are some commonalities between this method and the seed stage market valuation methods we analysed previously, as they both consider the price of a recent round funding to be relevant to estimate the company’s current value. The risks and factors analysed in these methods can be used to analyse the company’s progress.

This is an example of how this method can be applied:

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

114

5.10 COST APPROACH The Cost Approach, differently from other methods, is not future-oriented. It attempts to assign a fair value to a company based on the value of the assets it owns (Net Assets Value) or based on what would need to be invested to build the same company from scratch (Replacement Value).

This method is used only in certain situations, for example for Real Estate companies, where the value of net assets is a representation of its future monetary earnings, and to establish the liquidation value of companies as the lower boundary for the company’s valuation or in cases of insolvency. There are a few reasons why this cannot apply to startups:

•

There is often no reliable balance sheet, and IP values are often not measured correctly

•

The lowest value of a pre-revenue startup is often 0, as even the technology or IP that has been built cannot so easily be sold to third parties

•

The future possibilities of a startup far outweigh anything that has been invested so far

However, the amount that has been invested into the company so far is still very relevant, and it is also positively correlated to the company’s seed valuation. For example, the investments by the founders is interpreted as a strong indication of commitment by the investors, and additional equity injections by third parties also decrease the company’s perceived risk.

Even though this does not result in the company’s value, we can list all the costs sustained by the company so far, possibly excluding costs that did not contribute to the company’s development, salaries paid, including unpaid time spent on the project by founders, as well as unused investments. If the IP or other asset built has been valued, the amount invested in the asset can be substituted with the value of the asset for simplification. We will then arrive at the startup’s replacement value.

Can we use this value? Not with the valuation methods that we have used so far and with the data that we have available today, but it is possible to use it if more data is collected. Even though the replacement value is considerably lower than the company’s market value, we can logically say that these value are usually proportional and positively correlated. We can therefore arrive at the startup value by applying a multiple.

More research and trial & error analysis is needed to establish the right set of multiples, but for now, by using multiples between 5-10 (similarly to the Target Multiple of Money gathered in the VC approach, but which will be used to multiply rather than divide the value) we can calculate valuation in line with other methods, assuming a realistic investments calculation. We will not include this in one of our listed valuation methods as there is not data to back up such a method, but it is displayed here to encourage other to establish a framework and start collecting statistics on the relationship between current investments vs. valuation.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

115

5.10 Cost Approach

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

116

5.11 VALITHEA METHOD TM I believe that most methods that we have seen so far have one or two undeniable weaknesses: they are subject to strong bias and/or require skilled research. Neutrality in selling the company’s achievements and transaction research skills do not usually appear in the founders’ skill set.

Additionally, experience teaches us to prioritise risk management and use logical analysis and objectivity based on the information available, but this experience is often lacking in the earlystage startup market. When carrying out startup valuation, keeping neutrality is the most important skill, but achieving this entirely is impossible as some biases always exist. That’s why creating guidelines decrease some of these biases.

Taking this into consideration, I attempted to create a method that can potentially be used by someone without valuation experience and that partly eliminates this problem. The Valithea Method TM is a rule of thumb method that represents a short but comprehensive version of the most important value drivers of a startup valuation combined into one calculation with a multiple choice questionnaire. This method can be used for a quick assessment, just like the other rule of thumbs methods are used. It is also a method that is dynamic as it takes into account sector and country popularity, so it needs to be readjusted once these trends change.

When using these method, 11 multiple choice questions are provided, which result in the calculation of two values that are then averaged to arrive at a post-money valuation, to ensure that we decrease the weight of erroneous inputs. It also indicates a maximum and a minimum value range based with a +/- 25% margin or error.

One non-politically correct feature of this method is that it puts into question the estimates by founders based on their validation effort and goals, thereby questioning their reliability, which unfortunately is one of the main value drivers of startups. Of course, it cannot account for the founders having no precise knowledge of their market size and revenue model and for the possibility that false achievements are entered in the model. However, the method does not ask directly for market size, but rather it requests information on number of customers and revenue per customer, which decreases the rate of error.

These main factors that affect a startup valuation are included: •

Exit  Market Size $, Validation, Time to Exit, Dilution, Sector, Stage

•

Investment Framework  Investment, Location, Team goals

The lack of objectivity in the inputs and research is why valuation calculators cannot be trusted, or even explained to third parties. The only way that we can create a calculator is to simplify and categorise companies, in a way that biases are minimised and research is minimal. That is how the Valithea Method TM created, to increase objectivity and also to allow the founders to explain the method to third parties.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

117

5.11 Valithea Method

TM

Unfortunately, because market prices have a strong effect on early-stage valuations, even more so than for standard valuations, some research is unavoidable. However, what we can do in this rule of thumb method is to standardise market prices or multiples, at least for the current year until trends change. Not all differences among countries and sectors are accounted for entirely. The method uses ranges of values rather than precise values. The ease of using this method is only ensured by more complex calculations that are at the basis of this method, which we will make available on our website in order to allow founders to use this method without carrying out calculations.

I have assigned points for each feature that is used to calculate the final valuation of the company, with questions that are based on both quantitative and qualitative information. These values are clearly simplified and bias in the inputs cannot be completely excluded.

The two values that are used to calculate an average post-money valuation are calculated as follows: 1.

Simplified Hybrid Income/Market Approach: Question 1-7

( (N° of customer x Revenue per customer) x (1 - Validation quality) x Sector multiple* ) :

( VC Multiplier** / (1 - Stage discount) ) x (1 + Dilution of rounds***)

2. Adjusted Cost Approach: Question 8-11 AVERAGE ( (Investments so far x Target multiple of money****) , (Next round / 12.5%) ) x (1 + Country Adjustment*) x (1 + Goals Adjustment) * Based on approximated values from experience in valuations in different sectors and countries ** The basic VC multiplier used here excludes the risk of failure and a 20% expected return is at the basis of the calculation *** The dilution is based on rounds with stakes between ca. 10-20% **** The target multiple of money is set to 7.5 for this simplified calculation

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

118

5.11 Valithea Method

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

TM

119

5.11 Valithea Method

TM

Please view here how the calculator works in practice.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

120

5.12 ADJUSTMENTS Most founders think of the valuation as a clear-cut number. In reality, behind the valuation there are a variety of terms and conditions upon which that value is based. For startups, the investment is regulated by the term sheet, and subsequently the shareholder agreement when the terms are finalised, which define a variety of clauses attached to the investment.

The basic assumption is that, at least in theory, the market value of the company as a whole is different from the fair value of the company and each shareholding might be valued differently depending on the rights and clauses it is subject to.

Just like we have seen in the case of an exit valuation, where an earn-out renders the total value conditional upon certain future goals, the startup valuation during funding rounds can be interpreted in a variety of ways.

One of the most obvious differences is the liquidity preference: in fact, dilution can be higher than expected due to the liquidity preference of investor shares, which could convert at 2x or 3x of the stake value at a liquidity event (the exit). This means that the fair value of the company, accounting for the higher stake of the investor during a specific liquidity event, would be lower when this clause applies.

There are a variety of options and clauses attached to these investments, depending on the sophistication of the investor, that often not all negotiating parties are aware of (even minority investors sometimes), including different dilution preferences, voting rights, commercial agreements with corporate investors, etc. Many of these clauses are listed here.

The term sheet is a non-binding offer that is signed before a potential due diligence, then followed by a shareholder agreement, in case of an equity transaction. Most term sheets likely include some of these clauses, but you should consult an expert or a lawyer to ensure that they are fair. Typically, VC term sheets will be stricter than the ones presented by some business angels. The most well-known clauses names or terminology used are listed here, which you can research to familiarise yourself with them:

VALUATION: Pre-money/ Post-money/ Fully diluted FUNDING MILESTONES: tranches may carry a different valuation every time a tranche is paid and have conditions based on the business plan, use of funds, etc.

SHARES: ordinary or preferred shares, conversion rights, different preferences EXIT or SHARE TRANSFER: liquidation preference, tag-along/ drag-along/ forced sale, special investors rights, IPO clauses; pre-emptive rights, lock-up, right of first refusal/ right of first offer, call options/ put options, clawback shares, incentive options, ratchet clauses FUTURE FINANCING dilution and financing rounds rules

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

121

5.12 Adjustments

GOVERNANCE: board composition, veto and information rights PERSONAL LIABILITY and indemnification COVENANTS: IP assignment and non-compete, non-solicitation clauses TERM SHEET: exclusivity, expenses, timing and drafting responsibilities, legal nature and confidentiality.

In summary, there can be a way, to, objectively and subjectively, depending on the clause, translate all terms and conditions attached to a the company’s ownership, into a discount or premium over the final valuation. This would be similar to applying a control premium or minority discount to the a company’s shareholding in a standard valuation.

What does this lead to, and should we change the way valuation data is published?

Probably not, because the reason why some of these clauses are there is because the investor and founders cannot agree over a certain valuation, with the investor usually believing that the valuation is lower. Therefore, instead of changing the official valuation, clauses are added to reflect the true underlying valuation and safeguard the investment. Only when we need the fair value or fair market value, these adjustments should be applied.

This takes place because of the high-risk characteristics of this market, where not all participants recognise or agree on the true risks involved. Startup investments also involve a risk that needs to be managed though clauses that motivate or deter both founders and investor from certain actions. It also happens because it’s normal to compare the value to other startup valuations in the market, which are also subject to the terms and conditions that are unknown to the public.

This is how the parties use the stated valuation and contractual clauses as a negotiation tool. On one side, high valuations have the aim of creating hype towards particular companies or technologies, sort of like a marketing tool, but at the same time, these valuation expectations need to be pushed down through strong term sheet clauses. These clauses are more common in sophisticated and liquid venture capital markets, where investors have learnt to capitalise on highrisk investments.

To conclude, we do not carry out adjustments based on the terms and conditions of an agreed startup valuation during a round of funding, as that figure has a specific scope in negotiations.

There are however cases where carrying out this adjustment exercise is appropriate. For example when valuing the startup assets in an investor portfolio, the aim is not to calculate the market value at the next fundraising, but the fair value of the shares, and therefore the realistic value of the cash inflows expected from a future exit and sale of those shares, taking into account all the clauses and investor rights that will influence this cash inflow, as well as additional risks or benefits attached. By doing this, we arrive at the fair value of the investor’s shares, which we explain later in more detail.

These adjustments should not be applied for startup fundraising, as the public valuation figure is the value that investors and founders would accept based on the agreed terms & conditions, so if the value were to be adjusted, so would the terms and conditions have to be respectively adjusted.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

122

5.12 Adjustments

Another reason why it makes things complicated when these adjustments are applied, is that during negotiation, a valuation is initially agreed upon, and subsequently the term sheet is presented, and therefore applying the adjustments would take place after a valuation has already agreed upon. This could make negotiations more complex. However, since the startup valuation and term sheet clauses in a round of funding are intertwined, founders can use two valuation versions when presented with a clause that they do not fully agree on or that is excessive or unusual. At this point, small adjustment no longer count as the negotiating power of the parties would determine the valuation outcome.

However, there are other adjustments that can be applied to the startup valuation.

One of the most important aspects to understand about structuring the financing deals is dilution, and how the founders’ stakes and those of investors may reduce over time with new funding rounds, as well as different liquidity rights and options that alter the reward that each investor receives in case of an exit.

Events and clauses that dilute or reduce shareholdings at the time of exit or earlier are: •

Vesting of ESOP (employee stock ownership plan)

•

Investing of new shareholders and capital increase

•

Maturity or options of convertible debt

•

Liquidity preference of VCs or other investors in case of an exit

•

Other clauses or options e.g. higher payments to investors when the exit value is under expected amount, or waterfall that prioritises later stage investors

You may own a much smaller stake of your company at exit, but it could be a small stake of a large company, so dilution is not a bad thing per se, but it needs to be accounted for when calculating the current valuation.

However, since we have a variety of methods, we do not apply dilution to all methods, and therefore we cannot carry out this adjustment at the end when we have used different methods.

Methods that use recent funding rounds as the basis of the valuation (seed market methods or rule of thumb methods) already imply that future dilution is taken into account, as similar companies typically have the same fundraising path that is expected by investors. Instead, methods that use the exit value or other non-market methods should include a dilution adjustment. For this reason, you can see how we carried out this adjustment after each relevant method, instead of at the end.

Additionally, when a new major shareholder enters the company and contributes as key management personnel, or as an active business angel offering a significant contribution, you may consider a downward value adjustment.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

123

5.12 Adjustments

In this case, whereas the value of the company would take into account going concern and future exit possibilities, a discount on the total value would be justified, meaning a lower valuation and therefore an increase in the new shareholder’s stake, to account for the contribution offered by the new shareholder, provided that: •

A positive scenarios is used that takes into account the contribution of the person to the company’s future (otherwise you would be lowering the company’s value twice)

•

The additional contribution to the company’s success is not fully accounted for in the salary that the person receives

The calculation of these figures, however, can be highly subjective.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

124

5.13 COMPARISON OF VALUATION METHODS Seed Market Methods

Brief description & steps

Adjust the median premoney prerevenue valuation of comparable companies’ rounds of funding by the features of the startup

Hybrid Income/ Market Approach

Simple VC Method

First Chicago Method

Price of Recent Investment

Discount the Exit Value of the startup to the present

Divide the Exit Value of the company by a Target Multiple of Money

Create multiple scenarios and discount the weighted exit value of the company to the present

Adjust the price of a recent funding valuation for bias and company’s progress

Multiple choice questionnaire that incorporates a simplified Exit discounting and Cost Approach

Reflects the most likely scenario

Reflects the potential market pricing of the specific company

Easy to apply

Valithea Method

Pros

Easy to apply

Precision & Flexibility

Reflects the ROI of investors

Cons

Inflexible and needs adaptation

Discount is imprecise

Discount or multiplier imprecise

Difficult to estimate probabilities

The calibration is subjective

Needs periodic adaptation

Research required

Yes

Yes

Yes

Yes

Partly

No

Variations

Risk Factor Summation Method, Scorecard Valuation Method, Dave Berkus Method, Development Stage Valuation Approach

Use of exit or adjusted terminal value / Use of startup discount rate or adjusted expected ROi

Different use of discounting, ROI or multiplier

Different use of discounting, ROI or multiplier, different order of calculations

The adjustments can be subjective

-

Complexity

Low

High

Medium

High

Medium

Low

Dilution adjustment

No

Yes

Yes

Yes

No

*Included

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

125

5.14 VALUATION RESULT We have analysed a variety of different methods that can be used for the valuation of startups.

A comparison of different valuation methods specific to startups reveals how each method can have different pros and cos, levels of complexity and amount of research required as well as different dilution adjustments to apply. Rule of thumb methods, despite their approximations, may be superior and more practical for estimating a startup value, as they rely on observed market preferences and help us frame and weight different risks and features logically.

All methods have their unique strengths and weaknesses, but they all have a high margin of error due to the uncertainty in an early-stage startup’s potential.

Professional valuations of standard companies typically do not allow or recommend averaging between methods. For startups instead, averaging two methods is appropriate because of the uncertainty of the valuation and high margins or error, as also recommended by Bill Payne, a US angel investor that has been actively investing in startups for three decades: “There is no perfect methodology for establishing the pre-money valuation of pre-revenue seed/startup ventures. Consequently, investors are advised to use multiple methods to arrive at a final valuation. The angel investor may expect between 10-40% stake at an average seed valuation between $1m - $4m of the company’s equity, higher if their shares get diluted through an option pool for employees and subsequent funding rounds.” 1 The figures mentioned are of course outdated and may no longer be true in today’s investment market, but the rule of thumb methods that we still use today originate from Bill Payne.

I suggest averaging the valuation result of two different methods rather than two very similar methods, choosing: •

1 between the Hybrid Income/ Market Method and a Venture Capital method, including methods with one or multiple scenarios

•

And 1 between a Seed Market Value/ Rule of Thumb method and the Price of Last Investment method

Averaging a method based on the discounting of the potential exit value, and one that is based on recent funding transactions balances different factors and corrects an eventual mispricing in the market by comparing short-term and long-term expectations. You can also use the additional new methods that we presented here, such as the Cost Method with Multiplier or the Valithea MethodTM, but since they are untested so far, I suggest only using them for comparison purposes.

Sources: 1. www.angelcapitalassociation.org/

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

126

5.14 Valuation Result

Ideally, the results of the two methods would be close, and if they are not there are three possibilities: •

There’s likely an error in the assumptions used

•

The market data is not reliable and should be reviewed, adapted or discarded

•

The company is not a startup and should be valued with different methods

•

The company may be a startup but is operating in a traditional or non-startup sector.

When we can’t arrive at a realistic value, we could make some adjustments and/or also use a traditional valuation method, but this would be subject to the discretion and experience of the valuer.

The average value calculated form the two methods represents our post-money valuation.

The pre-money valuation, which will be needed for cap table and term-sheet calculations, can be derived by subtracting the investment amount from the post-money valuation.

Assuming an equity injection, the stake for the investor can be calculated by dividing the postmoney valuation by the amount of funds sought.

The Return on Investment (ROI) can be calculated as follows: (Exit Value – Total Funds Needed) / Current Funds to Raise x Investor’s Stake However, it’s important to remember that this is not a guaranteed ROI but rather just a speculative figure at this stage, as also the dilution figure used is highly uncertain.

The figure below represents the final valuation result with the discussed averaging of two methods and adjustments. In the case of fundraising valuations, the adjustments have a low impact and could optionally be left out. Of course, in this case we have not used data about a real startup, so the two methods produce quite different results. In a real world setting, we would ideally have much closer values to work with.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

127

5.15 VALUING A STARTUP WITHOUT A FINANCIAL PLAN It is possible to value an early-stage company. In fact, most seed stage startups are valued this way, without carrying out complex valuations or projections. However, this makes the valuation highly uncertain, since the financial projections are also part of a company’s business model validation. Another important weakness is that without a financial plan, the amount if investment sought cannot be estimated correctly, and that founders’ expectations regarding the funds to raise is usually wrong, sometimes setting the bar too low (not taking into account cash flow risks) or too high (not having a realistic view of how much can be raised on the market at a certain stage), which results in unbalanced valuations.

There are two pieces of information, that despite the lack of a financial plan, are extremely useful: revenue and the number of users/customers at the time of exit. Without these, the most used methods cannot be applied, such as the venture capital method, or any method involving the calculation of an exit value. However, it may be possible to estimate an exit value and time to exit based on the sector average, by analysing comparable exits, especially when the sector has stable trends; less so when exits do not appear to follow a specific trend or when data is scarce.

Of course, projecting the number of users and revenue in a simplified manner, without using a market top-down approach, would not provide us with very reliable figures, so it is recommended to use the lower multiples within the range researched.

The methods that can be used without any problem in the absence of financial projections are rule of thumb methods, which, however, are only suitable for early-stage startups. When done correctly, these may even be more reliable than exit-based method, as they take into consideration the current funding market trends.

Another method that can be used, only in circumstances when the company has had a recent round of funding, is the Price of Recent Investment Method. Even when no proper valuation had taken place at the time, a recent valuation would indicate how the company is valued in the market, provided that the investors are not friends & family or have other non-financial interests in the company.

Additionally, the Valithea Method ™ is another rule of thumb method that estimates the value of a company by using a mix of the above methods through a multiple choice questionnaire and approximation of market trends for different types of companies.

Since none of the methods used for startups can be totally reliable due to the high uncertainty of early-stage investments, we should calculate an average of two/three methods to arrive at a valuation.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

128

5.15 Valuation without a Financial Plan

To summarise, we can use any of the following methods to calculate the value of a startup, in the absence of a financial plan: •

Exit-based methods by using an approximation of the exit value – VC Method, Hybrid Income/Market Method

•

Rule of thumb methods – Risk Factor Summation Method, Scorecard Valuation Method

•

Price of Recent Investment Method

•

Valithea Method ™

Without a financial plan, we should not consider any valuation exercise to be fool-proof and the result should be a Value Estimate rather than a Calculated Value, to be used for low-risk transactions or last-minute negotiations. A Calculation Engagement Report or a Valuation Engagement Report should not be prepared in these circumstances.

An example of a fast-track valuation using the methods mentioned (2-3 would usually suffice) is illustrated here:

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

129

Chapter 5 - Startup Valuation

Quick Recap 

For startups at seed stage we cannot apply the market method, but we can adapt it by researching comparable rounds on funding. The rule of thumb methods that we can use for the seed market method are the Risk factor Summation method, the Scorecard Valuation Method, the Dave Berkus Method and the Development Stage Valuation Approach. The first two, most common methods, involve estimating the average prerevenue pre-money valuation in the location/sector and adjusting it for the company’s different features comparable to the market.



The exit value is fundamental to apply early-stage valuation methods: we calculate the future exit value of the company. This value can be used to arrive at the value of the startup today through different valuation methods, starting from an estimate of the exit value.



To calculate an exit value, the first step is to analyse comparable transactions or companies, focusing on the sale of late-stage startups or other closely comparable transactions and business models. By comparing the comparable companies’ valuations to their figures at the time, such as revenue and users, we can calculate average multiples and exit timing to apply to our startup. Based on the startup projected figures at the time of exit, by applying and weighting the multiples, we can calculate the future exit value of the startup.



The income approach is the most unpopular valuation approach for startups and earlystage investors, as it adds complexity to an a highly uncertain investment. Startup investors usually earn a return from a liquidity event and a cash surplus is unlikely, making the DCF method redundant.



Many of the valuation methods used for startups are hybrid valuation methods that include both elements of the income approach and market approach. In fact, the exit is a cash flow that is paid to the owners of the company at a single point in time in the future. This expected cash flow is then discounted to the present by using a startupspecific discount rate or divided by a multiplier, as it is typical in VC valuation methods.



When using a discount rate to discount the exit value, we cannot use the CAPM: for startups, we can use a specific discount rate for different stages, adjusted for additional risks, or we can use the investor’s required return on investments, adjusted by the startup failure rate.



The hybrid income / market approach involves the discounting of the company’s exit value, and then reducing this value by the expected dilution of shares until exit.



With the Venture Capital method we can divide the exit by a Target Multiple of Money, calculated using the expected ROI, time to exit and risk of failure, and then adjust the value by the expected dilution.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

130

Chapter 5 - Startup Valuation

Quick Recap 

The First Chicago Method involves creating different exit scenarios, assigning probabilities to each scenario after discounting each exit value by the Expected ROI, and calculating the weighted average. The NPV can then be adjusted by the expected Dilution.



The Price of Recent Investment takes into consideration the company’s valuation at the latest funding round and adjusts it for any bias, special rights and progress of the company.



There is a positive correlation between how much the founders (and possibly other investors) have invested so far and the valuation of the company, particularly in the early stages.



The Valithea MethodTM is a rule of thumb method that can be used by founders by answering 11 multiple choice questions. It decreases bias as well as the need for research by assigning fixed values to each answer. The final post-money valuation is calculated as an average of the Simplified Hybrid Income/Market Approach and the Adjusted Cost Approach.



Adjustments for term sheet clauses should not take place for fundraising transactions, but they should be accounted for in the assessment of fair value and the valuation of investors’ shareholdings.



Dilution adjustments should be carried out for valuation methods based on the exit value or other non-market methods, while in some cases the valuation can be lowered for shareholders offering a significant contribution.



A comparison of different valuation methods specific to startups reveals how each method can have different pros and cos, levels of complexity and amount of research required as well as different dilution adjustments to apply. Rule of thumb methods, despite their approximations, may be superior and more practical for estimating a startup value, as they rely on observed market preferences and help us frame and weight different risks and features logically.



To arrive at our final valuation result, we will then select two methods, ideally 1 between the Hybrid Income/ Market Method and a Venture Capital method, and 1 between a Seed Market Value/ Rule of Thumb method and the Price of Last Investment method. After averaging the two methods, we can apply any necessary adjustments when present and calculate the final post-money and pre-money valuation, the investor’s stake and expected ROI.



Without a financial plan, a valuation can take place using some typical startup methods, but the result will be speculative.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

131

Chapter 6

Special Situations 6.1 LATE STAGE STARTUPS In this book we have predominantly analysed the methods used for seed or early-stage startups, which, even if they relate to lower risk transactions (as the investment amount is lower), are the ones where most doubts arise. Tech startups are valued fairly often as they raise funds on a regular basis, often every 1-2 years, or even more often in the earlier stages. Over time, the methods to value these startups can be fairly consistent when the valuation is carried out by the same lead investors, or internally by the company.

As the stage progresses, the methods used can gradually become more similar to those used for standard valuations, taking into account different startup sector trends. However, before a startup is acquired or has an IPO, the exit will remain the main value driver and therefore a DCF with terminal value is not recommended.

As the stage progresses, adjustments to the valuation methods we discussed in the previous chapter, can involve: •

The possible use of the bottom-up approach instead of a top-down approach, depending on the business model and when the market is already defined, and reliance on past data to build financial projections

•

The use of net debt, when this is present, to calculate the value of equity, including excess cash resources

•

Discarding some rule of thumb or seed market methods, as they are more suitable to prerevenue companies, or the adaptation of these methods to a later stage only when similar fundraising transactions can be found in the market

•

The use of discount rates closer to the MCAPM, including a return expected that is more in line with SMEs investments and without an excessively high failure rate

•

Less uncertainty regarding the exit value and therefore the use of less diverging scenarios

•

Less reliance on current funding transaction multiples and more reliance on exit multiples and recent IPOs

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

132

6.1 Late Stage Startups

To simplify: the methods discussed in the previous chapter, such as the Hybrid Income/ Market method, the VC method, the First Chicago Method and the Price of Recent Investment can all be used as main valuation methods, as long as the different risk and market multiples are incorporated into these methods.

Other methods could also be used for as comparison, but they may require some adaptation and therefore the experience of a valuer would be required to adjust these methods correctly to account for later stage trends. The Valithea MethodTM can also be used, but as it is an untested method, it should only be used for comparison purposes at this stage.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

133

6.2 EXIT VALUATION So far, we have mostly focused our attention on early-stage funding rounds because they represent some of the most uncertain transactions. This is also the most common situation in which an early-stage startup valuation would take place. There are other situations where a valuation may come into play, so I will analyse how the methods may differ in these situations.

Exit valuations for startups usually take place at later stages after year 5 of operations, so in this case we would use standard valuation methods, adapted to the features of the company. An exit valuation means a higher scrutiny of key figures and of the company’s road to profitability.

The methods of choice would be a traditional DCF method and the market method, with the market method being preferred for unprofitable companies. The maturity of the company of course determines what type of multiples are used, and whether the guideline public company method can also be used here; the type of exit or transactions also influences the comparability of different multiples.

It is also possible for a startup to sell at very early stage, at a time when there is no profit and very low or absent revenue. In this case, the interest in the acquisition of the company lies in its technology or in achieving market leadership through the acquisition, aimed at preventing the development of a potential future competitor, which leads to a valuation often based on demand, number of users or technology. Finding precise multiples will be challenging, but it is possible by focusing on the stage of similar transactions.

Except for ensuring that the selection of multiples and selection of the right company figures is in line with the startup sector, the application of market method follows traditional methods. We have illustrated the calculation to an exit value previously. This value, in the case of an exit valuation as of the present date, represents the value of the company today, so discounts or multiplier do not need to be applied. Something to consider, is that later-stage companies may have a net debt to subtract to calculate the equity value, as well as other adjustments as contained in traditional valuation literature.

There are some situations to take into consideration, both when we analyse multiples and when we consider the terms and conditions of our target company acquisition. When the company is expected to keep operating independently from its new owner, revenue or profitability goals are usually set during the acquisition process, and an earn-out is often established, meaning that the company’s total valuation depends also on the company’s performance after the acquisition. This is often the case when the two parties do not agree on a valuation, when the company’s potential is uncertain, or to motivate the management to stay on and to reach certain goals during the transition period. Another situation in which the official valuation figure may be up for interpretation, is when the payment does not take place only in cash, but also in stock (of the joint company). In fact, the value of this stock may change over time, and a vesting period may be set, which is aimed at motivating the management to stay on and focus on future performance.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

134

6.3 EXIT OF FOUNDER The exit of a founding partner is a situation that startup founders do not prepare for, but which unfortunately can create enormous problems and in some cases, can lead to the premature shut down of the company.

Ideally, the shareholder agreement would determine what happens in case a shareholder decides to exit or is pushed out, and could potentially include the valuation methods used. This is because, as the valuation quickly grows for early-stage startups, the founders would usually be unable to buy out another shareholder, and new investors may refuse to do so as well and decline to invest in a company with internal problems. For this reason, it is recommended that anyone with a significant stake in the company will actively contribute to its success, as a major passive shareholder will likely become a barrier for the future success of the company.

Let’s consider the case where a co-founder decides to depart and wishes to have their shares bought back. Ideally (from the perspective of the remaining founders), the company can be valued with the cost method, based on how much has been invested and created so far, or the liquidation method, if permitted in the shareholding agreement or country of incorporation.

Instead, the departing shareholder would want to have his stake valued at market value.

The shareholder agreement could also have vesting clauses included that state a reduction in the total shareholding of the departing founder, before a certain period of time or before certain duties have been performed. The legality of this should be double-checked with a lawyer.

Even when a cost or liquidation valuation method cannot be not applied, in a standard startup valuation based on market value, a realistic case can be made that the departing shareholder can cause significant damage to the company’s performance, and that the future earnings and exit possibilities will decrease because of it, when considering the point in time when the co-founder leaves. The departure of a co-founder may well cause the failure of a startup: new resources may have to be invested to find a replacement and to substitute their skills. In this case, the value of the company is significantly reduced.

The reduction in the company’s value is actually a very realistic scenario. If the remaining founders are unable to pay back the shares because of their high market value, the startup would be left with a major inactive shareholder, which hurts the reliability that any investor would have in the core team, and often leaves the company unable to get new investments to continue operating. In an iterative situation, the company could actually become worthless in this scenario.

It is therefore important for founders to agree on a valuation and for the departing founder to realise that only with a fair agreement among founders their shares actually have any value.

Potentially, the shareholding agreement can also determine if the valuation should be carried out internally or externally and in which circumstances it should be accepted. If the founders cannot come to an agreement, of course the case can be brought to court, where hiring independent valuers may become mandatory.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

135

6.4 SALE OF INTELLECTUAL PROPERTY In the first stages of a startup’s operations, sometimes the question regarding the potential earnings from the sale of the technology or other Intellectual Property emerges. Whether the founder can earn more from selling the IP compared to operating the same startups, provided that the asset is marketable at all, really depends on the risk that the founder is willing to take. At these early stages, the asset that is most likely marketable is a new trending technology. There are some cases where the IP alone can be worth more than the startup in a going concern situation, but these cases are rare. Even if, in many cases, operating a successful company could generate a higher long-term return, the trade-off depends on the risk of the company, a hard figure to assess. The final decision may ultimately depend on the personal goals of the founders, but an analytical approach can be incorporated to compare an IP exit value today to the potential future exit value, discounted, using one of the methods included in Chapter 5.

In fact, there are some founders that would rather focus on growing the value of their assets as their short-term exit strategy, instead of managing a large startup for many years, and prefer to take a cut in the potential company exit proceeds in exchange for a quicker liquidity event. We would still classify these companies as tech startups due to the above average investments needed at seed stage and the potentially large exit relative to the company stage.

A startup may also be forced to liquidate its assets because of failure, often because it is unable to raise additional funds.

The assets that can be valued in the case of a revenue-generating company or a startup that has established a presence in the market could be customers, technology or a distribution network such as shops, depending on the sector. In rare cases real estate. For early-stage startups, however, most assets that can be found will take the form of intangible assets.

The value of intellectual property is difficult to determine in most circumstances, as comparable transaction data and royalty rates is scarce and close comparability for different IPs is rare, clearly more so for new innovative technologies. In many cases, this value is closely linked to the company’s operations, so determining the value of an IP separately from the company is a challenge and it is best left to qualified intellectual property valuers. The value of the IP in case of a sale often depends on how a third-party can generate cash from it in the long-term, and therefore how transferrable and separable the potential IP is, as well.

At least, this is not a problem we face when a pre-revenue startup sells its assets as no market operations are taking place yet. However, if an untested technology is promising but not yet established in the market, it’s not a given that someone would be willing to buy the technology, as implementing a new product in the market still requires investments in sales, ease of integration, the setup of new operations and a technical team. There will also be doubts about how the IP can be used in the future to generate income when this is yet untested.

In a standard intellectual property valuation, we would use methods such as the Incremental Income Analysis, the Royalty Rate Analysis or the Residual Value method, among others. These are not easily applicable for pre-revenue or early-stage startups as earnings cannot be calculated reliably for a pre-revenue company and for an innovative technology or IP.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

136

6.4 Sale of IP

When looking at startups that were sold before year 5 of operations, even in a share deal, it is likely that the buyer’s interest mostly lied in the company’s assets. When similar sales are available, we can then estimate the value of similar assets from other pre-revenue startup, which gives us an indication of how the market values certain technologies or other IP. Sector comparability will be very important, as well as recent transactions, and if no asset sales in the sector can be found, it’s likely an indication that they might not be valuable of marketable at such an early stage.

In the past, I observed exits in the early-stages of companies active in AI, robotics or similar technology, or of companies with no revenue but a large traction with users, as well as companies that quickly developed a valuable distribution network. For these startups, we may be able to determine roughly how their assets were valued in the transaction based on the sector and time of development, as other income-related multiples cannot be calculated for a business that has little or not revenue. Moreover, similar comparable transactions for seed stage companies are unlikely to be found in royalty rates databases.

However, extracting multiples may not be possible as the only piece of information we often have available is the number of years the technology has been developed for. Potentially new type of multiples can be created from this and from the market they address: these would only be approximations of value as they do not conform with the traditional valuation methods used for IP valuation.

When analysing these multiples, an upward trend in the exit value based on development stage for similar pre-revenue IP exits may be observable: in this case, when we do not find outliers that disprove this trend, these figures can help establish a range of values based on the development stage. Some additional sector-specific trends can be observable and used as multiples.

When calculating the IP value for an early-stage startup, we recommend using this method together with a traditional IP valuation method, when possible.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

137

6.5 STARTUP SHAREHOLDING VALUATION We have seen in the previous chapter how the valuation of a startup would change if we adjusted the value by the terms & conditions attached. These adjustments should not be applied for startup fundraising, as the public valuation figure is the value that investors and founders accept based on the agreed terms & conditions, so if the value were to be adjusted, so would the terms and conditions have to be respectively adjusted.

However when we seek to calculate the value of a startup shareholding in an investor’s portfolio, we’re not calculating a market value for a funding rounds, but rather the fair value of the company and its relative stake, and therefore we should carry out some adjustments.

We first start by calculating the value of the underlying asset, the startup, at the valuation date, according to the methods illustrated in the previous chapter. If there is no upcoming funding round whereby the startup expects a certain valuation, a preferred method in this case is to use the Price of Recent Investment and adjust it or calibrate it to the present, when this price is reliable. Seed market methods are useful when the company regularly raises funds on the market at different stages, so this need to be taken into consideration to understand if comparable rounds of funding can be used to value the company’s shareholding.

We should use the average of two methods to ensure that the market value is reliable, when possible. Ideally, this would be the Price of Recent Investment and a Hybrid Income/Market Method or VC Method.

After carrying out the valuation, we need to apply the investor’s stake % to arrive at the fair value of the shareholding. However, other adjustments are necessary in many circumstances: •

The investor’s stake to be used should be the fully diluted value, according to the latest cap table. To calculated this, ideally the rights and preferences of other existing shareholders should be known. If this information is available, we can input all monetary options and liquidity preferences of the investors and other shareholders invested into the company, to arrive at the realistic dilution of the investor’s shares so far;

•

Additionally, some investors or founders may have been granted additional qualitative rights that can be accounted for, even though this would involve a subjective quantification of these rights. It is worth doing this exercise when there rights are significant, such as unbalanced voting rights of the board or strategic interests of an investor.

In any case, these adjustment should reflect only the current terms and clauses that are not reflected in the valuation assumptions taken into consideration in Step 1.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

138

6.6 ESOP The rules for the valuation of a private company’s shares for the purpose of establishing the value of an Employee Stock Ownership Plan vary from country to country. Some countries, such as the United States, also mandate that a valuation document, the 409A, is submitted to the IRS on a yearly basis when an ESOP exists. I am unaware about similar regulations in other countries, so please contact your local tax consultant to know more about any potential reporting duties in your country.

The 409A is an official document and therefore the valuation is expected to follow recognised valuation standards. For this reason, rule of thumb methods should ideally not be used for the ESOP valuation. There are no set valuation guidelines for the 409A but there are recommendations and common practices: one major requirement is the ‘safe harbor protection’, whereby the report should clearly explain the qualifications of and the relationship with the valuer to be considered a valid valuation by the IRS. The report, after a standard company, market and valuation analysis takes place as typical of Certified Valuation Reports, it would detail the allocation of value to the different class of shares.

As Andreessen Horowitz describes it: “The first step determines how much a company is worth (i.e. “enterprise value”). The enterprise value is then allocated across the various equity classes to arrive at the fair market value (FMV) for the common stock. Finally, the last step is to apply a discount to the FMV to take into account that the stock is not publicly traded.” 1 The methods used to calculate the enterprise value of the company would usually be more traditional methods such as the market and income methods, while the allocation of value to the different classes of shares would take place through the Options methods or other similar of hybrid methods.

Useful resources: 1. "16 Things To Know About The 409A Valuation", Andreessen Horowitz 2. “Basics of the 409A Valuation Report”, Eqvista 3. “What is a 409A valuation?”, Carta

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

139

6.7 ICOs The valuation that can take place for an Initial Coin Offering is very different for a variety of reasons. The widespread ICOs trend has passed for the most part, and today it remains a way to raise money mainly for some companies working in the blockchain space.

The ICO press has recently been dominated by news regarding lawsuits and past scams, which is not surprising since large sums of money have been invested in companies based on unrealistic valuations, without sufficient investors rights and with no concept of basic valuation concepts by the participants. This still provides an important lesson, so that we can better understand what happens when the rules of the market change without oversight. There are also positives that can be drawn from the ICO market, such as the possibility to sell shares before an acquisition and the ability to trade utility tokens.

When analysing and/or valuing ICOs, some concepts are important to remember.

•

When collecting fundraising data of comparable companies: an Initial Coin Offering is not comparable to other funding rounds, and therefore those values should not be included in the valuation of a company not doing an ICO.

•

We need to distinguish between utility tokens and security tokens. Utility tokens are not strictly an investment instrument, they instead represent money exchanged for future goods and services of the company. Many ICOs, especially when this trend began, have been utility tokens and many investors have wrongly treated them as an investment. They are rather a prepayment for a product than an investment, with the added advantage that these tokens can be traded in the market, provided that there is an active market for these tokens to grow in value.

Whether additional returns and dividends are granted is doubtful and may depend on what legal rights investors hold. No equity valuation is needed in this instance but instead an asset valuation. The price of the tokens sold have been calculated in large part based on the expected high liquidity and size of the future token market, much like a startup would be valued based on the much more predictable activity in the future acquisition market.

Assumptions about the liquidity of the future utility token market did not materialise, as the token market has not grown in line with expectations, at least so far.

•

Security tokens are instead considered an investment. The reason why most ICOs have not been in the form of security tokens is that these investment are covered by regulations when marketing them to investors, understandably. The way that the company would be valued in this case is the same as any other startup, considering both potential and risks. However, there are some major open questions regarding the exit possibilities and the investors’ rights. A discount would have to be applied if the ownership rights are not strong enough. The advantage of ICOs, for investors, is that of an earlier exit, which reduces risks and encourages investments that have earlier return expectations, but this was determined under the assumption of a liquid security market. This market liquidity and the exit assumptions are very different for security tokens, and should be analysed on a case by case basis. This early exit advantage is therefore far outweighed by a number of risks concerning the business models and early-stage of these companies, the excessive amount of funds raised that represents an added risk, and an unknown exit market, all factors that should be accounted for in a valuation.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

140

Chapter 6 – Special Situations

Quick Recap 

Exit valuations for startups usually take place at later stages after year 5 of operations, so in this case we would use standard valuation methods. An exit valuation means a higher scrutiny of key figures and of the company’s road to profitability. The methods of choice would be a traditional DCF method and the market method, with the market method being preferred for unprofitable companies.



As the stage progresses, the methods used can gradually become more similar to those used for standard valuations, taking into account different startup sector trends.

However, before a startup is acquired or has an IPO, the exit will remain the main value driver. The methods discussed in the previous chapter, such as the Hybrid Income/ Market method, the VC method, the First Chicago Method and the Price of Recent Investment can all be used as main valuation methods for late stage startups, as long as the different risk and market multiples are incorporated into these methods.



The exit of a founding partner is a situation that startup founders do not prepare for.

Ideally, the shareholder agreement would determine what happens in case a shareholder decides to exit or is pushed out, and could potentially include the valuation methods used. This is because, as the valuation quickly grows for earlystage startups, the founders would usually be unable to buy out another shareholder, and new investors may refuse to do so as well and decline to invest in a company with internal problems. A case can however be made for a reduction in value as the departing shareholder can cause significant damage to the company’s performance, and the lack of an agreement between the founders would lead to the company to become non-investable.



Whether the founder can earn more from selling the IP compared to operating the same startups, really depends on the level of risk that the founder is willing to take and the marketability of the asset. The value of intellectual property is difficult to determine in most circumstances, as comparable transaction data and royalty rates is scarce and close comparability for different IPs is rare, clearly more so for new innovative technologies and for pre-revenue companies.



When we seek to calculate the value of a startup shareholding in an investor’s portfolio, we’re not calculating a market value for a funding rounds, but rather the fair value of the company and its relative stake, and therefore we should carry out some adjustments based on the fully diluted shares and the different rights of shareholders in the company.



The 409A is an official document in the United States for valuing an Employee Stock Ownership Plan and therefore the valuation is expected to follow recognised valuation standards, as well as to apply additional methods for the allocation of value to different share classes.



The valuation that can take place for an Initial Coin Offering is very different from the valuation of other startups. Additional risks to account for, on top of clearly distinguishing between utility and security tokens, are investors’ right, the excessive funds raised, the different business model, the liquidity and assumptions of the exit market.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

141

Chapter 7

Conclusion 7.1 REPORTS & NEGOTIATIONS This book illustrates the analysis of a valuation market with very few standards to date.

The startup fundraising process is highly focused on people, networks and connections. Many valuations are decided in negotiations rather than through an analytical approach. For early-stage founders, usually the funding choices are limited to few investors who hold most of the negotiating power, whereas for very popular startups, the rules may change as it becomes very easy to raise subsequent rounds within the same network, and too much money chasing few deals leads to a stronger negotiating power for these founders. This happens because the VC business model relies on unicorns and outlier opportunities. However, there are not enough unicorns to meet demand.

These preferences are at the core of the venture capital business model. However, there are also investors with a variety of different preferences or priorities, some who just focus on people and introductions, some who want to go deeper into the numbers, some who focus on the technology or business model primarily, and some who focus on validation and the development of operations, or a mix thereof.

For this reason, there isn’t a set standard in negotiations, just as this book does not cover the way that everyone screens opportunities. Founders may have to be prepared to deal with investors that have different priorities. Typically, the investor would want to see some financial projections, but the scrutiny over these projections, in most cases, is very basic.

Here I chose to focus on a more detailed analytical approach, as for those who do want to focus on the analytics, there are very few resources to use as reference. Another reason is that the financial plan and valuation are very important for the strategy development: if we want to step away from an investment market that gambles purely based on the instinct of the investor, and if we want VC returns to become less dependent on large outlier opportunities, we will need a framework to analyse early-stage ventures better and to decrease the failure rate.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

142

7.1 Reports & Negotiations

Not only may we need a different early-stage investment approach in the future, but also a better strategic approach by the founders, as there are so many avoidable mistakes that are common among early-stage startups. When a founder is uninterested in what the numbers say about their company and about the probability of success of its future strategy, or does not have any grasp of its revenue model, commercialisation or costs, it should be a worrying sign for investors.

However, advanced financial literacy is not expected of founders. What is expected during negotiations is an explanations of the startup’s development, opportunity and value drivers.

The main figures and information that a founder should be able to explain are: •

The market size in value or volume, its growth, and the realistic penetration expected, preferably compared to competitors

•

Why is this an attractive opportunity at this point in time and how was it validated?

•

The stage of the technology or product development and its development risk

•

The marketing or commercialisation strategy

•

The basics of the main revenue streams and monetisation strategy

•

How is the company scalable and what is the product pipeline

•

How the funds will be used

•

When the company could break-even

•

The size of similar financing rounds or exits in the market.

The extent to which a valuation is discussed in depth typically depends on the knowledge of the negotiating parties and on the size of the investment. It’s unlikely that advanced valuation techniques are discussed during early-stage funding rounds.

At the same time, some investors who want to logically follow how the company developed their projections and make sense of them, can benefit from an advanced financial analysis, or an external valuation report by a professional, which helps increase trust in the founders’ assumptions. A more analytical report can provide additional information and points for discussion compared to the typical pitch deck.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

143

7.2 COVID-19 AND BEYOND All these valuation methods have been created and adapted over the course of years, so they are not yet adapted to 2020 and beyond. The recent pandemic has brought about many changes recently, including the closure and consequent failure of many businesses, reduced consumer demand or outright inability to purchase certain services such as travel, and the instability of stock markets. There is much to be said about this, but I will make a few points to consider for startup valuations, including whether we should change the way we do valuation at all and why. 

We don’t have relevant statistics regarding changes to long-term startup investments, but some startups have reported that investors have been holding off investing or have pulled out of funding deals they have committed to. The additional potential short-term risk in the availability of funds should be considered, as the lack of funds will force more startup to close whether their business models were affected or not, as most startups rely on regular cash injections for survival: the risk of failure could be increased by around 5%.



At the same time, the reopening of the economy has brought about a quick pick up in economic activity, so we don’t have any clear information that would suggest that this is going to affect startup investments in the long-term. Certainly we are now experiencing a crisis, many businesses have closed, the consumers’ available income has diminished and even those with available capital are currently risk-averse and have curtailed spending. What we don’t know is whether this artificially induced crisis will pick up once the world can get back on its feet, or whether the economy will pick up at a slow pace just like other downturns in the past. When considering only the economic downturn, the risk is higher but I would suggest avoiding the overestimation of long-term market risks in the financial projections, accounting only for diminished demand in the next 1 year.



Short-term stock market volatility does not necessarily affect startups in the early-stages, on one side because we don’t use the CAPM to value startups, and on the other side because most investments are private and are long-term, sometimes with an expected exit timing of 10+ years. If a short-term exit is expected, it is recommended not to use multiples older than 1-2 years when possible. The future long-term exit potential should be analysed on a sector by sector basis, as many new trends are likely to emerge while making other technologies or business models redundant. The exit value can therefore be lower or higher than the historical multiples suggest, depending on the sector. However, structural industry changes will create more opportunities as much as they will increase uncertainty and industry risks, leading to a slightly increased discount rate or expected return on investment. Change for the startup world is an opportunity. I don’t like the concept of a ‘New Normal’, but this is no doubt an opportunity that many will take advantage of in order to push new products, new technologies and new business models that help solve new perceived problems. So I don’t predict a change in appetite for new investments in the long-term, but a shift in the type of startups that will take up the investors’ interest.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

144

7.2 COVID-19 And Beyond



In terms of sectors, advanced technologies will keep being at the top of investors’ interests, but we may see a shift in the business models of these companies, as businesses and governments become the preferred client-types and more profitable than consumers. We may see an uptake in new products ad services related to the pandemic such as pharmaceuticals and security, among others. Please refer to this analysis on new sector trends for more information.



Monopolies are proving to be a good bet for investors, so we may see more money poured into fewer companies. Despite the suggestion in this book to focus on non-unicorns, the trend may be for investors to put their money into companies that can achieve some kind of monopoly or market dominance in their industry as a way to decrease risk, as market leaders may have more power, influence and resources to take advantage of new opportunities or to avoid threats such as changes in regulations. This trend will influence a company’s financial projections and business model viability based on its size.



We may see an increase in political instability and potential wars, as well as a change in diplomatic and economic relationships among countries, as some power structures are reshaped, which will hurt some companies’ international activities, but we will also see new companies emerge that offer solutions to these problems. This trend will influence startups on a case by case basis: good knowledge of the main markets where the companies operate and of its political risks is necessary.

In summary, I don’t recommend dramatically changing the way we carry out valuations for startups based on what we know today. However, it will be increasingly important to carry out sectorspecific valuations and account for an increased perceived short-term risk for startups, and longterm uncertainty as industry structures change. Closely monitoring the markets will be a must for valuers.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

145

7.3 THOUGHTS ON THE FUTURE I wrote this guide as a starting point for creating a framework to value startups and early-stage investments. There are many factors in this market that are out of balance: •

The fact that the majority of companies do not classify as being tech startups, but nevertheless most newly founded ventures sell themselves as being one, even though some businesses may be more likely to achieve long-term success through a different path;

•

The fact that many believe that a technical analysis and a professional valuation is not necessary for startups as it is mainly a people business, yet many complain about high valuations and IPOs of largely unprofitable companies, as unfortunately this is a problem that can be tackled early when selecting the right business models to finance;

•

The fact that the startup business is all about momentum and getting to market fast, while many consider the team to be the most important factor in the startup’s success, which implies a partnership and a network that take a long time to build, and it implies time taken by the investor to understand if the team is trustworthy. It is difficult to combine the right momentum with the right preparation;

•

The large amounts of money chasing few deals, with a large number of companies struggling to find financing because they don’t fit the VC model or because of the too high early-stage failure rate;

•

An attractive startup culture that leads many to want to become entrepreneurs without the necessary business or sector experience, seeking money and introductions to finance an idea from day 1, before the right market and business model has even been found and validated.

This is often a consequence of the venture capital business model and culture, focused on chasing one-in-a-lifetime opportunities, but which has also gifted us of entire new industries and products that have made our lives a lot easier and a lot more complex at the same time.

However, this is not the only business model that exists for new ventures. What we need is an alternative early-stage financing business model and alternative financing methods that focus on lowering risk and providing tools for success. There are barriers to achieving this in the current market: •

The sectors in which VCs typically invest require a fast-growth, in order to keep up with the competition, which also lowers profits in the market until critical mass is achieved, as the companies are fuelled by capital and tend to charge lower prices while focusing on growth.

This becomes a problem when this business model is applied to sectors with lower scalability where critical mass is hard to achieve, and therefore profits remain low. This means that new ventures not financed by VCs should ideally operate in markets that are not heavily funded by venture capital firms in order to avoid excessive competition, but of course these market gaps are not easy to find;

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

146

7.3 Thoughts On The Future

•

Lack of commercial and financial literacy of many new entrepreneurs, and a financing and consulting industry that idolises startup culture often without teaching or rewarding responsibility, resulting in wasted potential and too few early-stage opportunities. At the same time, the financial return from teaching this type of financial and commercial literacy in the early-stages is too low;

•

The long time it takes for companies to achieve a profit, which leaves the exit as the only source of return for most investors, and the lack of an active secondary market where stakes are easy to sell;

•

The long-time to exit, which reduces the investment pool to only those investors who can afford to separate themselves from their money for long periods of time, sometimes over a decade, and reduces the number of business angels available;

•

The need for investors to double-down on their investment in non-performing companies in order not to lose the entire investment, and to keep financing companies in future rounds, which means that funds should be able to manage investments successfully in the long-term and not just for one round;

•

The high-risk of the startup industry and the importance of the exit, which requires a sophistication of the investors and the ability to actively manage and monitor the investment, as well as tap into a network that takes years to build;

•

The need for term-sheet clauses and investment sophistication to decrease risk and that take into consideration the needs of both parties, which leaves unsophisticated investors out of the market or unable to bring an investment to success;

•

The long-time to exit leaves investors unable to have a timely feedback about the quality of their investment skills, and to adapt them, as 10 years later, the market is different, and old lessons learnt cannot always be applied to new markets;

•

The ability for many startups to receive investment for many years without any transparent reporting methodology, which leads to many problems emerging before an exit or IPO takes place without the necessary available time to fix them.

While the ICO market was highly speculative, it brought a good idea to life, which is to have an active liquid market for investors to be able to trade their shares. Many startups cannot sustain the burden of a public market cost, and sometimes the scrutiny and reporting regulations it involves: however, the time it takes for founders to look for an early-stage investment is already a major time investment. The reality is that, if subject to close scrutiny, most startups would not pass the test to be listed on a public exchange dedicated to startups. Even in places where these stock exchanges exist, they haven’t been very successful.

However, a better and more efficient way to select, invest in and exit startups is needed. What I would like to see in the long-term is a higher focus on real businesses that have a tested strategy, higher scrutiny and responsibility for their finances, and for investors the ability to have a shorterterm return before an exit. I believe that the market can gradually adjust itself to serve all interests and provide a different offering to the parts of the investment market that are underserved.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

147

Chapter 7 – Conclusion

Quick Recap



The startup fundraising process is highly focused on people, networks and connections. However, the financial plan and valuation are very important for the strategy development: if we want to step away from an investment market that gambles purely based on the instinct of the investor, and if we want VC returns to become less dependent on large outlier opportunities, we will need a framework to analyse early-stage ventures better and to decrease the failure rate.



I don’t recommend dramatically changing the way we carry out valuations during COVID-19. However, it will be increasingly important to carry out sector-specific valuations and account for an increased perceived short-term risk for startups, and long-term uncertainty as industry structures change.



A better and more efficient way to select, invest in and exit startups is needed. What I would like to see in the long-term is a higher focus on real businesses that have a tested strategy, higher scrutiny and responsibility for their finances, and for investors the ability to have a shorter-term return before an exit.

Startup Valuation in the 21st Century © 2020 Valithea OÜ. All rights reserved.

148

Startup Valuation in the 21st Century

>> VISIT VALITHEA.COM Olivia Passoni, CVA October 2020

© 2020 Valithea OÜ. All rights reserved.