Valuation models are tools that help investors estimate the worth of a company or a project. They are essential for venture capital, as they help determine how much to invest, what return to expect, and how to negotiate terms with entrepreneurs. But how do you analyze valuation models? Here are some tips to help you evaluate different methods and assumptions.
The first thing to understand is the difference between pre-money and post-money valuation. Pre-money valuation is the value of the company before receiving any investment, while post-money valuation is the value of the company after receiving the investment. The post-money valuation is equal to the pre-money valuation plus the amount of investment. For example, if a company has a pre-money valuation of $10 million and receives $2 million in funding, its post-money valuation is $12 million. The investor's ownership percentage is calculated by dividing the investment amount by the post-money valuation. In this case, the investor owns 16.67% of the company ($2 million / $12 million).
Having worked or seen 40+ startup deals, I note that we rarely discuss point estimates but we conclude upon a range. VCs use the range to build our cap and floor and provide a convertible note or a CCPS rather than taking straight equity at a very early stage and leave the valuation aspects to the next round of investors and future rounds when valuation can be ascertained using few key metrics such as revenue, GMV or EBITDA (if it's stabilised or positive) It's imperative to understand that valuation at this stage are based on more factors than pure numbers. From Berkus methods to Scorecard. Considering that's my day to day job and I am not allowed to deep dive into it right now due to company rules, I can say it's Numbers+narrative.
Valuation models at pre seed stage are more a coin toss and an estimate of teams ability to execute, sector of play and probability of revenue traction to get to seed stage. As business gets de-risked at every subsequent stage of fund raising one can use a blend of public market comparables, exit probabilities in sector, operating leverage in the business etc. There is no science for many of these valuations until you get to series B stage. You need to build a probability scenario of base case, worst case and best case to assess a theoretical value. However, final investment decision can be independent of the valuation call and depends on various opportunity sets and risk metrics that might engineer a better than expected outcome.
?? Having done 100+ valuations, I feel that Pre-money and post-money valuations are more than numbers ??. 1?? Recognize how you arrive at Pre-money valuation - ?? DCF (Discounted Cash Flow) or ?? Scorecard Approach: 2?? What factors - TAM ??, capability ????, traction ?? VCs have looked at while arriving at this fair pre-money value 3?? ?? Balance: A high pre-money valuation may lead to lofty expectations, while a low valuation may mean more ownership dilution. 4?? ?? Mutual Benefit: Structure the deal to align with the VC and the founder. 5?? ?? Precedent Setting: The pre-money valuation sets a tone for future funding rounds, affecting company value, negotiations, and terms. 6?? ?? Bull Market: Often leads to high valuations
This is something that can sound so obvious, that it doesn't actually register. I know many get confused when getting started with VC maths. A mnemonic that I used when I was learning: Premoney+newmoney=postmoney Ownership is gained postmoney
Theoretically, pre-money and post-money differences hinge on anticipated investment. Based on my experience, the most realistic pre-money assessment has entrepreneurs view it as their firm's future valuation without today's investment. Conversely, post-money reflects that future with current investment. This distinction is vital. Often, pre-money might be zero when investment is vital for survival. Yet, when real growth opportunities arise, pre-money exceeds zero, aligning with traditional views.
One of the most common valuation methods is the discounted cash flow (DCF) method. This method projects the future cash flows of the company and discounts them to the present value using a discount rate. The discount rate reflects the risk and opportunity cost of investing in the company. The higher the discount rate, the lower the present value of the future cash flows. The sum of the discounted cash flows is the DCF valuation of the company. To use this method, you need to make assumptions about the growth rate, the terminal value, and the discount rate of the company. You should also compare the DCF valuation with other methods and market benchmarks to check its validity and sensitivity.
The passage gives the DCF (Discounted Cash Flow) framework, but remember, it's a "Garbage In, Garbage Out" (GIGO) approach, and the quality of DCF depends on the inputs. ??? Please keep in mind the following when doing DCF: 1?? ?? Do sensitivity analysis to look at the change in value when the assumptions change. 2?? ?? Look at the capital structure to ensure that the discount rate accurately reflects the cost of debt and equity. 3?? ?? Do historical analysis to determine the projections based on past trends and performance. 4?? ?? Calculate marginal and effective taxes as that will impact cashflows. 5?? ?? Understand how you calculate a terminal value, whether using the Gordon growth method or Exit multiple
To use the DCF valuation method effectively, a company should demonstrate at least 24 months of sales using a proven, scalable business model. This ensures that DCF predictions are grounded in reality. Typically, business models with such scalability emerge by the Series A funding rounds. Importantly, startups planning a pivot shouldn't rely on DCF. Additionally, if the projections account for international growth, it's essential not to base them solely on present market economic conditions.
Discounted Cash Flow, while essential to traditional finance and Private Equity, is rarely used in Venture Capital (VC). VC targets investments with the potential to be highly innovative and fast growing. These type of companies have a negative cash flow for a protracted period, and therefore using a standard DCF model would lead to a negative valuation.
Another common valuation method is the multiples method. This method compares the company with similar companies in the same industry or market and uses their valuation multiples to estimate the value of the company. Valuation multiples are ratios that relate the value of a company to its financial metrics, such as revenue, earnings, or assets. For example, the price-to-earnings (P/E) ratio is the ratio of the market value of a company to its earnings. The higher the P/E ratio, the more expensive the company is relative to its earnings. To use this method, you need to identify comparable companies, select relevant multiples, and apply them to the company's financial metrics. You should also adjust the multiples for any differences between the company and the comparables, such as growth rate, profitability, or risk.
There are 2 assumptions if you want the multiples method to fetch the right valuation for your firm: 1?? Select the Right Comparable ?? 2?? Choose the Right Metric (financial/operational) ?? What I see investors do is identify comparable companies in the same industry. If Company A's earnings are 1 Mn ??, and P/E for comparables are 15, 18, and 20, you can: Average the P/E ?? (15+18+20)/3 = 17.67 ? Multiply 17.67*1 ?? 17.67 Mn ?? You MUST ensure that growth ??, profitability ??, and risk ?? are similar across the peers, or else, make adjustments using regression ??. Further, different industries use different multiples; banks use P/BV, Tech firms use P/E, and Mfg uses EV/EBITDA. Growth firms have high P/E, while size does matter! ??
A specific valuation method for venture capital is the venture capital (VC) method. This method estimates the value of a company based on its expected future exit value and the desired return of the investor. The exit value is the value of the company when it is sold or goes public, usually within a certain time horizon. The desired return is the annualized return that the investor expects to earn from the investment, usually expressed as a multiple of the initial investment. To use this method, you need to estimate the exit value of the company, apply a discount factor to it based on the desired return and the time horizon, and subtract any existing or future investments from it. The result is the VC valuation of the company.
This approach is used by both VC and PE firms where the key drives for the valuation are: 1?? Future Exit Value ?? 2?? Expected Returns ?? ?? How Does It Work? Let's dive into a real-world scenario: 1?? Exit Value: $10 Million 2?? Holding Period: 5 years 3?? VC's Investment: $2 Million 4?? Desired Return: 5x 5?? Annualized return = 5^1/5-1 = 37.9% 6?? Valuation: Discounting $10 Million at 37.9% over 5 years gets you $2.8 Million. ?? The assumption is that there are no interim cash flows??. ?Estimating the exit value is like hitting a moving target ??. It requires strong industry expertise ??, and any change in macro/company operations can sway the exit value and the valuation. ??
Finally, a useful technique to analyze valuation models is the scenario analysis. This technique involves creating different scenarios based on various assumptions and outcomes and calculating the valuation of the company under each scenario. The scenarios can reflect different levels of risk, uncertainty, or optimism, such as best case, worst case, or base case. The scenario analysis helps you understand how sensitive the valuation is to different factors, such as growth rate, discount rate, exit value, or market conditions. It also helps you identify the range of possible values and the expected value of the company.
Scenario analysis is like playing a "What-If" game with numbers. It helps you see how a firm's valuation can change under different assumptions. ???? ? Base Case: You expect a 10% growth, 10% WACC, and a $5 Mn exit value. ?? Best Case: The company rocks! Growth jumps to 20%, WACC drops to 8%, and exit value skyrockets to $10 Mn. ? Worst Case: Oops, things don't go as planned. Growth stumbles to 2%, WACC climbs to 12%, and exit value plummets to $1 Mn??? ?? Tools like Monte Carlo simulation transform each scenario into a continuous distribution, painting a vivid picture of potential values for the startup. ?? Scenario analysis isn't just number-crunching; it's about understanding risks and building bridges in negotiations.
Absolutely correct. Running sensitivities in the financial model is likewise very important, to arrive at a base case, on which valuation is based. Methods of valuation are all well known. In a practical sense, a lot of weightage has to be put on the team that has drawn up the plan and is meant to deliver on the plan. I have seen funds overpaying initially, but still coming out great winners as they backed the right team.
Beyond valuation, you should consider the entire cap table structure. Not just what your holdings will be (the output of the valuation model), but also what the founders and other co-investors have. You need to ensure that all parties are incentivised and that it is easy to pass decisions. For example, founders post-series A should still have around 50% of the company. Also, you should make sure no investor has a de-facto veto right. A clean cap table is key for a successful journey.
As always, the valuation will be a balance between upcoming value, company potential, willingness to invest, general context, CEO (& board) negociation skills.... & much more. It always needs to be considered as part of a deal, not the only viewpoint. Own experience : higher valuation is NOT always the best deal on the table.... rarely is actually.
I generally see multiple approaches to valuation, effectively a checks and balances way to cross-validate or question. What I tend to focus on is the how, physically, the business plan will be executed. For me, this boils down to human capital and non-human assets (parts, components, software licenses, etc.) - will the right components be in place and able to perform in a timely manner to deliver the financial results projected? Enthusiasm, while important, and hope are not effective management strategies when it comes to turning ideas into profits, again from my perspective.
Since early stage profits , revenues may be negative, zero, low-at-start, important to do real not superficial diligence on the IP - what makes the company special, able to get customers at all, then charge a premium not commodity price , over a sustained time despite copying and incumbent attacks - what is the DISV = “Different, Interesting, Special, Valuable, Disruptive, Innovative, Memorable, Edge” = unique selling proposition, sustainable competitive advantage. And will the alleged IP actually work, deliver value , avoid /minimize attacks from others claiming infringement etc.
The Financial Asset Pricing Model or Capital Asset Pricing Model (known as the CAPM model) is one of the most used tools in the financial area to determine the rate of return required for a certain asset. Three main economists worked simultaneously, but separately, on the conception of this model: William Sharpe, John Lintner and Jan Mossin, whose research was published in different specialized journals between 1964 and 1966. The concern that attracted them to this topic was the development of explanatory and predictive models for the behavior of financial assets. They had all been influenced by Harry Markowitz's Portfolio Theory, published in 1952 and reformulated in 1959.