Valuation of Start ups

Prateek Mittal

For a start-up looking to raise seed capital, there is always a question of how much to value your business and how much stake to dilute. In this article, we will try to analyse the various means to value a start-up.

When we talk about valuation of a company, the first things that come to our mind are discount cash flow value or relative valuation or comparable companies. However, in case of a start-up both these methods may not be relevant. The primary component of the DCF value is the terminal value. The terminal value is calculated assuming that the free cash flows will grow at a steady rate (terminal growth rate). While determining the terminal growth rate can be tricky in itself and using a high value can extrapolate the DCF value multiple times. While using a terminal growth rate as a very low value may not be fair for the start-up company.

Relative valuation or comparable companies analysis uses the concept that a company should be valued similar to companies which are identical to the company in question in terms of size and business. However, in the case of start up again it might not be possible to identical companies with similar size and business operation and even if we find some company then the valuation of such a company might not be readily available as there are usually not many listed comparable companie

So now we come back to our basic question on how to value a start-up. Here are some ways which are used by the Venture Capitalists to value start-ups:

The Venture Capital Method: This method assumes return and terminal (or exit) value of the investment from the investors’ perspective. It takes into account the return on investment as envisaged by the investor and the value at which the investor assumes that it can exit from the investment at a future point of time. The terminal value can again be based on market potential and future growth outlook of the start-up company and the return on investment for venture capitalists is usually 20-30 times. For example, a venture capitalist estimates that the valuation of an investment will be $1000 million after 6 years and the return on investment expected is 20x.

So post-money valuation of the company = 900/30 = $30 million.

Reducing the investment amount from this value = pre money valuation = 30-5 = $25 million

So post-money valuation of the company = 900/30 = $30 million.

Assuming that the venture capitalist assumes that there will be 30% dilution in its stake over the period then the post money valuation as calculated above will be reduced by 30%.

Hence the final pre-money valuation = 25*70% = $17.5 million

Keep reading for more valuation methods for start-ups.