How to value: Startups

Valuing a company is one of the most integral parts of investing. After all, to make a smart investment, you have to assess the value of what you’re buying! Of course, different types of companies demand different approaches, so we’ll be looking at a variety of valuation methods. Today we’re looking at startups.

Before he started a tech company, our CEO Adam was an investment banker. He spent a lot of time on valuing companies. Reading through thousands of balance sheets and analyst reports. Fun times. 🎉

This experience has come in very handy — not least during our own fundraising rounds!

Crowdfunding was the original spark that lit Freetrade! It completely aligns with our own mission to open up investing to everyone.

Where before the startup investor pool was limited to the very wealthy, big institutions and VCs, now, in the UK at least, individual investors of all kinds have access.

As keen investors, a lot of our team have put their money into crowdfunding rounds. Viktor and James are probably in the lead right now.

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However, while startups are an exciting asset class, you should still assess them with as much care and rigour as any investment. We’ve seen our community and obviously our investors are interested in crowdfunding too.

So we thought it would be worthwhile to reflect on the methods and techniques around valuing startups. We’ll focus more on early stage startups, as this is where most crowdfunding opportunities are right now. 🤔

How do you value a startup?

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It’s not easy!

There are a lot of structured methods for valuing large private or public companies. These are usually based around detailed financial statements and metrics like company assets, cash flow, or earnings.

For startups, especially early stage startups, these methods are less relevant/worthwhile. Most are (or should be) in high growth mode. Depending on the industry and timeline, they may not be generating cash or profit for a long time. 💸

Depending on the size, they’re not required or expected to disclose the same level of financial detail as a large private company, let alone a public one. After all, a biannual financial report won’t really give you an accurate picture of a startup that’s scaling fast. 🏎

For startups, the value usually exists in terms of future potential and this is a tricky thing to measure.

So what do startup investors rely on?

Comparable businesses

This is a pretty simple approach.

In this method, you look at the valuations of similar businesses to the one in which you might invest. You then use this comparison as your yardstick for a fair value on the company.

For example, if a startup brewery with £1m annual sales has been valued at £5M by other investors, the value of a very similar brewery with the same sales shouldn’t vary too much.

If it does, they need to justify that with a competitive advantage or innovation. Like their own distribution network, a growing brand or a special manufacturing technique.

This can be a quick, simple way to find your bearings and make sure you’re not paying way over the odds. 💪

However, if valuations in a sector are crazy across the board, the comparison could still steer you wrong. It can also be difficult to find exactly comparable businesses, especially as startups tend to avoid disclosing very specific financials to compare.

All in all, this method is probably best used in concert with other techniques.

The scorecard method

The scorecard method is a step-up from the comparable business approach. First you establish that average valuation for equivalent companies. Taking the brewery example, we’ll say £5M again.

Then you tweak the valuation based on a weighted scorecard measuring the unique qualities of the business.

Depending on the investor, the scorecard might be weighted:

• 30% Founder or team quality
• 25% Potential market size
• 25% Product
• 10% Competition
• 10% Marketing and sales

To score the business you multiply each quality by a factor. If you think a quality is only average, multiply it by x1; if it’s better or worse, multiply it by >1 or <1.

For instance if you think that the founders of the brewery were much more impressive than average, you might multiply that 30% by 1.5 and score them at 45% in that category. If you think the product itself is average though, it only scores the average 25%.

Assuming everything else is average too, you end up with a scorecard like this:

• 45% Founder or team quality
• 25% Potential market size
• 25% Product
• 10% Competition
• 10% Marketing and sales

Then you just add up all the percentages: 115%.

Since your startup scored 15% above average then it could suggest a 10–15% premium on that £5M industry average: c.£5.5M.

Obviously, the scoring and the weighting are pretty subjective. However, this is an engaging way to judge a company when financial metrics are scarce.

User lifetime value

A slightly more technical route is to look at the lifetime value of a user or customer.

A pitching startup will often disclose revenue, growth rate and user numbers, as well as their own figure for the lifetime value (LTV) of those users.

Lifetime value is all the potential gross profit generated by an average user/customer. That’s all the revenue a customer brings in minus the direct costs of providing of service.

So in our brewery example, that’d be roughly the revenue from every bottle of beer a customer buys minus the costs of brewing the beer, getting it in the bottle and in their hands.

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The longer you can retain a profitable customer, the more lifetime value you can generate.

For a SaaS (software as a service) business that runs on subscriptions or a similar service-led model, the lifetime value is often assumed to be higher because subscriptions are particularly sticky — much more so than a business that depends on repeat purchases.

It’s why, for instance, Amazon Prime has been such a success. When was the last time you cancelled a subscription?

If the company discloses customer acquisition cost too, you should also compare the lifetime value to that cost too. Acquisition cost is all the marketing, discounting and salesmanship that goes into winning the customer in the first place.

Divide the lifetime value by the acquisition cost to calculate a ratio; 3x more value than cost is generally the rule of thumb. It shows whether the company can make a decent return on the money needed to gain customers.

If you can work out a fair lifetime value and predict how many users they’ll eventually get to (or agree with the company projection), you can calculate a valuation. Just remember to lower that valuation to reflect the risk and the time you have your money locked away.

The VC Method

Many VCs, though not all, rely on a more formal approach: the imaginatively named ‘Venture Capital method’.

Using this method, VCs will look at various data points including lifetime customer value but also revenue growth, potential market size, competitor valuations and most importantly discounted cash flow — basically an estimate of how much cash the company will generate in the future.

With these metrics, they project a future valuation in 5–7 years time when they might expect an exit — though it’s often taking longer for companies to go public these days.

Then they’ll discount/lower that valuation to compensate for the time you’ve got your money locked into the investment, as well as the inherent risk of the startup.

The VC method has advantages: it’s data-heavy, accounts for risk and has a degree of objectivity.

The downside is the inherent unpredictability of financial metrics; the more metrics you estimate, the greater the possibility of unexpected results. Don’t be dazzled by the complexity: there’s still plenty of uncertainty in the VC method.

Be aware as well that VCs diversify across different startups as part of their strategy to temper some of that unpredictability. So their method can afford to have some extra slack built in.

Rewards

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This is a kind of a sideways approach. Some companies that crowdfund (including us) offer rewards to their investors like discounts or special features.

If you’re definitely going to use the company’s product enough to make back your money on the rewards, working out the company’s potential value might be less relevant than the specific value it has for you.

For example, say the brewery offered half price pints to all their investors over £500. If you know you’ll drink enough of their beer that even if your investment goes nowhere, you’ll still benefit from the offer, then the investment might make sense for you.

As long as the company stays in business and keeps delivering its rewards, this approach is pretty watertight. Just be sure you won’t mind if the investment itself doesn’t work out.

Company valuations are hard. Startup valuations are harder. It’s unlikely you’ll be able to value a crowdfunding company with as much confidence or detail as a public one. That’s why it’s a higher growth, higher risk investment opportunity! There are more unknowns. 🤔

However, these are still methods worth considering, especially if you’re investing a significant amount.

And remember even a great crowdfunding investment will likely keep your money tied up for some time, so you definitely don’t want to go in with nothing but dreams and daring.

We’re interested to hear everyone else’s experience with crowdfunding and how they made their investments. Just head to our dedicated topic in the community.

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At Freetrade, we think investing should be open to everyone. It shouldn’t be complicated, and it shouldn’t cost the earth. Our investment app makes buying and selling shares simple for beginners and experienced investors and keeps costs low. So download the app and start investing today. Choose from a general investment account and a tax-efficient stocks and shares ISA or SIPP account.

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