Valuing Early Stage Startups – Venture Capital Approach

Valuing early-stage startups can be difficult for several reasons. Firstly, these startups lack historical financial data, making it challenging to use traditional valuation methods. Secondly, there is a lot of uncertainty about the future of the company, including the market, competitors, and product reception. Additionally, there may not be many comparable companies in the industry, further complicating the valuation process. There are different valuation approaches like a milestone-based approach, ARR multiples approach, or a simple $250k/500k check for specific ownership, say 15%-20%. Sometimes VCs may also use convertibles to delay the valuation at Angel and Pre-seed stages. But in this article, we want to discuss one such approach that becomes particularly important after the Angel and Pre-seed stage.

The Venture Capital (VC) method, developed in 1987 by Bill Sahlman, a Harvard Business School professor, is a prominent method for valuing early-stage firms used by VC investors. It considers the potential exit value, which is the amount of money the investor expects to get when they sell their stake in the business at a future funding round. Below are the steps involved in the VC method:

1-Total Addressable Market

The first step is the estimation of the Total Addressable Market (TAM) or the potential size of the opportunity for the next 3-5 years for the business. One common approach is to use a top-down analysis, which involves estimating the potential number of customers and the price they would be willing to pay for the product or service. This can be done by looking at industry reports, market research, and other sources of information to determine the size of the total market opportunity.

Another approach is a bottom-up analysis, which involves estimating the size of the market opportunity by estimating the actual number of customers in the market by analyzing sales of the competitors and the price these customers are paying for competing services.

2-Terminal Year

The terminal year is the year when the early-stage investor can expect an exit. It should also consider that no additional funding round will be required before the terminal year. Generally, 3^rd year is more practical considering that startups need funding more often in the initial years. If the investment size can meet growth requirements, even 5^th year can be used as the terminal year.

3-Market Share

It’s important to consider the realistic market share that the startup can capture in the terminal year. This involves assessing the competitive landscape, the strength of the startup’s offering, and any barriers to entry. For example, a startup with a highly innovative and differentiated product may have a larger potential market share than one that offers a product that is similar to existing solutions. Benchmarking of successful startups in similar industries can also be used to estimate the market share in the terminal year. The market share in the terminal year is used to estimate the startup’s revenue expected in the terminal year. 

4-Exit Value

The Exit Value (EV), also known as the Terminal Value, is the value at which the company can be expected to be sold. This is typically computed as a multiple of the company’s sales in the year of sale (terminal year). The sales multiple is estimated by looking at series A rounds of similar startups from various databases.

5-Pre-Money and Post-Money Valuation

To determine the post-money valuation, the investor discounts the exit value to its present value. This is the value of the business after the investment has been made. The concept is simple and can be illustrated using this formula:

Post-money Valuation = Exit Value /(1+discount rate)^n

The discount rate is the required rate of return by the investors. Considering the risks of early-stage startups, this can range from 40-60% depending on several factors.

The Pre-money valuation is the company’s valuation before any external funding is raised. To calculate the pre-money valuation, the investment amount is deducted from the post-money valuation.

Pre-money valuation= Post-money valuation – Required Investment

The ownership of the new investor is estimated by dividing the investment by the post-money valuation.

New Investor Ownership = Investment Required/Post-money Valuation

Let’s look at an example to better understand this method. Assume that Startup A has developed a new software product that it believes has a large potential market. It estimates that the Total Addressable Market for this product is $100 mn, with a market growth rate of 10%.  After conducting comprehensive market research, Startup A believes that it can capture 1% of this market within the next 3 years.

Drawbacks

It’s worth noting that the VC method does not come without its flaws. It is based on a number of assumptions such as the future income and the company’s expected growth rate. Moreover, it uses multiples to arrive at an Exit Value which is mostly based on historical transactions. As such, it’s important for investors to conduct thorough due diligence and have a good understanding of the market and the startup’s growth potential before using this method to value a company. Ultimately, the required rate of return by investors is purely subjective depending on the investor’s perceived risk. There is no one-size-fits-all strategy to assess risk. The VC method is also based on the assumption that the startup will continue to grow and prosper, which is not always the case.

Platform01 Insights on VC Valuation Approach

1. We believe the most important aspect is the Investment Required. Many startups underestimate the investment required and further investment rounds are required before a possible exit. Therefore, we recommend both VC investors and startups prepare detailed financial models which can stress test assumptions to get a fair idea of the investment required before the next planned funding round. A detailed financial model can help estimate the CAPEX, OPEX, Working Capital, and Pre-Operating Expenses. It can also be used to track performance against KPIs.
2. The second most important aspect of this approach is market sizing. Before investing time and millions of dollars, we recommend entrepreneurs and investors invest in analyzing the market, consumer preferences, and competitive landscape. This is a very important step in making sure the opportunity size is correct and the right steps are taken to reach the end consumer.
3. We believe that the Exit multiple should be realistic. In times of low-interest rates, the valuations were on the higher side. We suggest entrepreneurs and investors use average multiples across the economic cycle, smoothening the impact of extremely high or low valuations.
4. Since this is not the only approach that VC investors use, we advise startups to understand other approaches as well that could help founders assess what to expect during their discussion with VCs
5. We also believe that the post-money valuation is driven more by business strategy and execution as compared to inputs used in the model. We highly recommend our clients use professional consulting services to optimize business strategy, business model, and implementation. A startup business strategy service worth $15,000-20,000 may save $1 million investment by reducing the cost of trial and error during startup lifecycle.