Question: Why would you use financial methods for the valuation of a startup company?
Answer: Because the public market uses it for valuations.
And more in depth, for these 2 reasons:
1| The public market has an effect on private valuations
With public market we mean companies traded on the various stock exchanges. They are usually large, but a small percentage of their shares is traded every day. This means that a transaction that contains the price of that specific company happens at least once a day. For these companies, all the traditional valuation methods are applied, creating a very complicated models. The majority of the methods are based on financials – DCF, Long-term growth, multiples, etc.
Why does this affect private companies then?
Angel investors and VC firms always aim at selling their stake in startup companies, they have to realise their profit and return the money to their partners. The public market is the natural exit opportunity for a large number of startup companies. For this reason, a VC investing in a startup is going to use the public market as a reference for the price the company will be sold in the future.
Let’s take as an example what happened last year with public tech companies. In 2015 the valuation of these companies collapsed. It started with Linkedin and Twitter and then moved on to Square and others. The message the public market investors were giving is that the amount companies were valued at before the IPO was too high. So, when companies were presented to the public market, investors realised that the fundamentals of these companies were not supporting those valuations. They adjusted their expectations and the price per share went below the IPO price.
Public investors were basically stating that they do not like the way private companies are valued. The entire private market received the message. The VCs raised the bar already at series A. If before companies were able to raise a Series A round of $1M with 10K MRR, they can’t anymore. Investors would probably want to see $30-40K in MRR before even considering the company for a series A. The public market had a direct effect on private valuations and required milestones.
A large number of companies (the likes of Uber, AirBnB, etc.) raised billions of dollars against billions of valuation. Naturally, people asked why these companies did not go public and raised on the stock market. The reason is that they knew valuations in the private market were high and wouldn’t achieve the same numbers on the public market. Private market investors behaved more irrationally compared to their public counterparts.
Indeed, during that period, many non-traditional investors entered the private market and flooded it with capital, willing to pay top dollars to get on the best opportunities and make a name for themselves. These players included hedge funds, corporate VC funds, etc. Naturally, with the larger supply of capital, valuations increased. It is a simple equation of supply and demand.
This increase in valuations, then, happened without the corresponding change in fundamentals. One single company managed to go public and maintain their valuation, that company is Atlassian. And they were the only one with extremely strong fundamentals.
This is the basic mechanic that makes public valuations influence the private ones. It happens because VCs raise funds form limited partners(LPs) (generally mutual funds or institutional investors) that are more inclined to calculate returns using public-market valuation models. VCs found out that if they didn’t lower their valuations, they wouldn’t be able to raise another fund.
As this trend spreads among VCs, we are going to see more and more of them relying on data analysis and less on hubris. We will also witness greater transparency in the way companies are valued.
2| Human nature
The amount you are willing to invest in a company is determined by the amount of money you believe this company will return at the time of exit. As much as valuing early-stage companies is speculative, you still want to have an idea of what the company’s potential is.
As potential is largely determined by the amount of revenues and profit the company will make in the future, financial projections become pivotal and deserve a reality check. If the company is estimating a turnover of $100M in a niche market that in its entirety is smaller than that, you’ll probably reconsider either the market or the investment.
As we all know, financials are not the only factor to consider. There are plenty of soft aspects such as team, founders’ expertise, or economic conditions. Yet, neglecting the financials could be harmful.
So which are the methods that derive from public companies but are more than applicable to startups?
The Venture Capital Method
Venture Capitalists (VCs) receive and evaluate thousands of companies per year. For this reason, they came up a quick valuation method, that however gives them a good idea of the investment potential, the VC Method.
This method does not consider anything that happens before the time of the exit, hence its simplicity. On what is it based then? Only on the exit potential. It estimates turnover and EBITDA potential when the company could be sold (generally 5 to 10 years ahead in case of a Series A). It then uses a multiple on EBITDA to estimate the exit value. The exit value is then discounted by the risk the company has, and the number of years it is going to take to exit.
The Discounted Cash Flow Method
An investment is always an exchange of present cash flow for future cash flow. The expectation is that the future cash you will receive will be more than the investment, and will compensate you for the risk of separating from your initial cash.
The discounted cash flow method (DCF) stems out of these two assumptions. By estimating future (yearly) operating cash flow and it’s risk, it derives today’s company value.
Once yearly cash flows have been estimated, the exit value is added. Indeed, when the company is sold, all its investors receive part of the price, in financial terms: a positive cash flow.
Two particular risks distinguish the DCF method used for public companies from the one used for private ones: failure rates and illiquidity.
The failure rate is the probability that a company will go bankrupt. This is much more significant for private companies compared to public ones, thus deserves special attention and a specific discount in the method.
The illiquidity is a risk factor that is applied due to the lack of marketability of the company’s shares. Public company’s shares can be traded almost any second. As they are traded on the stock market, a buyer is almost always available and selling even “larger” chunks does not affect the price much. The story is different when we are valuing private companies. Large sales of shares will impact the price, lowering the return that an investor interested in exiting can achieve. As a particular risk factor, it has to be added to the DCF method when applied to private companies.
Mind the Public Market, as its valuations will be reflected on the private one
As explained, several dynamics link the private and the public market. Entrepreneurs can be less concerned about the private market than institutional investors or traders. But make no mistake, if something is happening to the large capital providers, it will, at a certain time, reflect on the private funding environment.
Valuation, as a mix of data and sentiment, is one of the first parameters to get affected. This affect the likelihood of raising capital and dilution not only for founders, but for current investors as well. Timing your fundraising and taking into consideration these aspects is then pivotal for its success and ultimately for the success of your startup.
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