Valuation of your Startup - How to link your Business Strategy to your Valuation.

The valuation of a Startup depends mainly on its milestones achieved and the milestones for the next 12 months. Besides the marketing talk, are you ready to link your business strategy to your valuation ?

Fund Raising is not Fun

It is painful to get rejected and fund raising is not fun. Startup fund raising is exhausting, humbling and character-building. It is not a surprise therefore that 77% of early stage startups founders use their personal savings to start their business[1]. For startups who need external funding, most then turn to family and friends, wealthy individuals, crowdfunding and venture funding. The chances of getting funded by a top VC such as Andreesen Horowitz is 0.7% - of the 3,000 startups they look at every year, they invest in about 20 of them.

It appears that only 1% of startups get investment capital. These statistics provide a sobering reality of how difficult it is for startups to raise money. The media today bombards us with success stories of yet another 1,000 startups raising monster rounds. This fuels the misconception that it is easy to raise money from a VC.

Personally, I have participated in many fund-raising discussions with VC and I have become immune to rejections. I don't envy VC also because they have to vet through countless of fund-raising proposals each labelled with the same title "The next Unicorn with three horns".

Valuation of a Startup

The insider joke of startup valuations is,"Tell me the number that you want". This is true especially for startups which are pre-revenue and may not have a ready product. The valuation of a business is very different from the valuation of a startup. We can value a typical business as long as it a track record of profits or losses or we can rely on the net asset value as a guide. However startup valuation is incredibly difficult because so much of it is dependent on its future success. If history is any guide, only 1 percent of companies founded between 2003 and 2013 reached Series F. Most of the startups will fail. This payoff distribution is wildly asymmetric.

Valuation Methods to value a Startup

There are broadly a few methods to value Startups. The valuation methods are no different from how we may value to a traditional business. However, certain valuation methods are more suitable given the unique business state of a startup.

1) Revenue Multiple - This is used for SaaS-based startups. This is used when there is some evidence of annual recurring revenues. VC could use multiples anywhere from 10x to 15x for a Series A round for example. The revenue multiple ignores profits and focuses on market share.

2) Earnings multiple - This is less commonly used for obviously because startups in their quest to dominate the world are not expected to be profitable so soon. Hence they need to raise money.

3) Rule-of-thumb - This is used for pre-revenue businesses where investors would value "hope" based on industry averages. For example, in our experience talking with investors, the valuation such companies seem to be between USD1m to USD3m for pre-seed rounds.

4) Comparable transactions - For startups which already have a track record, have verifiable activity and transactional metrics, comparable transaction multiples are used frequently to cross-check the valuation euphoria.

5) Cost method - Personally, I think this method contradicts the very nature of a startup which is to be scalable. The fundamental value of a startup is from future revenue or profits and its intangible assets rather than from its depleted balance sheet.

6) Venture Capital Method - This method was first described by Professor Bill Sahlman at Harvard Business School in 1987. This approach is useful for setting the pre-money valuation for pre-revenue startups. Every investor has a specific return in mind. For high risk investments in a pre-revenue startup, the investor may want a cash-on-cash return of 20x. We will first calculate the exit valuation of the startup and then divide it using 20x to arrive at the post-money valuation today. The pre-money valuation can then be obtained by subtracting the amount of funds needed today. An example is show here.

7) Discounted Cashflows - The discounted cashflows method is widely used if the startup already has some traction and it is possible to do a forecast based on business drivers.

Linking your Business Strategy to Valuation

As professional valuers, we encourage startups entrepreneurs to think about how they can link their business strategy to the valuation of the startup. It may sound easy but it is not simple. Given how difficult it is to raise money, startups can turn the valuation process into a competitive advantage. Think of it as using valuation outcomes to complement your story-telling.

We think that the discounted cashflows valuation method is the most effective method when we want to link the business strategy to the valuation. This is because we can model the various business scenarios and estimate the respective values of each initiative or building block. We can convert valuation outcomes to valuation metrics such as per user, per transaction.

How to use Valuation Outcomes to Create your Competitive Advantage

1) Think about the key milestones for the next 12 to 24 months. For the purpose of valuation, a milestone is defined as a financial turning point in which outcomes can be quantified.

2) Forecast the financial impact of each milestone.

3) Value each milestone as a building block. There should be a story to support the milestone.

4) The pre-money valuation of the startup is then the sum of the value of each milestone/building block.

5) We can then develop multiple scenarios and stress test the valuation outcomes.

We recently completed a valuation for a fintech startup in the commodities sector. This startup focuses on developing a platform to automate 10 steps of a typical commodities trade. These steps include KYC, contracting, vessel monitoring. With digitalisation, risk management becomes better. The commodities sector is ripe for disruption given it is fragmented and trade management is manual and cumbersome.

We identified 3 key milestones over the next 12 months and each milestone has a distinct financial impact. We used the discounted cashflows method to value each building block to arrive at the pre-money valuation of the company. We could also independent cross-check the value of each milestone to market benchmarks for reasonableness.

The valuation story (redacted) was shown in this manner:

When the valuation of the startup is broken down into the building blocks, the founder can confidently explain why the startup is worth that much. The business strategy is thus intimately linked to the valuation.

Closing Thoughts

As professional valuers, we continually think of novel ways to tell the valuation story. The journey of a startup is long and arduous. Making your valuation story multi-dimensional and interactive would make the fund-raising experience more rewarding and successful.