Startup valuations are often confusing. You may regularly read about total valuation metrics (or market cap) completely out of this world and not making any common sense.
Typical questions at this point:
- How the … that startup is valued at 1 / 10 / 100 m / bn $ without having … revenues?
- Why on earth could anyone invest … dollars at such a valuation, there is practically no chance to see that return?
Quite challenging to explain briefly, but let me offer 3 factors coming to mind when reading about such seemingly overpriced transactions. Good to know for startup founders. Or mentors typically taking equity for advice, like myself.
First, three short and digestible statements:
- Companies do not have objective values. At all.
- Investors are not stupid: liquidation and other preferential rights. (I believe that is most interesting and rarely discussed factor)
- StartUp value is also branding.
And now in detail:
1. Companies do not have objective values. At all.
If you ever made any investments (such as shares, equities, bonds, whatever), you probably already know that the value of any company is the exact amount your future buyer actually pays for you. Period.
As long as you do not have a buyer, and the transaction’s amount has not reached your bank account, you only establish valuation models and some sort of faith about what will happen during sales. When selling equities, we are looking for a price point and good enough reasoning both parties just agree on at the end.
As an illustration about how subjective and uncertain evaluations are, let’s have a look at the valuation methods of publicly listed companies. Their business is generally more transparent and forecastable than startups… still, we are far from anything accurate. Just a few methods (with my own explanatory names):
- You can consider Fundamentals. Meaning value is derived from the actual financials of the enterprise: DCF, Book Value, Dividend-based approaches, etc (note: even those include hypotheses and provides you with value ranges rather than discrete value points);
- Then you can consider Market habits. How much others pay for similar companies, whatever the rather philosophical “similar” means. So you pick some comparable metrics: P/E, P/BV, P/Sales, P/Div, etc. Interestingly, these are typically considered as Fundamental Analysis, but I hope now you clearly see that the basis moved from the company’s operation to a new field: what market players tend to do, as a benchmark;
- Then you can set up values based on Money/Liquidation trends. Pure traders base their decisions on factors quite far from the business itself: technical indicators of price and volume movements, expected future investment trends, thinking in portfolios regulated by various rules and compliances, etc;
- … and the many-many bespoke strategies. Like when you suspect a given corporate, industry or country will need to do something due to external conditions.
Company valuation is rather artistic than scientific. And rather dynamic in nature than a static target.
And now about startups.
Even more complex. The interested parties need to agree on an appropriate investment model and respective logic in the early revenue generation phase. Sometimes without any revenues seen. Which opens several gates for risks and assumptions, whether an expected trend indeed results in a Tornado, or how the future market shares may look or how much we can bet on our developing technology being acquired by an enterprise. Oh, and of course the chance to fail at market validation, not everyone survives…
The more complex situation means further evaluation methods. A good read: a fantastic collection of 9 startup-focused valuation models.
Let me highlight the “Venture Capital model”. In that case, valuation is derived from the expected growth. Sounds nonsense at first, right? The value is not based on anything related to the profile or operation of the company — but on the exit expectation of the investor! Later I will explain why this is NOT stupid.
Take away: there is no single number how much a startup worth today. Whenever a value is present, it is always tied to a valuation model and also timeframe. Valuation is about finding the right models, acceptable to all parties and fitting the expected business.
2. Investors are not stupid: liquidation and other preferential rights.
Speaking about market cap (or total valuation) initiates a bad reflex: feels like all of the owners sit in the same boat, have aligned interests and their take from the company is somehow proportionate in good and bad times, however the business sails.
This is not the case of course. The model protects the interest of the investors even if the company fails to generate exponential growth and/or to make it to an ambitiously priced IPO. Well, even a decrease in the assumed valuation can be accommodated.
The magic lies in the various sort of payout preferences.
For example, if my investment in your startup is in fact provided as a loan (debt, note, etc), I will be paid before shareholders in case of liquidations. They will not receive anything unless the debts towards me are settled. The same situation happens if you see provisions about liquidation preference (or preferred stocks) on the term sheet.
Well, after being on top of the payroll… I can sleep better. I do not really care about the total valuation itself. My biggest concern becomes whether the value I can take in the future is above my investment (+yield).
As an illustrative example, let’s say I invest 10,000 USD in your startup and accept that the valuation is 1,000,000 USD. I will take a minor 1% from the company — all I ask for in exchange to be preferred at payouts and a bit of voting control. So, what is the right company value for me with these rules? -> Actually, anything that generates the 10,000 USD (+yield). As long as the company’s value is above my own investment’s — I’m fine. No need to multiply total valuation and get to 2–3 or more million… I can do well even at 10–20,000 USD. Hope you understand the asymmetric leverage.
That may appear as a serious blow towards the founders. But (there is always a but!). A few further considerations favouring the founders:
- Founders have the chance to build a large and hopefully operating business from someone else’s capital. Assuming a great strategy (and a bit of luck), the revenues/values generated will tremendously lift the founders’ take in case of an exit. I know we are human and everyone has a different viewpoint about such dynamics.
- If the business grows, founders in management positions can work and live according to their role in terms of salaries, benefits, etc. Even in the case of “mediocre operation” (aka missing excessive expectations), a top managerial role is maintained together with some equity value gained. Well deserved after all the grind and risk-taking. Still, it’s not that bad anymore, is it?
Take away: should not worry too much about the valuations aired. The key criterion, in reality, is whether the potential real value is above the already invested cash. Real troubles start when invested and spent money does not generate returns.
3. StartUp value is also branding.
Wanna know another less obvious impact of startup valuation? Whatever number you dare to assume and publish also differentiates your company. It assimilates with your brand and generates actual benefits in several business aspects.
- High valuations increase pressure on founders and investors. Ambitions expressed, time to unite under the flag and march towards the goal. A purpose for your daily grind!
- Recruitment gets easier. Employees are happier to join a company where a high valuation is published suggesting business growth expectations and probably some investors validated the operation… and perhaps some equity is already on the table. (Apart from common sense and anecdotal evidence, I know I have read a study recently about the relationship between becoming a Unicorn and being able to attract more talents… which study I do not find anymore. If you read it, would be great to see a link again in comment.)
- Increases trust in clients, especially when targeting enterprises. Door opening is so much easier for a startup having an investor-backed 10m-valuation — than emphasizing 1–2m revenues and 0 profits.
Take away: I often tell during consulting/mentoring that startups have 2 products to manage. One is obvious, the service provided for clients — the other the startup as a company itself. Valuation is an essential part of the brand, having an impact on the product’s options as well. Whether you like it or not — need to deal with it.
Can we help you? AbilityMatrix mentors are regularly available for free StartUp Office Hours. Our mentoring sessions provide you the opportunity to introduce and discuss your project in about an hour. Would you need an honest, independent and sometimes harsh viewpoint — just book a session!
Schedule a session: https://blog.abilitymatrix.com/book-a-free-session/