How to Value a High-Growth Startup Company

Susceptibility to Biases

First, the projections that serve as the basis for the discounted cash flow model are typically provided by the subject company’s management and thus are susceptible to biases that might influence a value result in a particular direction. Further, the overwhelming majority of the time, projections are formulated using a top-down approach, which means that revenues are assumed to be equal to a percentage of the addressable market and expenses are set to be percentages of revenue. Projections produced by this method are dubiously reliable, at best. Finally, even for well-established companies, projections are considered potentially reliable to out to two years at most. Yet a two-year projection is nearly useless for startups as revenue and especially profitability may not be achieved for well after that point.

Disregarded Discounted Cash Flow Model

Second, and more convincingly, most early-stage investors don’t rely upon the discounted cash flow model when they determine the price that they are willing to pay for equity securities in a startup. Investors may review and test the discounted cash flow model to better understand the overall company thesis, but when it comes to pricing the deal, the discounted cash flow model is often not used.

Instead, investors rely on market data when pricing their investment opportunities. To understand this, it is essential to understand what a startup investment opportunity is from the early-stage investor’s perspective.

Random Outcomes, Loaded Dice

To experienced early-stage investors, investments in startups present random outcomes in which the investors hope the dice are slightly loaded to their benefit by virtue of their ability to select opportunities that are more likely to succeed than is typical.

The distribution of outcomes typically expected of startup investments resembles the following:

Outcome = Total Loss → 60% (meaning most or all of the investment is lost)

Outcome = Disappointing Return → 30% (meaning there is some recovery up to possibly a 10% return)

Outcome = Strong Return → 10% (approaching a 3x return on investment or greater)

Of course, the investor doesn’t know the category into which any investment will fall (they’d never invest in anything other than the strong returns!), so as far as they are concerned the investment outcome carries with it a substantial degree of randomness.

In essence, investors in startups are purchasing very sophisticated lottery tickets.

When the value discussion is framed in this way, it is obvious that a discounted cash flow model is not very satisfying as an indicator of value, just as nobody determines the value of a lottery ticket using a discounted cash flow model.

Market Approach in Valuation

Which leads us to the market approach. The market approach in valuation determines value by comparing the company to other companies bought and sold in the market and their respective prices.  When the market approach is used for conventional companies, value is expressed as a ratio of the price of the company to some financial metric, such as revenue or EBITDA.

But what do you do when the company has no profit, or even revenue? Simple, compare the company to the prices paid for companies with no profit or revenue! Where do we find these? In the $165 billion venture capital market (Source: IBISWorld).

Valuations Derived from Market Transactions

The key is to find startups that are similar in product offerings or industry, received funding relatively recently (in the last three years prior to the valuation date, but this may be shortened to avoid COVID deals), received funding of a similar type (e.g. seed capital, angel capital, Series A venture). Let’s say you assemble a group of peer companies like the following:

The average pre-money valuation is $5,275,000. Now, let’s say that certain features of our company make it less risky/more attractive than the companies in the peer group – for example, because of an unusually experienced management team or a strong intellectual property portfolio. This might lead to a 25% value premium, which leads to a value of approximately $6.6 million.

This simple example illustrates a startup valuation derived from market transactions, rather than the more common discounted cash flow model. The three advantages this approach offers include being relatively simply to execute, providing key market intelligence (fundings of similar, possibly competing companies) and replicating how the market values startups in practice. While this approach isn’t perfect (no approach is) it does provide a straightforward story that is supported by market facts that enables investors and entrepreneurs to be better decision-makers where providing or investing capital is concerned.