If start-up founders or management want to raise external venture capital to develop their business and grow faster, they will not be able to avoid a company valuation. Founders want to achieve as high a valuation as possible so that they have to sell or dilute fewer shares for the same capital. As the negotiating partner, investors have an interest in receiving an acceptable share in return for their investment. For us it is not about forcing entrepreneurs to part with as many shares as possible. Rather, it we want to motivate them as best as possible to work on increasing the value of the company. Part of this motivation are founders’ own shares in the company, which is why we are always minority shareholders.
When valuing a company, a distinction must be made between pre-money and post-money valuation. The connection is simple, however: post-money = pre-money + investment. In the negotiations the parties must agree on the pre-money valuation and the necessary capital. During development of the business, the company valuation must increase substantially faster than money is invested. This is how value is created.
The simplest company valuation is possible with liquid, publicly traded securities. To find out the valuation of SAP, Tesla or Shell, it is enough to look up the current stock market value. For companies that are not publicly traded, it is more difficult. In private equity, so-called multiples are often used, which vary by sector. Here, a value such as turnover or profit is multiplied by a sector value in order to obtain an indicative valuation. Another widespread and scientific method is discounted cash flow (DCF) whereby future cash flows are assumed and discounted to the present. The idea is that future money flow is worth less than today’s. This makes sense, because payments in the future are associated with risk and are not yet available for alternative investments. It would mean borrowing money in advance in order to be able to invest it today.
However, both methods are problematic with regard to start-ups. It doesn’t make sense to apply a multiplier to a company that isn’t making any profits yet (but is making losses) and which only has small sales. This approach would lead to very low or even negative company valuation. The DCF method isn’t suitable either because it is extremely difficult to assume future cash flows in a start-up without any history or reliable forecasts. You would have to price in a huge uncertainty factor, which, again, would lead to a very low valuation.
The typical approaches are therefore ruled out in a start-up valuation, which is why valuations are discussed on a case-by-case basis during contract negotiations. An approximation can be made via an assumed exit value after an assumed development and holding period. Calculations are made retrospectively from this exit point to estimate how much money is needed to achieve this goal. The calculations must also take into account any dilution the different financing rounds entail – risk must be considered in an appropriate manner. The second unknown, the assumed exit value, can be gauged via a peer analysis which shows valuations comparable start-ups have achieved. This, of course, gives rise to the next difficulty, which is finding “comparable” start-ups. After all, every start-up should have its USPs and shouldn’t really be comparable.
In summary, a fair valuation of a start-up is difficult to obtain, and it is not so much based on reliable factors. It is therefore the core business of a VC fund to assess technologies and business models, and ultimately to put a value on them without recourse to measurable KPIs.