Understanding Startup Valuations

An article we liked from Thought Leader Amy O'Brien:

How do startup valuations actually work?

Enterprise value is at the forefront of everyone’s minds right now. But how exactly does valuing a startup work? And what happens when the market is in turmoil? 

It’s the golden question for any company: how much is your business worth?

While the value of publicly traded companies fluctuates from day to day with their share price, privately held startup price tags are less fluid. They’re negotiated by investors at each fundraising round, which may not happen every year, or even every few years.

But like public valuations, private tech valuations are also at risk when economic or business conditions worsen, and we’re beginning to see the first signs of the public tech stock slump trickle down to private startups in Europe.

So how exactly do investors arrive at the valuations they give startups? How have startup valuations changed in the current environment? And is valuation the be-all and end-all for founders?

What do pre-money and post-money valuation mean?

A startup’s valuation determines how much money anyone with a stake in the company — whether that’s an investor, founder or equity-holding employee — will reap on exit. VCs refer to valuations in terms of pre and post-money.

Pre-money startup valuations are the estimated value of a company before the new investment is taken into account. Post-money is comprised of the pre-money valuation with the new investment amount added.

For example, Very Clever Capital wants to invest $5m into SuperStartup based on a $10m pre-money valuation. The post-money valuation is $15m — equal to SuperStartup’s pre-money valuation plus Very Clever’s fresh $5m capital injection.

What VCs consider when valuing a startup

Investors say they consider a wide range of factors when pricing startups, and that their methods mainly depend on what stage in the startup lifecycle a company has reached.

“Valuation, particularly at the early stage of investing at seed and Series A rounds, can be more of an art than a science,” Kilian Pender, partner at Northzone, tells Sifted. “Then it becomes increasingly about the financial metrics as the company progresses in its journey.”

Seed and Series A: when people matter more

At seed and Series A, where a company may be pre-revenue generating or working out its product-market fit, investors say they concentrate more on the quality of the founding and management teams. Characteristics they look out for are:

• Strong work background. Evidence of founding teams having worked at strong existing startups, corporates, consulting firms, banking or other industries which are difficult to get into.
• Impressive academic background.
• Evidence that the founding team has strong insights into the specific vertical which they are tackling. So, for example, has the founding team of an AI startup been working in the sector for a long time?
• A founder (or founding team) that has a strong vision for what they want to build. “It’s always impressive when founders have a good idea of how the world could look if the product they want to build is successful,” Pender says.

Series A+: When financial metrics matter more

Later on, when companies are revenue-generating, investors double down on financial metrics.

These include:

• Revenue multiples — often used as an initial guide, as revenue is often the most stable metric for loss-making startups. Calculated solely on the basis of revenue, a startup that is growing at 30% to 40% a year, for example, might be given a valuation of 6x to 10x its annual revenue.
• The Customer Lifetime Value to Customer Acquisition Cost ratio (LTV/CAC) — pegs the lifetime value that can be gained from a customer against the cost of acquiring that customer.
• Payback periods — the length of time it will take a company to recoup the costs of investing in their business — whether by launching a new product, entering a new geography or hiring more people — with the money earned from that investment.
• Retention rates — the ratio of customers that stay with a company vs the risk of losing them (turnover).
• Product usage rate — measures how often and how much customers use the product.
• Growth rate — how fast a company’s revenue is growing annually. This tends to be higher at the beginning of a startup’s lifecycle.
• Is revenue recurring? — investors will analyse whether they think a portion of a startup’s revenue is likely to remain stable and predictable in the future.
• Company margins —although profitability is rare in startupland, investors will scrutinise whether the distance between the costs to run a business and the amount of revenue it brings in will narrow or keep growing as it scales.
• What are the revenue multiples like for competitors?
• Could the company’s market share be threatened? — how many other startups claim to be doing what this one is doing? Could they steal this startup’s customers, and therefore revenue? Are there newer entrants? How much capital have competitors raised?

Investors typically expect lower returns on later-stage investments.

“At the early stage, we might be aiming for 10x+ on our returns, but later on, we might be looking for more like 3x to 5x returns, depending on the risk stage of the investment and the risk of the sector,” says Pender.

Future value

Investors also make calculations based on forecasts and estimations for how much a company would be worth at an eventual exit — ie. its IPO value or cost to acquire.

For VC firm Eight Roads, which invests at Series A and B, the main consideration when it comes to a startup’s valuation is a forecast of...

Read the rest of this article at sifted.eu...

Thanks for this article excerpt to Amy O'Brien. 

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