How to Read Pitch Deck. Startup Valuation
The process of evaluating a startup always precedes investment. But how exactly venture funds do this often remains a real mystery.
How do you think investors evaluate startups? The first thing one might think of is a conference room with people in business suits furiously studying tables, charts, and graphs, and clicking loudly on calculator buttons. The truth is, things look different in reality. Evaluating startups is frequently a subjective process, where dry numbers get along with assumptions and hypotheses. The younger the company, the harder it is to calculate anything, and vice versa. It's good when the company is mature, with sales and a staff of financiers. But that is not always the case. To understand a startup's value, investors resort to both traditional tools and non-obvious solutions.
The lead investor in close coordination with the startup itself usually does the valuation, so most of our readers are unlikely to encounter this case in practice. We decided to write about the topic for two reasons. First, it's always interesting to know what's under the hood. Second, the evaluation of startups is regularly accompanied by speculation and manipulation. The fact is that there are a great many ways to evaluate a company. Depending on the methodology, the difference in numbers can reach dozens of times.
For example, the Indian recruitment startup Apna didn’t have any revenue and somehow miraculously got a valuation of $1.1 billion. Another example is the Nikola startup, which makes electric trucks. About the “makes” part, we were too hasty. In fact, the startup hasn't made a single truck, but that didn't stop it from being valued at $4.77 billion. You're probably wondering where these unknown numbers come from. That's what this article is about.
Many thanks to investment analysts Daryna Koval and Volodymyr Medin from TA Ventures for contributing to the article and making it as precise as possible
Why do we need to evaluate anything?
Don't think a company's valuation exists only for high-profile media headlines – it is also minted in the legal documents that each round participant signs. That means that all the parties need to reach an agreement regarding the valuation. This is supposed to result in a number that will align with everyone’s incentives and will hopefully benefit each participant.
It is not as easy as it sounds, since the interests of different parties can vary. For example, new investors will be interested to invest in a “cheap” company. If you invest $100,000 in a startup that is worth $5 million, your ownership stake will equal 2%. But if you invest the same amount in a startup worth $10 million, you will own only 1% of it, which is two times less than in a previous case. At the same time, in case of exit, investors' interests will be the opposite – the higher the valuation, the happier investors will be.
Founders also have their incentives, and those don't always align with the incentives of investors. Founders would be happy to have a higher valuation to give a smaller share of their equity to investors. However, if the valuation gets too high, the founders might face the need to do a down round in the future, which is, in some cases, not an optimal scenario – neither for founders nor for some investors.
Factors that affect a company's valuation fall into two notional groups: those that are easy to count and those that are not. The first is financial ratios, valuations of peer companies in similar industries, market size, and tangible assets. The second group includes the team, product/technology, competition, and intangible assets. In addition, it should be noted that the evaluation includes both current indicators and future ones, which opens up a lot of room for speculation. Investors may well get caught up in bubbles and inflated assessments that are poorly reasoned. This can be caused by errors on the part of the lead investor, the wrong valuation methodology, and even manipulation by the startup founder. It is not uncommon for startups to exist literally on one assessment, attracting more and more money, but showing no real results.
Now let’s dive deeper into the specific ways of valuing the company, which TA Ventures and the club divided into two groups: pre-revenue and post-revenue.
Pre-revenue
Pre-revenue for the most part includes startups at the pre-seed and seed stages that have not yet generated revenue. Such companies are the most difficult to evaluate objectively, because due to their young age and pre-revenue status, they have not yet accumulated a sufficient amount of data. In the absence of numbers, investors often resort to subjective methods and guesswork, trying to predict the future. We focus on two popular methods used in practice: projection and venture capital.
Projection is done by looking at similar companies in the market and comparing them to the startup we are trying to value. You can use open industry statistics like CB Insights and PitchBook, or you can use the help of the room – the startup founders and investors you know who have come across a similar project in their practice. This method is devoid of precise calculations, but it is typically the best that can be done in the absence of numerical data. It sounds easy, but in practice, it may be more complicated than other techniques.
There are a lot of startups, and they are all different. The variety of categories, markets, business models, and other nuances makes it hard to compare companies. It's even worse if the startup offers a really innovative product that never existed before. For example, valuing a new social network for dating might be easier than valuing a NeuroTech startup that works on technology that can read human thoughts. Nevertheless, the projection method helps to come to a consensus and find a balanced assessment of the company, which at least will not be abnormal: overstated and vice versa.
Venture capital is the second method, based on the investor's expectations of the exit from the deal. As with the previous method, we compare and try to find similar startups. The main difference is that now we define a valuation based on one particular parameter – the revenue the company can bring in the future. To do this, we need a mature project to serve as an example. As many characteristics as possible should match. Next, we look at our good old multiples and make an assumption that our startup can achieve the same metrics. In the end, we calculate what the value of our startup should be now, so that it can achieve the same multiples after a certain number of years.
Here, the projected revenues and profits are still subjective, although in the early stages it is time to get used to this fact. Here are a few examples of current valuations of early-stage companies in different categories, according to CB Insights Q2 2022 Venture Capital report:
The median valuation across all industries is $16 mln.
Fintech – $38 mln.
Digital Health – $39 mln.
Retail Tech – $30 mln.
Post-revenue
Post-revenue companies are usually Series A startups and above. In contrast to their younger counterparts, such companies manage masses of financial and other data that help make more accurate assessments of their assets. In the later stages, investors rely less on hypotheses and more on analytics and calculations. As with pre-revenue, VCs prefer to practice one of two methods, which we'll talk about.
Discounted Cash Flow is a valuation method where we estimate the value of an investment using its expected future cash flows. At first, we compute the cashflows themselves. Next, we calculate the discount rate by determining our risk profile and the conditions of the capital markets. Finally, we project the value of the cash flows to today, thus obtaining a valuation of the company.
The obvious advantages of this valuation method include accuracy and objectivity. Here we are working with something more real, as opposed to projections and comparisons. In addition, with the DCF, we can calculate the IRR and stress-test the startup's finances. There are, however, some disadvantages. Among them is the need for large amounts of data and high requirements for analysis, where it is easy to make mistakes. Also, the DCF method is sensitive to both future cash flow forecasts and the discount rate, because no one knows what will actually happen in the future. To summarize, the DCF method is considered complex. Without exaggeration.
Multiples Approach is a valuation method that evaluates one financial metric as a ratio of another. For example, Enterprise Value to Revenue Multiple (EV/R) is a financial ratio used in company valuation that compares enterprise value to its revenue. Investors then use this ratio to compare their target company to other businesses in the same industry.
The main advantage of this method is the simplicity, but everything is spoiled by the fly in the ointment. The financial data for the multiples calculations is difficult to find. Here are a few examples of current valuations of late-stage companies in different categories, according to CB Insights Q2 2022 Venture Capital report.
Fintech – $1.4 bln.
Digital Health – $1 bln.
Retail Tech – $1.6 bln.
Conclusion
Unfortunately, there is no single method that can give a reliable valuation for a startup. At least not yet. At best, we will come close to objectivity, but calculating what is called penny for penny remains a ghostly hope. After all, each participant of the round has their own incentives and biases. However, as investors and founders, we can appeal to our conscience and remind ourselves about simple best practices of ethics and long-term success.
VCs should not use an undervalued or overvalued multiple. In addition, investors should not take a large stake and squeeze all the juice out of the startup. By leaving a large stake to the startup team, you increase their motivation, productivity, and, as a result, the chances of success. Greed will ruin any valuations, because the very intangible factors that are hard to predict will interfere.
Startups in turn should not overestimate income forecasts and flaunt them in front of investors. Such a trick will work exactly once, after which you will face inflated valuation and problems with raising money in future rounds. Lastly, ask for money only if the business really needs it.