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Hello friends,

In the last post, I wrote about a couple of basic valuation terms - pre- and post-money valuations - and a few approaches to valuing early stage startups. Three of the approaches are checklist/scorecard-based methods - Dave Berkus, Scorecard and Risk Factor summation - while the VC method requires a) check/investment size and b) expected returns, adjusted for dilution.

Today, I shall share about a couple of frameworks for startups that have matured into growth-stage companies.

At this stage of growth, the companies would have been operating for 3 to 4 years already. They would have accumulated more operating metrics and financial performance data. Using this historical information, the companies and investors can adopt more quantitative approaches to value the companies’ worth.  

Valuation Methods for the Grown Ups

Once a startup grows over the years into maturity, then it will have more information, data and/or metrics to build a more robust valuation model. You can use historical financial data in conjunction with some forecasting on future performance to determine a company’s value.

At this stage, we can apply one of these commonly used quantitative methodologies:

1. Discounted cash flows (DCF) - This method involves estimation of future free cash flows and discounting them to present value to determine a startups’ valuation. Discounting means ‘bringing back’ future values into today’s dollar/ringgit/rupiah/dong. Valuation is about determining what is the price today for future growth potential.

In DCF, you also need to make a fairly educated assumption on the growth rate, profit margin, and discount rate. The method is highly sensitive as the final value is highly dependent on the assumption you make on the terminal value (the year you think you might cash out).

Source: Corporate Finance Institute

2. Comparables (or comps) analysis:  By taking a comps approach, unlike DCF, you are valuing a company relative to others out there. You look for similar kinds of companies in the market (this is highly subjective exercise) that operate in the same industry with similar characteristics. The closer the better. 

There are two types of comps analysis. The first is taking a list of publicly-listed companies’ financial metrics and comparing them against another business.  

For example, recall our little startup called DeepAi from the previous post. DeepAi uses a highly advanced vision learning algorithm to analyze your food and drinks intake and predict how successful you will be in life. The company has an annual sales of $10mn. Since DeepAi is a pioneer in this space, there isn’t a direct comparison against other companies out there. The closest list of public-listed companies we can gather as comps would be The Coca-Cola Company, Pepsico and several other beverages companies.

Source: Corporate Finance Institute

By applying the lowest (1.5x), median (2.2x) and highest (4.9x) EV/Sales multiples from the above table, DeepAi has a pre-money valuation range of $15mn ($10mn sales x 1.5) to $49mn, with a median of $22mn.

Alternatively, you can also perform comps analysis by compiling a list of past mergers and acquisitions (M&A) transactions to value a similar business today. M&A simply means Company C bought Company K for $273mn in 2020, for instance.

This approach relies on publicly available information to create a reasonable estimate of multiples or premiums that others have paid (and if you have private transactions data, please add it to the analysis by all means)​.

Source: Corporate Finance Institute

Similarly, we can apply the lowest (1.3x), median (2.0x) and highest (5.1x) EV/Sales multiples to DeepAi’s annual sales of $10mn. As a result, DeepAi’s pre-money valuation is estimated to be from $13mn to $51mn with a median of $20mn ($10mn sales x 2.0). For a better chance at accuracy, one can consider adding multiple comparables​ - agriculture, FMCG or poultry sectors.

Simplicity Rules 

IRL, we hardly use any of the above methods, particularly in valuing early stage startups. Since there isn’t a lot of historical operating and financial performance data, we typically use a simple approach called Ownership / Dilution methodology.  

In this approach, we only need two numbers 1) the check/investment size and 2) the percentage ownership percentage target in return for the investment.

Perhaps an example or two might help.

Scenario A: If the founder asks for $1mn for 10% of the company, then:​

​Post-money Valuation = $1mn/10% = $10mn​

Pre-money Valuation = $10mn - $1mn = $9mn

Scenario B: If the investor plans to invests $5mn in exchange for 20% ownership, then the company is valued at:​

Post-money Valuation = $5mn / 20% = $25mn​

Pre-money Valuation = $25mn - $5mn = $20mn

In order to figure out whether the valuation is overpriced or not, you can ask around as a benchmark.

A Concoction of Art and Science

Notwithstanding the various methods I have laid out in this and previous post, the fact of the matter is that valuation is an exercise where it involves a lot of creativity especially in estimating the future potential of a company. The formulas are there to help organize these assumptions in a common language (numbers in this case) that everyone can comprehend and engage in a meaningful discussion or negotiations to buy or invest into a company.

A good valuation is 75% art and 25% science because it takes into account the story behind the numbers of a business, says Matthew Schubring, a managing director at Chartwell, a financial advisory firm.

Credit: Cartoon Stock

To the untrained eye, the word valuation may bring about some fancy notion of a highly paid banker spending 95 hours a week crunching highly sophisticated excel spreadsheets to churn out a magic number.

Well, you may need some smart Alec with CFA combined with an MBA to crunch the numbers if we are talking about merging Proton and SingTel. For they each have a complicated legacy of financial histories and inter dependencies to untangle.

However, for most early (and sometimes growth) stage startups, the basic approach is easier in practice. Some folks may try to persuade you to employ fancy frameworks, but equipped with this knowledge, you know that a simple and straightforward approach gets the job done.

More importantly than the actual valuation, once you agree to take Other People’s Money, it is super critical for you to scrutinize the terms that accompany the investment. As they say, the devil is in the details!

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Be great,

Reez Nordin

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