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Hello there,

A few days ago, I was hosting a Clubhouse room to explain what a Venture Capital (VC) is, the terms commonly used in the industry and its business model. Invariably, there were a couple of questions on valuation. How to value a company? What does it mean if a company is valued at $683mn? Is there some sort of formula to arrive at a valuation, or is it just a hocus pocus number plucked from the sky?

There might be some truth to the latter 😱. That said, there are various formulas and equations that industry folks employ to quantify the highly subjective nature of forecasting valuation (and in the process may get paid a lot of moolah).

Simply put, valuation is an exercise to determine what a company is worth to shareholders, investors, potential buyers and to some extent employees, if they have shares in the company as part of their compensation. Usually, the company’s value doesn’t necessarily equal to the amount of cash it has in the bank. It is more about the company’s future growth potential.

Before I venture further into the mechanics of valuation, let me share two common terms that you will hear about when discussing this subject.

Pre-money valuation: the term refers to a company’s worth before it receives any new investment or capital injection.

Post-money valuation: as the name suggests, it indicates the value of a startup after it receives cash in the bank as part of an investment or financing. 

It is important to get the vocabulary right, lest you might be confused.

What Does Football Have Anything to Do With Valuation?

In the process of establishing a company’s valuation, we would employ various methodologies to calculate a range, with minimum and maximum values, instead of a specific number. This is a crucial concept to bear in mind.

The outcome of this exercise is normally presented visually in a ‘football field’ chart.

Source: Corporate Finance Institute

Using this football field chart, the company will initiate discussion with potential investors or buyers, negotiate and reach a final figure that’s agreeable to all parties.

It is worth noting that each side, the buyers/investors and the seller, will have their own football field charts to work out what they each think the company is worth. The hope is that the two ranges do not diverge too much as to derail the discussion.

Quantifying the Qualitative

Although the end goal is similar, i.e. establishing a valuation range of a company, we would typically apply different methodologies depending on the maturity of the company. For early stage companies, with small (or even zero) revenues, there are several frameworks we can use.

1. Dave Berkus method: Created by the namesake, this method assigns a number or a financial valuation, to each major element of risk faced by all young companies - technology, execution, market and production. On top of it, we also evaluate the soundness of the idea. 

Source: Berkonomics

A startup can be credited in each of these areas with a maximum of $500,000 for reducing risk for each element. A perfect score will give the startup a valuation of $2.5mn.

2. Scorecard Method: This particular method compares the startup (typically raising angel investment round) to other funded startups according to the average valuation based on factors such as region, market, and stage. Once we have an indicative valuation, say $3mn, we then evaluate the startup according to a scorecard with several components.

Source: SpicyVC

In the above example, the weighted score comes out to 1.13. If we apply the average valuation of $3mn, then the startup is valued at $3.39mn ($3mn x 1.13).

3. Risk Factor summation method: Similar to the other two methods, you need to apply a certain rating to the startup based on a bunch of risk factors that can imperil the startup’s progress.

Each risk factor is assessed, as follows: +2 very positive, +1 positive, 0 neutral, -1 negative and -2 vey negative​. The average pre-money valuation of the startup is then adjusted positively by $250,000 for every +1 (+$500,000 for a +2) and negatively by $250,000 for every -1 (-$500,000 for a -2)​

Source: SpicyVC

Looking at the table above, it turns out that the overall score for DeepAI.com is +1 positive. It means we can add an additional $250,000 to the average early stage startup valuation of $3mn (within the region), for a total of $3.25mn.

4. Venture Capital Method: Professor Bill Stahlman from Harvard Business School evangelizes this method in 1987. It allows investors to calculate the pre-money valuation of a startup today, based on their future returns expectation and the anticipated value of the company at exit (terminal value). The pre-money valuation can be further refined to accommodate anticipated dilution from future fund raising exercises.

Let’s say as an Angel investor, you are looking for a 20x return (ROI) for your $1mn investment to compensate your risk for investing early. According to industry comparables, you think DeepAi.com could be sold for $100 Million within 8 years. Based on this information you can determine the startup’s valuation, after adjusting for dilution. It comes out to be a pre-money valuation of $2mn.

Source: VC Method

Valuation Through Triangulation

As you can see, in order to apply any of these methods, we need to make a lot of assumptions since there isn’t a lot of data/metrics to go by for young companies. Ultimately, these frameworks attempt to quantify the qualitative nature of early stage startups.

It is therefore a good practice to use multiple methodologies to arrive at a valuation range, rather than depending on one single number derived from a particular approach. You, as an investor, can use the range of valuation to initiate the investment discussion with the startup.

In the next post, I will discuss a few more valuation approaches you can use to value growth stage companies. These more matured companies will have more information - historical operations and financial performance - to work with. This means the methodologies will be more quantitative in nature, although you still have to make some assumptions (educated guesstimates really) on a company’s future trajectory. Plus, I will share one super simple method you can use to quickly establish a startup’s valuation. 

Stay tuned!

🙌

Reez Nordin

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