Story-based valuation: A new simple early stage startup valuation model

Why a new valuation for startups?

In my post here I discussed what is the fundamental difference between a business and a startup and why startups are valued billions. We then learned why startups are valued billions of dollars even though there seems to be no profit involved.

Let us recall

A startup is a temporary entity established to solve a huge problem and thereafter finding a profitable and scalable business model for the solution.

A business is a permanent entity that operates to generate and maximize profit by offering a unique and differentiated value proposition in a product or solution to customers in an established and competitive market.

It is always important to start with this differentiation because it reminds you that standard business goal and operation can hardly match that of a startup. With this clearly in front of us, we also now understand that because the definition and purpose of a standard business differs to such a large degree, every fundamental will also differ.

One of the most important questions that are being asked is how a startup is valued. But for the answer, people go back to the standard valuation techniques like Earnings before interest, taxes, and amortization (EBITA) or Discounted Cash Flow(DCF). As the nature of operations in a startup and the business are completely different, the valuations that are followed in business when brought into the startup, it will with all likelihood fail. Following is a short summary of the ingredients for valuation between a startup and a business.

For a business valuation the key ingredients are Market, competition, customers, product or solution, value proposition, differentiation, profit, and operation.

On the other hand, for the startup the key ingredients are huge problem, solution, search for a business model.

If we further simplify the ingredients,

A startup is a story, a believable story that gives one the confidence that, yes perhaps a dream and hope of a better future is achievable, and if achieved, something great can also be achieved financially.

You can see that startup valuation is simply a story valuation. The numbers will be affected by the value of the dream, the power of the future, and the confidence that the story gives for that future. But how to evaluate a future/dream/confidence? These are not measurable. Are they?

In this post, I would provide you a framework to evaluate a startup based on the startup story. We will evaluate the abstract notions of dreams, future, journey, probability, hope.

Ready?

Story-based valuation framework

Parameters:-

1) Power of the future(Pf):

Everyone will have their own motor car. (1)

Everyone will have their own computer. (2)

Common people with computer need no knowledge of the software. They can start using the computer for their own productivity purpose. (3)

Everyone will have their own mobile phone. (4)

People can easily search and find relevant information on the internet. (5)

Everyone will be connected to each other. (6)

You can call anyone, anywhere in the world without ISD. (7)

People will have access to all their documents wherever they go without having to carry them. (8)

Celebrities can now directly talk to their followers. (9)

Every retailer in the world can buy products from any distributors from any part of the world. (10)

The entire world can purchase anything and everything they want from a single store. (11)

Even people without a credit/debit card in India can now buy online. (12)

You can find a hotel in your budget with standard experience anytime in any city in the world. (13)

You can enjoy the local culture and make friends when you travel to any part of the world by staying with local families. (14)

No car owner will ever be guilty of harming the environment by owning a battery-driven car with better experience than the gas cars. (15)

Space travel will be almost as cheap as air travel. (16)

Wherever you want to go, a car will come and pick you up within minutes and drop you exactly at your destination. (17)

Without trying to think of the companies providing these services, how much the proposition sound just from one sentence? Just read the sentences slowly and try to see a picture. They look quite big. Right?

Here are the companies that are solving those problems.

Ford, Apple, Microsoft, Reliance, Google, Facebook, Skype, Dropbox, Twitter, Amazon, Flipkart, Oyo, AirBnB, Tesla, SpaceX, Uber.

A startup is a bold promise of the future.

What are some of the current situations that you may think of?

• No one will ever have to sleep with hunger.
• Everyone will have a roof to live under.
• Everyone will look young till they die.
• No one will ever have to suffer a broken marriage.
• Even the poorest of the poor of the world can become an engineer.
• No business will ever be in loss.
• No one will have to travel for more than 5 minutes to reach their office.
• Every startup now can get easy funding.
• No life will ever be lost due to accidents.
• Every storyteller can now easily make and release his films.

The most audacious future:-

YOUR WIFE will ALWAYS LISTEN TO YOU.

You can now convert your startup into a bold claim for the future.

The Valuation of Power of Future(Pf) can be calculated simply as a product of how many people want to see the future and how much money they are spending now because they don't have that future.

Pf=(Total People At this moment who wants to see the future)x(How much they are paying because this future is yet not achieved) x 365.

Example:-

Hunger:- 5B people spend nearly $5 every day for their food. hence Power of future(Pf) of a startup that can solve this problem will be $5 x 5B x 365 or 9.12 Trillion dollars. So, if you are solving the hunger problem today, your Power of Future which in tradition business is called Market Value will be 9.12 trillion dollars.

Similarly, there are 150 million homeless people in the world. Today even for a basic home, they might have to pay about $20,000. If you are solving the problem of roof for all, your Power of Future is 3 trillion dollars.

If you are trying to solve the Antiaging problem, Power of the future will be (3.8 Billion people between the age of 15-50)x*$236 a year)= $778B

(The $236 is based on Olay's anti-aging cream that costs about $11,800 for lifetime/50 years of usage)

You can now easily calculate the Power of Future(pf) or in traditional business the potential market size of your business too. You need to be practical and honest with your assumptions. Making a mistake here will cost you greatly. I will tell you why in a short while.

2) Power of Confidence(Pc)

Promising a bold future is the only the first part of the valuation. As you see almost all of these futures appear so intimidating that it is difficult to even comprehend how to reach there. The promised future looks almost impossible.

If I tell you that I will create a pill that will cost you only 2 cents and you will not be hungry for the entire day, you might pass my number to some mental health institution against a potential client referral bonus.

But if the same thing is told by Elon Musk? Well, it may make headlines in all the newspaper tomorrow. Right? If Bill Gates says, I will make a home for everyone, that doesn't look too audacious. Does it?

Power of Confidence is simply the authority of the storyteller or the founder.

But, there are only a few Bill Gates and Elon Musks. The critical problem is always solved by a new founder in a new area. So, how you measure this authority? How to measure the authority of 20-year-old college dropout who says "I will produce engineering graduates for $100 within a year?"

It is very simple. How many engineering graduate equivalent he has produced? How many he can produce, with his resources in a year. If he has a lot of teachers or people in his network such that he can produce ten such graduates par year now, then his power of confidence will be the current ability of him and his team to deliver a similar solution to Cx amount of customer.

Power of Confidence(Pc)=exp(log(Cx+1))

Let us say that the college graduate can train an Engineer equivalent and help a candidate to get a job for a training cost of $100. And he and his friends together can produce 10 such Engineering equivalents. Then

Pc=2.718 for this dropout founder and his team to solve the problem of $100 for a 6 months engineering graduation.

Bill Gates and his team can probably build 1 Million home a year for the homeless. So, Bill Gates will start with 403 as Power of Confidence. However, he can probably produce no more than 1000 engineering equivalent graduates even with his large network under six months for $100. So, the power of confidence when it comes to $100 engineering will be about 20.

In a nutshell, the founder who has a great network and a history of solving the problem will always start as a favorite to solve a problem. The bigger problem the founder had solved, the more confidence people will get in their story.

3) The fraction of Belief(Fb)

You are talking about a bold future. But how bold is the future? The boldness of the future depends inversely on the number of people who believes that this future is possible NOW. If no one you talk to believes that whatever you are talking about is has any merit, then you are talking about an impossible future.

• Humans will never die.
• Everyone on the planet will become a billionaire in one month.
• We will no more need water.
• Politicians will never be corrupt.

A wife will always listen to her husbands without interruptions.

You are promising a bold future, but so bold that no one trusts or believes. There are some problems that some may believe and majority may not believe.

• We can produce engineering equivalent skilled professionals under $100 and within 6 months.
• There will be such a low-cost home that everyone can have a home.
• There will be a pill that will take care of your hunger for hours.

On the other hand, there will be some promise for the future that everyone or the majority at least will believe.

• Everyone can get hygenic food.
• Everyone will have their bank account.
• Every business can now start with revenue.
• Everyone can now code.
• There will be no unemployment.

These are bold promises, but some will surely believe. Now the trick is to find out what is the percentage of people who will believe?

Take as much a random sample of ten probable users who will be benefitted by the future and then calculate the fraction of belief.

Fb=total number of people believed my promised future/total number of people I asked.

So if you go to homeless people and ask them "do you believe that in near future there can be a home for you?" The same question you may ask a person living in rent and so on. Chances are that 20% of people will believe.

$100 engineering? Chances are that at least 30% of the engineering graduate will believe that it is possible(They will think of online courses etc).

This will vary from one group to another. As you increase the sample size, the data will become more and more stable. So, if you query 1000 hungry people, you will get decent stable statistics.

Fb=0 and Fb=1 are both bad for the startup and you want to be between 0.1 to 0.3. The moment it closes at 0.5, more and more people will believe and will try to solve the problem.

4) The Power of Want(Fw):

Just like Fraction of Belief, you have to ask the users "Do you want this future now?"

If you ask any engineer if they would want their engineering to be under 6 months and not more than $100 then chances are 50% will say yes. 50% who are in premier institutes may brag about how it takes time for engineering and how a quality engineering needs money. They are happy with quality education. They don't want cheap engineering.

If you ask different people about hunger pill, not many in urban areas may say "Yes". They will say "food also is a way to spend time with family, enjoy the taste" etc. So if you can select a good and big sample, you can come up with a stable statistics.

That's all you need for the startup valuation.

The final model then becomes

• Valuation of a startup(Vs)=(log(Pf )*Pc*Pw/Fb) in Million USD

However, now the challenge is how will you prove that this model works at the first place. How come the model be so simple where traditional valuation takes revenue projection, market and what not?

Case Study Valuations

Facebook in 2004:-

Pf: Almost 2 billion people wanted to remain connected to their family and friends. They would have on an average spend $100 for this connection(the price of an average mobile phone then). Hence Pf=$200 Billion

Pc: Mark Zuckerberg could connect almost 10,000 students effectively in his Stanford network. Pc=54.6.

Fb: People were already using Orkut and Myspace back then. So remaining connected through the internet was not an out of reality. But the users back then suffered from technical glitches and chances were high that some 20% geeks only could believe that flawless connectivity was possible. Fb=0.2

Pw: Almost 40% of the early social network users and internet users back then would have wanted to remain connected with their friends and family.

Facebook valuation therefore back then would have been

(log(200 billion )*54*.4/.2) in Million USD or roughly 1.2 Billion USD.

Air BnB in 2008

Pf:- It is a fixed industry, for travel. We can simply consider the hotel industry market size then. ie $350B.

Pc: The founding team had already arranged for Air Beds for tourists of conferences and could easily arrange for 1000 tourist's staying arrangement in the year.

Pw: Say only 10% of the travelers back then were really interested in culture consumption. This number would be probably 40-60% of global tourists.

The valuation of Air BnB back in 2008(the initial year of starting the company) would have been log(350 billion)* exp(log(1000))*.1/.2 in Million USD or about 115M USD.

You can take up the companies and do your startup story valuation.

Difference between Story-based Valuation and Actual Valuation

Drawback

If you try to use this model for your startup, you will come up with any number between $100 B to $5 T valuation for your startup. But don't get excited. This is exactly what is called a First-Person Bias.

When you give the same formula to an investor, he will value you $10,000 or if he is too generous, $100,000. Don't get too worried about this. This is what is called a Third Person Bias(Observer Bias). We can always tilt the numbers towards our side no matter what model you use for the startup valuation.

The stability of the model will depend upon minimization of the bias, which will depend upon the sample size. Therefore, before you have started solving the problem if you have asked 5000 people about the Want and their beliefs, the Pw and Pb will be extremely stable. If you have asked only 10 people, well both will be extremely unstable.

Therefore it is said that

Only Identifying and defining a problem correctly will lead to a powerful solution.

But what mistakes we make as founders? We first build a cool prototype(the solution) and then start searching for the problem. Our stupidity do not stop there. We go to our family and friends to ask them what they think about the solution and do they believe that this solution may exist? They do not want to hurt us also they don't have the problem. At the same time, they are seeing something in front of their eyes. So both Pb and Pw will be biased.

Advantage:

Our drop from dreamland

Let us consider an example. We literally started as an ECG startup(Duh!). I asked my elder cousin brother who is a cardiologist. Do you want it? Yes, he said. Pw=1(sample size1) Do you believe that this ECG is possible? (Who the hell cares? I have done 1 lakh patient's ECG. But yes, this is small and handy and I am seeing a prototype. So yes possible). Pb=1. How many such prototype ECGs we could build? About 500 a year.

So what was the stupid valuation of my venture?

log(7.5 billion)* exp(log(500))*1/1 in Million USD= 146 Million USD. My estimation was that the next month itself I will have a 100 Million USD in the bank.

Then, I went out to meet 50 cardiologists and the WANT was only 2. So, the effective valuation now became:

log(7.5 billion)* exp(log(500))*2/50 or roughly 5 Million.

Because I and my team could meet only two cardiologists a week, irrespective of the number of prototypes we could make, we could deliver only 100.

log(7.5 billion)* exp(log(100))*2/50 or roughly 2 Million USD.

But this valuation is based on the assumption that no other competitors can provide what we are providing(we had some unique USP, but I will pass that as a founder's bias). At that time, there was at least about 100 startups and established companies who were capable to solve the problem we were trying to solve(in our imagination)

That was like $20,000. So our practical valuation was only $20,000.

You see, this model can bring you down to reality the soon your focus on Fb and Pw. And all these needs is a survey sheet, going out and talking to potential customers.

So the main advantage of this model is that it can bring the founding team to reality from it's Lala land faster than anything else.

The advantage for the investor?

You receive hundreds of decks every day. Probably even God could not have remembered what decks and companies you received. Why waste so much productive time into startups that are mostly "Founder's hope" rather than "Customer's Hope"?

If you ask the startup to just provide:-

1) The bold Promise.

2) Authority of the founding team.

3) The number of people they have talked and gathered data from.

4) The number of people who have said that they want this product.

5) The number of people who believe in the change that the startup is promising.

That is very much all you need to come to a decent initial idea about how the startup is going. Here A startup can simply provide you their business value in half paragraph along with their own valuation, which you can evaluate. Yes, startups may forge the number of people they have spoken to, but you would always know when you try to see the data.

This is particularly an effective model for an early-stage investor(pre-seed/angel)

Conclusion

• The story-based valuation model for early startups that I provided here is a simple form of a model. It has only three consideration:
• How big is the problem
• How true is the problem
• The capability of the team to solve the problem

An early startup needs proper direction and focus, rather than a sexy deck. Every number about projection you put will be unrealistic. However, this model will allow much less time for evaluation and a quick understanding of the direction the startup may want to go.

This is not scientifically tested with enough sample size. Therefore the accuracy and reliability will remain a doubt for both founders as well as investors. If you give this model a chance, along with your own model that you use, you will see over time that the prediction of this model will be much more accurate then whatever tools you have been using at this moment. It is simple, give this a try!

Do share your thoughts and observations in the comment below.