March 1, 2020

Why is valuation important for a seed startup when fundraising?

Going through a fundraising process is a difficult process, especially for seed startups.

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In 2019, right before the current COVID19 pandemic, Swiss Startups collectively raised almost CHF 2.3 billion, a staggering 628% increase compared to 2012. Investors driven by FOMO (fear of missing out) and low-interest rates went on a spending spree and heavily funded startups in the hope of substantial future returns. A couple of recent events, such as WeWork’s failed IPO and Lime’s last round of financing (valuation dropped from $2.4 billion to $ 400 million), highlight the craze that has formed around venture funding. COVID19-related layoffs at Airbnb and Uber could be a preview of what is to come and what we keep reading everywhere: a drop in valuations. However, in a future post Corona time, you will most probably keep moving around in the green scooters and book your accommodation for your next trip to Lisbon on Airbnb. So what is valuation, and why does it matter?

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Valuation is the exercise of defining the economic value of a company (or asset). It is often different from the price, or in Warren Buffet’s word, “Price is what you pay, value is what you get”. Let’s take a concrete example, suppose you want to buy a specific 4K TV on Digitec, and the price is CHF 650. You take the night to think about it, and the next day, the same TV is listed at CHF 550 on the same website. As the TV’s quality and features stayed the same, you get an equal value at a lower price. This example also highlights that value is like beauty; it remains in the eye of the beholder. I use my TV mostly for Netflix while some of my colleagues are avid gamers. Therefore, we do not extract the same value of the same object. Digging a bit further, we could distinguish between absolute value, relative value, and perceived value.

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Absolute value aims to determine an asset’s worth by evaluating its intrinsic features. One of the most popular methods to calculate it is the discounted cash flow (DCF) method. The future cash flows of the company are forecasted and discounted back to get a single number, the present value. While this method is mostly used for assets with steady cash flows, it can also be a useful tool to value early-stage startups without vast historical performance. However, forecasting future cash flows is more an art than a science, and the final result heavily depends on the discount factor chosen. If you want to learn more, Investopedia wrote all about it here.

The relative value looks at the asset worth by comparing it to similar assets. It is one of the most natural and easiest ways to estimate the value. Scott Gallaway, professor at NYU, gave an excellent example this year by comparing Tesla's value per car to its competitors.

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We can agree a Model X is more stylish than a Prius, but we can see a significant difference in how these companies are valued relative to the number of cars sold.

The challenges of relative valuation are mainly to find the closest competitors at a similar development stage, the most relevant indicators, and to pay attention to market momentums. The market comparables and industry valuation multiples are the most common market methods to evaluate pre-revenue startups. Traditional metrics that can only be applied for revenue-creating startups are enterprise value/revenues and enterprise value/EBITDA. Here is an article with a more detailed explanation.

Finally, perceived value is the most subjective of the three concepts. Increasing perceived value is the marketing team’s bread and butter, and it is what makes someone spend an extra CHF 300 to get an iPhone instead of a Samsung with similar features. Perceived value is usually intangible and is derived from brand reputation, product design, and public recognition. It is harder to quantify perceived valuation and its impact. Bitcoin is one of the most extreme examples. For some, it’s a useless digital coin with little value, while for others, it’s the future gold.

Now that we clarified the concept of value, why is this useful for startup founders? In most cases, the valuation topic comes up at least once every couple of years when it’s time for a new financing round to know how much equity founders will have to give away in exchange for financing. Well, there is more to that.

The absolute value gives founders a roadmap of what they need to achieve in the future years and can compare their performance to what was expected from the original plan. By setting and achieving concrete milestones, they can create a track record and prove that they know where they are going. It also creates a sense of accountability as the company has to reach expectations to justify its valuation to generate trust and enough growth to raise a future round. Finally, it can also help founders during day-to-day operations by identifying critical KPIs and potential ways to strengthen their business.

Founders will also find relative valuation very useful. It gives them an insight into the potential funding the startup can receive according to its stage, and a relative idea of how “hot” the market is. It is also valuable to compare critical metrics when available. For example, a SaaS company could compare its growth rate, ARR, CAC, and LTV to peers in the same industry to benchmark its performance.

For early-stage startups, valuation is usually a long and tedious process. It often seems like looking in a distorted mirror filled with ugly truths, unreachable milestones, and out of this world competition. However, one should know that valuation is not only about obtaining one final number. It forces founders to have proper financial planning helps them gain insights about their business model’s revenue streams and cost structures, discover valuable market intelligence, and most importantly be well prepared for negotiations when facing investors.

At BV4, we have our own independent valuation methodology for startups that consists of three different valuation models. If you want to know more, have a look at our website and don’t hesitate to contact us.