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1 Preparing your Financial Plan 1

2 Valuation of new ventures 14 Valuation of new 2 ventures

One of the most frequently asked questions at any startup event or investor panel is: “How do early stage investors value a startup?” Unfortunately, there is no right answer, it all depends on the situation.

Valuation is an interesting topic because it has a large impact on raising capital. To raise equity funding, it’s important to determine the value of your startup. If you know your valuation, you can determine the exchange rate of money for shares for the investors.

Valuation is more seen as art than science. Even for mature companies, there isn’t any one right formula or methodology. For startups, it’s even more difficult. It might seem like you need to do fortune-telling, but with some guidance you’ll know where to look. You should have a basic understanding of the valuation process in order to determine a range of values for your startup. This will improve your negotiation process and make it easier to reach an agreement.

When putting a valuation on your startup, it’s important to know the difference between pre-money and post-money valuation. The timing when the valuation takes place defines the difference between both. Pre-money valuation does not Do you need advice from a funding expert? include the external funding. It provides investors with an Contact us! [email protected] idea of the current value of your startup and the value of each issued share. Post-money valuations show how much your startup will be worth after the investment. It’s important to know which one is being referred to when talking about valuation.

The main problems arising when putting a valuation on a startup is the lack of history, the lack of tangible assets and the uncertainty of its future. Therefore, most valuation methods aren’t really helpful because they rely on your track record and balance sheet. There are a large number of valuation methods available. In this chapter, we’re focusing on the most relevant ones for early stage companies. We’ll start with the traditional methods and afterwards, we’ll dive deeper in some alternative valuation methods.

14 | eGuide - Startup Funding 2 Valuation of new ventures 1. Traditional valuation methods A second parameter is the weighted average cost of capital (WACC). To calculate this, you need to make the assumption that your startup will keep its optimal capital structure forever. a. Income-based methods But for a startup, the capital structure will inevitably change We can divide traditional valuation methods in three when raising funding. The level of risk will change as well categories: the income-based methods, the market-based through the different stages. This will change the cost of debt methods and the cost-based methods. and the cost of equity. The Discounted Cash Flow Method isn’t often used by early- Discounted Cash Flow method stage VCs. If they choose to use it, it’s probably because In this category, the Discounted Cash Flow method (DCF- they feel obliged to do so since the DCF-method is the most method) is probably the most popular one. With this method, common way to valuate companies. But because of all the you need to estimate all the money an investor would receive, assumptions and restrictions, it’s very hard to get an accurate adjusted for the time value of money. Therefore you need and meaningful valuation for startups using this method. to estimate all the future free cash flows (FFCF). Then, you calculate the present value of your future cashflows by Dividend-based model discounting them with the weighted average cost of capital (WACC) of your company. The WACC represents the cost of Another income-based method is the Dividend-based model. capital in which each category of capital is proportionately This model is very similar to DCF, but instead of FCF, you weighted. will use the future dividends an equity holder will receive and instead of using the cost of capital, you use the cost of equity. Basically, you calculate the present value of the future dividends a company will pay out.

Via this link, you can find a complete guide on how to use the discounted cash flow method.

In general, it will be hard for a startup to use the discounted This method is hard to use for the valuation of startups since cash flow method since it’s based on a lot of assumptions you need to predict your future dividends and it assumes a where little changes can have a large affect. Therefore, it’s fixed growth rate of these dividends. Therefore, this method even harder for a startup to come up with strong arguments to works best for very mature companies that have a history of support these assumptions. regular dividend payments. A first parameter is the sum of the free cashflows. To estimate your FFCF accurately, you’ll need the following information:

• The past performance of your company (on average a 5 year period) • The evolution and dynamics of the market you’re operating in • Your future investments plans

You might notice that gathering this information can be quite challenging, if not impossible, for a startup. Mostly, there isn’t any historical information you can rely on for the future forecast.

Furthermore, often there isn’t a defined market because the startup is creating it or the market is still immature, which makes evolutions hard to predict. Many startups are founded to disrupt the market they are operating in. Lastly, the future investments often rely on the reaction of the market, which is hard to predict.

15 | eGuide - Startup Funding 2 Valuation of new ventures b. Market-based models VC Insights Market-based models are more relative valuation methods An interesting online document you can use is where you will use the benchmark of your market to evaluate the Noah Bible, a publication with the multiples and your startup. They are based on the assumption that similar valuation in all technology verticals in Europe. assets have similar valuations. The general way of working with these methods is to multiply a relevant KPI of your company with a multiple that is the standard of the market. A multiple is an indicator to value a stock. Some commonly used multiples are:

• enterprise value (EV)/EBIT (Earnings Before Interest and Tax) • EV/EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization • EV/FCF (free cash flow) • EV/sales • Price to earnings (P/E)

Below are two different methods to calculate this:

Comparable companies Analysis The first is the Comparable companies analysis (CCA). This analysis assumes that similar companies will have similar valuation multiples. Here you look at comparable listed firms. Usually, you look at three to ten companies with a similar profile (product, sector, geography…) and a similar financial profile (size, profitability, growth expectations…) and gather their financial information. With this financial information, you calculate the average or median of the multiples.

Comparable transactions Another method is looking at multiples from Comparable transactions. This principle is similar to CCA. You will look for recent similar transactions, based on the company and financial profile of the company and the profile of the seller. Then, you multiply the average multiple with your own KPI.

These are very easy ways to valuate more advanced companies. Startups on the other hand, are mostly quite unique and can’t really be compared to other companies. Plus, they often have a very different risk profile. Therefore, corrections should be made on the multiple.

A possible solution for this could be to look at recent transaction prices. Again, a similar way of working as mentioned above. You identify similar deals and calculate the average valuation. The downside of this is that it might be challenging to find publicly available information.

16 | eGuide - Startup Funding 2 Valuation of new ventures 2. Alternative methods

As the traditional valuation methods are often not easy to implement for startups, we would like to present some alternative methods to value your startup. The restrictions of the traditional methods and some insights of strategic management have led to more qualitative ways of valuation. a. Scorecard method One of these qualitative methods is the scorecard method. Using the scorecard method, you create a list of most important criteria that influences your valuation. Next, you weigh their importance and how well they score compared to the benchmark. This way, you get an adjusted weighting. You add these up for all criteria. Finally, you multiply this total score with the benchmark valuation. The advantage is that is the scorecard easy to implement. Please note that while it may be a hands-on method, it’s also subjective.

Criteria Percentage of the average scoring weighted value peer value (e.g. €5.0m)

Strength of management 0-30% 15% €0.75m team Size of the opportunity 0-25% 10% €0.50m

Product/technology 0-15% 15% €0.75m

Competitive environment 0-10% 0% €0.25m

Sales channels/marketing/ 0-10% 0% €0.00m partnerships Need for additional 0-5% 0% €0.00m investments Other 0-5% 0% €0.00m

weighted average €2.25m

Source: based on Payne, W. H. (2007). Definitive Guide to Raising Money from Angels

17 | eGuide - Startup Funding 2 Valuation of new ventures b. Berkus method This method is similar to the scorecard method. Each of the 5 criteria are worth $500.000.

If exists Add to company value up to

Sound idea (basic value) $500.000

Prototype (reducing technology risk) $500.000

Quality management team (reducing execution $500.000 risk) Strategic relationships (reducing market risks) $500.000

Product rollout or sales (reducing production $500.000 risk)

Source: Berkus, D. (2016). After 20 years: Updating the Berkus Method of valuation

The maximum valuation can be $2.0 million for a startup without revenue and $2.5 million for a startup that already generates revenue. This method is very easy but not very flexible. It doesn’t give users the change to assign risk elements that might be more important than those listed above. Also, it might not create a maximum valuation you’re willing to accept in a perfect situation.

18 | eGuide - Startup Funding 2 Valuation of new ventures c. Venture capital method e. Reverse engineering Another alternative method is the venture capital method. With reverse engineering, you calculate the valuation based This approach determines the present value of a company by on your financing need and the percentage of equity you’re discounting the expected price at the end of the investment willing to give away for it. By dividing the funding need by the period by the expected internal rate of return (IRR). This is the percentage, you get an implied valuation. This way, it’s very expected return of an investment. To calculate the valuation clear for both parties what they’ll give and receive. Please of your startup at the time of exit, you’ll need the following note that the valuation will largely depend on the cash burn information: of a startup. The more costs a startup makes, the higher its valuation, implying that it is very contradictory. • Your current income and forecasted growth rate: using this information, you can estimate the future income by exit For (pre-)seed VCs, the reverse engineering is often the go-to time. method as it barely needs any financial information. But also • Time of exit of the venture capitalist: this often depends on VCs that invest in later stages, will often use this method to the sector and the exit strategy. double check. • Profit margin after tax at time of exit (EAT/sales): based on your financial plan (see chapter 1), you can predict how much profit you’ll be making after tax at the time of exit. Alternatively, you can look at the profit margin of more mature companies in the same sector. Multiplying this with your future estimated income is equal to the earnings after tax at the exit time. • Price/earnings ratio (P/E): easy to calculate by looking at similar companies listed on the stock market since most financial websites will show their P/E ratio. Multiplying this with the earnings after tax at the exit time gives your enterprise value at the exit time.

These calculations result in a post-money valuation after the investment. To get the valuation pre-money, you should just subtract the amount that will be invested. d. First Chicago Method The first Chicago method is a commonly used adaption of the VC method. It works with 3 different scenarios. Typically the best-case scenario (most optimistic), a reasonable case (base case scenario) and the most pessimistic scenario (worst case). The best case scenario is the one we use in the VC method, assuming everything goes according to plan and there is a successful exit. In the base case scenario, the startup survives and will reach their break-even point but it won’t grow as expected and there won’t be an exit. In the worst-case scenario, the startup goes bankrupt. For each of these scenarios, the VC method is applied, so you will end up with three valuations. After the calculations of these valuations, probabilities can be applied to each scenario.

19 | eGuide - Startup Funding 2 Valuation of new ventures 3. Determining a valuation range VC Insights VCs will generally use three to four different methods to At our company (an early- and later stage eventually come to a valuation range. They use one main Belgian VC fund), we have an internal calibration method and use some others as verification, or they determine discussion to align on a valuation with all involved a weighted average of the outcomes of the different methods. team members. Next, after receiving the financial The weights of the methods depend on the stage and type of information from the startup and having several follow-up the startup. Reverse engineering, market-based methods and conversations, the valuation is determined. This will be previous valuations are often used as primary methods. For communicated with a non-binding term sheet. verification, VCs use DCF, the scorecard method or market based-methods (if they aren’t the main method). We advise startups not to start off with a valuation proposition during the first introductory pitch. This sets For more information we refer to chapter 3: “Term sheets” a precedent which may already negatively influence the valuation discussion. A tough negotiation may be harmful for the relationship that should go on after the investment. A valuation that both parties can agree on, is important for a sustainable relationship.

VCs in the Benelux often stick to the initially agreed valuation during the rest of the negotiation process. This is different than in the UK and the US for example, where they submit a relatively higher valuation (compared to EU investors), but this also involved clauses in the term sheets (e.g. full-ratchet anti-dilution, this clause protects early investors by ensuring them that their percentage ownership is not diminished by future fundraising rounds).

20 | eGuide - Startup Funding 2 Valuation of new ventures 4. Driving factors of valuation

Now that we’ve familiarized ourselves with different ways of calculating valuation, it’s time to take a deeper look at what drives valuation. a. Quantitative factors VC Insights Most VCs that invest in later stage startups, will find quantitative data more important. The most important factors It’s hard to list all factors because they’re are: often sector specific. But another quantitative factors that we look at is the customer base. For • The annual recurring revenue (ARR) and the growth (rate) example, the concentration of your customers. of ARR: this is for many VCs, this is the most important One customer that buys a lot is less favorable than many determinant of valuation. Not only do they look at the customers that buy little quantities. They also look at the current numbers, they will also look at the historical and international coverage of your customers. If you only sell expected growth and the growth rate of the annual recurring in one country, there is a chance that you’re a local hero revenue. and your product is country specific. The churn rate is also • Use of cash: VCs will look at the amount of money a startup important when looking at customers. They will also look at has already raised, and how they spend it. They will also bookings because they show a future revenue that’s already take into account the current cash position. This perspective certain. They acknowledge that KPIs are case specific so gives VCs a clear view on how much funding would be when looking into a new startup they will look for relevant needed, how much value they can add and how urgent it is. KPIs. • The future financial plan: an important source of information for investors because it shows a lot of information like your revenue and cashflows. • KPIs: VCs will look at KPIs like the churn rate (% of customers or users you lose), lead-times, the cost to get new customers over the revenue that customer will add (CAC/LTV) and the number of employees that work in your startup. b. Qualitative factors VC Insights VC firms that look more into the qualitative factors are often active in the (pre-)seed or early-stage. These startups usually Qualitative factors will be important when valuing a don’t have any existing numbers to use for a valuation. startup that only has an idea of their product. A VC Because most valuation methods need quantitative input for will then look at factors that point at higher chance their calculation, it’s harder for these companies and VCs to of success. Examples of this are founders that have get an accurate valuation. But even VC firms that focus on industry knowledge, passion, a co-creation with potential quantitative factors will look at qualitative data. For them, customers, a team that have already sold a business or that these qualitative factors will be more decisive to go or no-go. has proven they have operational success. Frequently used qualitative factors are:

• The management team: almost every investor checks on your management team because they play a crucial role in the startup since they are responsible for the startup’s growth. VCs like to see enthusiastic teams with unique and complementary skills. Investors will also look at the experience and track-record of the founders. This will play a significant role on the valuation. • Product: investors also look how innovative and exclusive your product is. They look at the technology behind it. Some VCs will even ask third parties for their opinion on your product. • Market: the market in which you operate is important to VCs since it shows your growth and internationalization possibilities. Also, your competitors are important for the valuation. Silicon Valley, HBO • Business model. Investors often find a business model that generates recurring revenue more attractive. Additionally, the type of client (B2B, B2C) is also critical to VCs.

21 | eGuide - Startup Funding 2 Valuation of new ventures 5. Valuation methods are negotiating tools, not measuring tools

Both traditional and alternative valuation methods have their limitations when it comes to valuating startups. Plenty of assumptions, the uncertainty of the startup’s future and the comparison with companies in different stages make a valuation very hard and subjective. Valuation is mainly used as a tool in the negotiating process. Some VCs use valuation as an argument in negotiations, they advise that entrepreneurs do the same. 6. Valuation isn’t everything

Valuation isn’t the same as price. Like Warren Buffet said: “Price is what you pay, value is what you get.” These two terms often get confused, but they have different meanings. A company generally gets valued when the owner wants to sell it and someone’s interested in buying it. The valuation will depend on who’s interested in buying the company, which method is used, and the time the valuation is made. Therefore, a company has several values but it only has one price. This is the one the buyer and seller agree upon. Your negotiation position and your arguments will have an impact on the price compared to the valuation. 7. The risk of a high valuation

VC Insights

If your valuation is too low, you will give away too much equity for a price that is too low. But a valuation that is too high, is also risky. When your valuation is too high, there is a chance that there will be a down round after and this has many consequences. It will be harder to get new funding rounds. New investors will be more hesitant to invest even if you have grown. It will also mean extra dilution with stricter terms. Investors could execute the anti-dilution clause following a down round. This means that the founders will have to give up their own equity to other shareholders. A down round is also harmful for your reputation and will be demotivating for your employees. In general it’s better to get a good investor on board that’s active and helpful than the highest valuation.

Conclusion

Unfortunately, there isn’t one right way to value your startup. We can’t give you one method that you should use for it, because it depends on a lot of different things. A pre-seed startup will use a different method than a growth-stage startup. Another important takeaway from this chapter is to understand how VCs perceive and calculate valuations, and the importance of valuation in the negotiation process.

22 | eGuide - Startup Funding 2 Valuation of new ventures