Ask a VC: what should my valuation be?
When raising capital from investors, you are giving away a piece of your equity for money (avoid as much as you can giving away equity for just advice, office space, etc. as incubators or accelerators ask you to).
Let’s assume you are raising 1m€ because that is what you calculated in the previous article on how much to raise. If your “valuation” is 4m€ before the money comes in, we call this pre-money valuation. But 4+1m now in the bank=5m€ post-money valuation. 1m/5m=20%; this is the amount of equity you gave to your investor. If s/he had agreed that your pre-money valuation was 9m, then post-money valuation would be 10m, and you would have given away only 10% of equity, ie. half!
So how do you know what is your valuation?
Valuation changes over time and is strongly associated with several factors, including perceived risks (“How likely am I to lose my investment” thinks the investor; therefore “for a high risk I’m going to ask for a bigger share of the pie”, and therefore valuation is lower); predictability of the business (and therefore of its cashflows); supply & demand; unique Ricardian rent, etc.
Valuation is always an estimate, as agreed by two parties, at a given point in time. It’s not a fixed number and is therefore calculating it is usually described more like an art.
More importantly, valuation is not value. If one person is willing to pay very expensively to own 1% for example of a very valuable asset (it happens all the time), it does not mean that the rest of the 99% will have the equivalent value, because there is maybe no market for this other 99%. Back in 2009 when Yuri Milner (DST) bought 1.96% of Facebook for $200m, everyone thought the number was crazy, but it turns out the investment paid off very handsomely. The implied valuation was 200m/1,96% = approx. $10.2b. This morning, Meta (ex-facebook) has a market cap of $809b, so it amounts to almost 80x in 13–14 years (assuming no shares were sold), even in this bearish market. Key takeaway: when someone raises capital, as reported in the press, at a valuation of X, that does not mean the whole company is worth that, just that a piece of the company was sold at that implied valuation, but it sets a benchmark for the rest of the equity. Another example: when WeWork raised money at $47b, that was because a fund (Softbank) was willing to buy another piece of the equity at that implied valuation. No one else did, and the shares were worth below $5b later.
So how do I calculate my valuation when I raise money?
Many techniques are discussed in this classic textbook from McKinsey, or in any proper security analysis book, such as this one. Let’s discuss 4 of them.
Keep in mind that what we are really calculating is the price of a share, defined as the total valuation/number of shares. Then whatever portion of equity is exchanged, the money is the amount of shares sold x share price. This makes all calculations easier. At pre-money and post-money valuations, the price of the share is the same, just the amount of shares is different, as the post-money valuation includes the newly issued shares.
- Discounted cash flow technique
Let’s imagine I give you 100€ today. If you put it in a savings account for one year at a 5% interest rate, the money will be worth 105€ then. You can therefore deduct that money in the future is worth less today, because of this interest rate phenomenon. Actually, the formula for future money was 100 * (1+5%) = 105. If we solve for x * (1+5%) = 100, then x = 100/1,05 = 95,94€ today. We call this the present value (PV). If money is worth 100 in 2 years, we do this discount 2 times, and so on. The formula becomes x = 100/[(1,05)^n] where n is 2: or 95,94/1,05 = 90,70€. The more in the future the money is, the less it’s worth today.
Companies make or lose money in a given period; if we assume this period is 1 year, then how much money is generated in 12 months? Startups tend to “burn” = consume cash in the first years, so this number will be negative. After they become “breakeven”, they will “produce” money, so the number will become positive. In the startup world, what really matters is the cash produced, not the accounting number in the P&L that takes into account non-cash expenses like depreciation and amortization. Luckily there is a formula to calculate the cash produced or consumed in a period; we call it “free cash flow” (FCF). In a nutshell, it’s the difference between
- (in green = cash in) Revenue + Variation of working capital requirement (ie if you get paid before you pay your suppliers, that is free cash on your bank. Retail for example uses this model. To some extent subscription-based businesses have this as well, you pay a subscription early for 12 months, and expenses occur after); and
- (in pink = cash out) all expenses + cash used for investments (we call it CAPEX).
So you can do this calculation for each year in the next 5 years, and more or less all startups tend to look the same in their growth journey. Assuming a discount rate of 30% (this is a super important variable, that has a huge impact; you can read all about how to calculate this correctly in the textbooks in the chapter WACC = Weighted Average Cost of Capital), the sum of the PV of the FCF for years 1 to 5 is always more or less 0 or even negative. The real value of a startup is created by the asset created then at year 5 (or whenever we sell the company), which we call terminal value. This can be the value associated with the number of users, the number of contracts, software IP, a multiple of revenue, the number of key employees, etc. In this case, I assumed a 4x revenue on 15m€ revenue in 5 years (worst case), and 5x revenue in 5 years (best case) We apply a discount rate over 5 years and we get the PV of the TV between 16m€ and about 27m€. Add the sum of all PV of the FCF, and you get the NPV (net present value), or theoretical valuation of your company (between 11 and 25m€). Said differently the cash you’ll generate in the next 5 years doesn’t really matter, what matters is the asset you are building (the terminal value). It’s key to understand this mechanism before you start your valuation negotiation.
In all cases, keep in mind that your P&L projections are super volatile, and could change considerably, therefore changing the FCF of each year substantially; that the discount rate impacts heavily the NPV; that the terminal value can be a factor of many things, and of course of supply & demand or appetite for your company, your product or your industry at that given time.
Most VCs never use this method for early-stage companies, because it has too many unknowns. It can be used for late-stage companies, or more usually to calculate the share price of public companies.
2. Multiples technique
I really don’t like this method, but it is very common. Basically, it means that if someone else looks like you, and behaves like you, then you can substitute their business with your business.
Let’s assume this example: AirBnB is making $9b in revenue in the world (check TTM = Twelve Trailing Month), and its market cap is $79. This implies that its valuation can be calculated as 8.77x revenue. So if you are starting a competitor to AirBnB (on a different market, with a technological twist, catering to a higher-end audience, whatever), then if you are expecting 5m€ revenue this year, your pre-money valuation could be 43,8m€. How cool is that? Right. It seriously means you are comparing apples with… marshmallows or something radically different. One company has an established brand (customer acquisition costs are different), a scalable IT infrastructure (you still probably have to build yours), an established inventory acquisition team (to sign new apartments), a team of international lawyers, access to capital, a different growth market potential, etc. Their risk factor vs yours are super different, hence discount rates are going to be different, and NPVs as shown above are super different. I’m exaggerating the example here, but you can’t really compare companies just on revenue (who knows how each is calculated either: it is with services, subscriptions, etc.).
Some folks use other ratios such as EBITDA after most costs are included, to compare net results. NYU Stern (and many others) publishes such as list of multiples. For example, if your business is a Software company on the internet, the multiple to EBITDA is 14.84x. But, all the above objections stand. Unfortunately, you have to have a positive EBITDA ;), which on my model above only happens in year 4, and changes drastically the following year, because of high growth. In addition, the multiples above are based on EV = Enterprise Value = valuation + debt to be paid back — available cash, which changes again a lot with leveraged or not startups (all those almost free grants you got from BPI or another regional bank, convertibles notes that will not convert, etc.).
I mentioned the YCombinator batch all raising $2m on a $8m pre-money valuation. This is the exact phenomenon of multiples not taking into account the reality of the business itself, of its markets, of its potential growth.
Some people try to approximate this uncertainty with a basket of multiples (pretty classic for investment banks to do this). Let’s say I take 5 to 10 very specific companies doing software on the internet, all already public (which means they are more mature, and with slower growth potentially than yours). I could do a simple average of all the multiples calculated on revenue, or a weighted average (better) depending on the company size (but then skewed towards bigger companies hence towards lower growth companies), or an average of the multiples on EBITDA, etc.
In all cases, this method will give you a new range of values, with merits, but with plenty of disadvantages and biases.
3. Supply and demand technique
This is probably the most common in the VC world. Let’s say you want a 24m€ pre-money valuation (and when the VC asks for the valuation you want, you should say it. No one really has time to play games). If he thinks he will make money with you according to his thesis, he’ll accept it. Or negotiate it a bit. Super simple.
The right thing to do here is that if you calculated that you needed to raise 1m€ and that you only want to give 10%, then your expected valuation will be 10m€ post, hence 9m€ pre. But many VCs have a minimum % of equity ownership rule. If it’s 20%, then they will only accept up to 5m€ post, ie 4m€ pre. Duh… Maybe magically, you can negotiate a 15% dilution, which is 6,67m post, so 5,67 pre, etc.
But careful, valuation is not the only thing that matters here. If the VC thinks your valuation is too high, and therefore risky for him for his expected return, he’ll add provisions in the investment contract that will “protect” his money, increase his proceeds at exit, and discreetly and mechanically reduce the valuation now without saying the word... A ratchet clause will give the VC more equity in case your next round is done at a lower valuation (imagine what is happening now in this bear market after the years of exuberance 3–4 years ago); a preferred liquidation clause to get his money back before anyone else could wipe the founders if the exit is too low (they even come at higher than 1x in some cases where the founders have no choice. I saw a 4x in one of my investments…); or issuing warrants (~ free new shares) if some milestones are not met, because the P&L is delusional.
4. The “VC method”
This technique is also called the back-of-the-envelope calculation and is done often mentally by VCs when you meet them.
Let’s say you are raising 2m on 8m pre-money, whatever the stage of your company and current assets. You are early, so you’ll need 4 rounds of financing (seed, series A, series B, series C) before an exit. Assuming a 20% dilution, everyone (you and the VC) will get diluted 4 times before the company is sold. 1-0,8^4 = 1-0,41=59% dilution in the coming rounds. So the 20% he’s getting in this pre-seed round is going to represent only 8,2% of equity at exit.
As a matter of fact, Carta Insights just published today the median dilution per round based on real data (keep in mind the widespread around the median):
Priced seed rounds: 20% sold
Series A: 20% sold
Series B: 17% sold
Series C: 12.6% sold
Series D: 8.1% sold
Now your financial plan says your revenue is going to be between 15–20M€ at year 5, and we can assume the terminal value is going to be 4–5x that revenue (based on “current” multiples). The first question is will you be able to reach this revenue? Then, will the multiples still be 4 or 5x then? What if the fad is gone (imagine you invested in crypto, NFTs, or metaverse when it was hot; it’s not anymore, and valuations have crashed 90% or more)? So if the value of the business is going to be 60–100m€, and the VC will only own 8,2%, then his proceeds are going to be only 4,92m to 8,2m. If he invests now 2m, then his exit multiple will only be 2,46x to 4,1x the invested pre-seed money.
That would be more than fine (in the upper range) if ALL companies in their portfolio performed the same way. But we know that statistically VC portfolios follow a power law. 1 out of 10 companies will outperform 10x or more, 4–5 will go bust, and 4–5 will just return some money in the 1–3x range. So the VC needs a winner to cover for the 9 other “failures”. If the VC expects a 3x on the portfolio, each company has to return potentially 30x the invested money, NOT the 2.5–4x range calculated above. The VC will then pass on your opportunity because the maths just don’t work for him.
Or he’ll negotiate down the price significantly. Or try to find ways to up your ambition, and increase the exit price (but he’s not paid to be a consultant, so don’t count on it). Or systematically find very low-risk businesses that will deliver against the power law (unlikely).
No method discussed above is the right one to calculate your correct valuation, because it’s more art than science, and depends on so many unknowns at the early stage of high-growth companies. But understanding the mechanics involved in each technique is precious to think about the benefits of your business, and help get to a yes much faster when raising a round.
—
I consult with corporates and startups and help them address issues like this and many more. Don’t hesitate to reach out at www.rodrigosepulveda.com or book a video call with me on intro.co.
