When we value a company, we value its equity (the Market Value of Equity) to determine the price paid for a transaction (acquisition, financing or other) where the investor receives ownership, which is an equity stake. The valuation can take place also for information purposes for debt financing, but it is mostly relevant for equity transactions.
When we talk about startup valuation, we use different terms than we would use in standard valuation, where we refer to Enterprise or Entity Value and Market Value of Equity to indicate the value of a company with or without its net debt (plus other adjustments).
With startup valuations for financing purposes, these terms are rarely used. Also, a startup is unlikely to have net debt or non-operating assets, and therefore the Enterprise Value usually equals its Market Value of Equity.
For startups, you will instead often see the terms post-money valuation and pre-money valuation.
Pre-money valuation refers to the value of the company before the investment. Post-money valuation refers to the value of the company after the equity financing has taken place.
The equity stake is calculated on the post-money valuation, which represents the Market Value of Equity in the traditional sense. The scope of using these terms, particularly the use of the ‘pre-money valuation’ is mainly to calculate the correct portion of shares before and after a transaction with its fully diluted value, which we will see later.
In many cases, an early-stage startup valuation is not calculated, but rather it is assumed based on the negotiated terms of the transaction.
The assumed value of your startup is calculated by dividing the investment needed by the amount of shares (or stake) given away to the investor, to arrive at the post-money valuation. This reveals the underlying or assumed valuation based on the investment that is at the basis of the negotiations:
Subsequently, we can also calculate:
Pre-money valuation = Post-money valuation – Investment
The calculation of ownership is then illustrated as follows:
|Pre-Money Valuation||$ 4 million||80% (existing shareholders diluted by 20%)|
|Investment Amount||$ 1 million||20%|
|Post-money Valuation||$ 5 million||100%|
SHARES AND CAP TABLE CALCULATION
Calculating the number of shares owned at each round, pre- and post-money is slightly more complex.
At each equity round, new shares are issued. The price per share that the venture capital investor is willing to pay is:
Per share price = pre-money valuation / total number of shares outstanding
|Pre-Money share price||$ 4 million|
|Total Number of shares outstanding||4 million|
|Pre-Money share price||$ 1|
The number of new shares to issue is calculated as:
New Shares issued = New Investor Stake x Post-money Total Shares Outstanding
|New Investor Stake||20%|
|Post-money Total Shares outstanding||5 million|
|New shares issued||1 million|
In the same way, we can calculate the post-money valuation as:
Post-money valuation = New Investment x (Total post-investment shares outstanding / Shares issued for new investment)
The total number of shares outstanding is also calculated on a fully-diluted basis in the Cap Table: this means that the total number of shares will include all outstanding common stock plus all outstanding options.
A Cap Table example is displayed below, with investment, pre-money and post-money shares calculated for each round, based on the pre-money share price calculated. TFD is the Total Fully Diluted amount, including ESOP (Employee-Stock-Ownership Plan) and other options not yet realised: the share price will be based on the fully diluted pre-money shares.
We’re not going to explore the details of valuation techniques here. However it’s worth mentioning where assumptions regarding funding amounts and stakes originate. For a startup investor, typically the only return will originate from an exit. This is why, even when an exit value is not calculated, a company’s valuation and investability will depend on its exit potential.
For example, when a founder states that they have no intention of selling the company, the company cannot be VC investment material, and it cannot be considered a startup usually. It’s not a negative decision, as the company may be able to reach profitability earlier and become an established SME without external finance, even if at a lower pace. it can also be an investable company once it reaches sufficient profitability and it can sell minority stakes in exchange for dividends.
A strategic exit entails the acquisition of the company by a corporate with a strategic interest and possibly synergies to develop with the target company. This is the most common type of exit sought among startup as well as other businesses.
An IPO is also a possible exit strategy among startups and it is most useful among startups with unicorn potential, as this allows them to invest significant amounts of money into expansion and market dominance, and to create synergies by acquiring other companies.
The company’s stage, which determines the risk, and the expectations regarding the exit size would flow into negotiations and valuations decisions.
At seed stage, an investor may expect 15x-20x return from an investment, not because this is the return on the portfolio, but because the successful investments will need to compensate for the other portfolio investments that have failed, leading to a preference towards startups with unicorn-potential. In reality, VC portfolio have more modest returns of around 15-20% per year over the value of the portfolio, probably equalling around 2-4x the initial investment. Most early-stage investment will fail completely, while some may fail in VC terms, as they may survive but not exit or just return the amount invested, while very few will meet the set exit expectations.
Another reason for the lower valuation set for seed stage startups is the expected dilution, which will render the initial investment smaller and smaller the more funding rounds a startup needs.
At more advanced stages, due to the reduced risk and therefore a higher amount of portfolio companies that will succeed, the initial return set at the basis of the valuation is lower, for example it can revolve around 7-8x at Series A, and 3-5x for more advanced private equity funding rounds.
In a future post, we will see how we can use these figures to apply the Venture Capital valuation method.
Calculate your Startup Valuation assumptions and expected Exit Value below: