MyFondia VirtualLawyer
April 26, 2013

How to define the value of a startup?

Some time ago I found myself in an interesting discussion about the valuation of startups. In other words, we tried to find answers for what is the value that a competent team can expect of their business that has not yet been commercially tested? The discussion also lead to a four-minute video (in Finnish) on the valuation of startups and the investors’ criteria for investing in startups.

Classical valuation methods

From the classical point of view, the value of a company can be defined at least with the following methods:

  • The net asset value (NAV) of a startup can be defined by summarizing the company’s assets and liabilities. The net asset value method works especially in equity intensive industries, but the net assets of startups are usually non-existent. Therefore, this method does not help much in the valuation of a startup.
  • The net present value (NPV) of the company’s discounted cash flows is determined by first predicting the company’s future cash flows and then using the tax-adjusted average cost of capital discounted at the valuation date. However, predicting the future of startups is very difficult. Often, the founders of a startup dream of quick international expansion, which is also reflected in the company’s figures. With these predictions, the present value of the company’s discounted cash flows may be astronomical, which is why this method is also not very useful when valuating startups.
  • The reproduction cost method aims to define who much it would cost to build the company from scratch to the state it is at the valuation date. This method may work for startups, but does not give a flawless answer of its value.

What happens in practice?

In practice, the investor usually considers the valuation from a completely different view point. Negotiations with the founders give the investor a fuller picture of the company’s needs for financing. After this the investor considers what would be the best ownership structure after the financing round, meaning how big a stake does the founding team need to be left with in order to keep them motivated. This calculation, called the pre-money valuation, estimates the value of the company before the financing round.

My own experiences from the startup field indicate that a market price level has begun to form for startups in Finland. In most cases that I’ve seen, a company that has a great idea and team behind it but not much to show of actual implementation, has been valued at 500.000 € - 1.000.000 € before the financing round.

Naturally each case needs to be considered separately: some companies should not be invested in even at a low valuation, whereas for some companies the valuation could be a lot higher than the range mentioned above.

Ratchet clause

In the ratchet model, the investor and the startup can agree that the valuation of the startup is tied to the company’s targets. In practice, the parties usually agree on a higher initial valuation, that is later adjusted (by giving the investor additional shares without consideration), in case the startup fails to meet its targets.

The ratchet model may be a practical model for agreeing on the company’s valuation. The startup may get a higher initial valuation than the investor would have otherwise agreed to. The investor, in turn, will be reimbursed in case the targets that the company pitched to the investor prove to be unrealistic. However, startups should keep their cool when negotiating a ratchet clause. The targets of young startups tend to be a bit too ambitious, causing the value of the company to set at the lower range of the valuation agreed in the ratchet negotiations.

How to proceed in practice?

When seeking financing, startups should keep the following things in mind:

  • Getting financing may take up to six months, so start the project early.
  • Consider carefully and critically how much you need financing and what for.
  • Choose potential investors carefully. Investors are most attracted by companies with an interesting business and a shared set of values. These kinds of investors are also of most value to the startup.
  • Be open about potential risks and lay your cards on the table already when negotiating. Investors do not like unpleasant surprises that appear later down the road.
  • Valuation is not just about the first financing round, but rather think of your company’s value in the long run. If further financing rounds are needed, they go a lot smoother if they can be made at a higher valuation than in the previous round.