Schrödinger’s Valuation Problem
Startup Valuation — the Reality between Art and Science
“There are a lot of ways to determine the valuation of a company, and by proxy, a venture fund’s portfolio. But there is a really important distinction to be made between valuation and worth. A company is worth only what someone is ultimately willing to pay for its shares.”
—Mattermark —
In simple terms, Schrödinger explained that if you put a cat and something that could potentially kill the cat in the same box, you would not know if the cat was dead or alive until you open the box, up to that point, the cat is both dead and alive at the same time. Scientific theory, like startup valuation, is right or wrong until said theory can be proven (opening the box might be seen as any financing round, liquidity event or winding-up). As a matter of fact we have never put any of our startups in a box. Nevertheless, startups are somehow in a valuation box by nature and both, VCs as well as startups, determine the actual value based on someones willingness to pay for its shares.
A prominent example to explain the issue between perceived value and actual worth is Theranos, in this case the cat was dead—obviously. Elizabeth Holmes managed to fool whole Silicon Valley, the once famed biotech startup went from skyrocketing superstar with a peak valuation of USD 9 billion to bankrupt in almost no time—all investors thought the cat is immortal.
Theranos has raised a total of USD 1.4 billion in funding over ten financing rounds from top notch investors. Even though this is a very special (fraud) case and Holmes’ vision was far too advanced for Silicon Valley engineers and their non-Apple budget — she managed to raise money on a vision and charm, fooling alpha dog investors.
The Reality between Art and Science
Putting a price tag on a startup is both art and science at the same time. The science is more or less the easy part — researching valuations for comparable companies and constructing a revenue or EBITDA multiple. The art is more subjective and primarily built on forward looking assumptions, estimations and a balanced combination of experience and gut feeling.
Moreover, there are various soft factors impacting the valuation of a startup, such as investors appetite (competing VCs), who is in the lead or co-lead (or just a space filler)? Is it a primary transaction or are secondaries included (blended valuation)? How distressed is the startup, what are the capital requirements (dilution)? How does the current cap-table look like (VESOP, fully diluted ownerships)?
Aside of the mentioned above there are plenty positive indicators VCs are looking for, such as a solid MVP or prototype, first traction (revenue wise), reputation of the founding team (e.g. serial entrepreneurs), timing of the industry and of course present funding supply.
Though, VCs are as well seeking to identify negative indications (red flags), such as incapable management, highly competitive and saturated markets, capital intense environment with low margins and a certain lack of product traction.
For revenue generating startups the valuation dynamics change to more traditional ones, such as profits and earnings, growth rates, recurring revenues and gross margins. In the best case your startup is highly profitable, growing at an above average pace with recurring revenues and an outstanding gross margin — well, we should get back to reality now.
In order to maximize your valuation and your chances to get a fair price tag on your startup you should be working on the following questions and answers (rather results):
i. What is your unfair competitive advantage, now and in the future?
ii. Are you serving a real need and do you have the ability to disrupt?
iii. How scalable and pivotable is your business model in the long-run?
iv. Are you targeting a vast total addressable and growing market?
v. How can you increase your one-time and or recurring revenue base?
Having a comprehensive idea of both your business and financial model, wrapped in a charming story may significantly improve the likelihood of receiving funds at the right valuation, at the right time, from the right VC(s).
Startup Valuation Methods
There is a fantastic reading by Stéphane Nasser summarizing the most common valuation methods to determine pre-money valuations, which I think are on the point:
I would like to dive a bit deeper into three of them, the ones I deem to be most practical.
i. Comparable Transactions highly depend on the type of startup and industry. It’s fundamental to find the right indicator, as a proxy for the price tag of your startup. Comparables could be revenues (MRR, ARR, GMV etc.), EBITDA, ACVs, gross margin or even MAU/DAU. Applicable for pre- and post-revenue startups.
ii. The Berkus Method (designed by Dave Berkus), is a fairly simple approach, starting with the value of a peer startup (same industry, stage and revenue model). Based on that value you define five valuation driving criteria such as prototype, management, sales and relationships. Applicable for pre-revenue startups.
iii. The Venture Capital Method, VCs usually seek for a certain minimum ROI for an investment in a predetermined timeframe, based on those two elements and the expected dilution one may do the backward roll from the anticipated exit value to get to the dilution adjusted pre-money valuation. Applicable for pre-revenue startups.
Summarizing the above, the theory gets us closer to reality, though multiple rational valuation methodologies will not prevent other VCs from offering a higher and more generous valuation. Furthermore, it is important to remark that the valuation methodology usually changes with hype topics, industries, economic cycles and of course regions.
Ultimately, startups receive valuations that an investor is willing to pay and an entrepreneur is willing to accept — exactly like in liquid public markets. A listed company is worth what the last person paid for the last share of stock purchased — it’s as simple as that.
In order to add another perspective on startup valuation and how you may approach this challenge Pierre Entremont wrote in one of his Medium posts “How much should you raise? An economic approach” the following:
“The optimal amount raised is the maximal amount which, in a given period, allows the last dollar raised to be more useful to the company than it is harmful to the entrepreneur.”
I personally think that this is one of the best and most accurate summaries in a single sentence. Do not over-raise, keep your dilution in sight, balance growth, your burn-rate and cash at hand—work forward looking and stay one step ahead of others!
Any thoughts or questions? Reach out! Want read more?
The Angel Performance Playbook
Venture Capital Fund(amentals)
Equity, debt and the grey zone in-between
KPI <kē pərˈfôrməns ˈindiˌkātər> Hunter
About myself
I am a passionate and hands-on venture capitalist (+6y), entrepreneur (+7y), mentor and angel investor. After 6years of flying over 1.000.000 miles, spending 1.200 hours on airplanes, looking at 1.000 start-up pitches on all continents, I decided to gather some of my thoughts based on this extremely rewarding professional journey at Mountain Partners. Reach out!
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