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Finance

Chair « Finance for innovation » NL #3 - Publications

01 août 2019
Determinants of Start-up Valuation

The valuation of a startup: the fruit of a rational process?

Valuation is considered, rightly or wrongly, as the main unit of measure for the success of a startup. The example is given again this month through the goal of 25 unicorn startups by 2025 set by President Macron. The reasoning for this is clear; the valuation of a startup is characterized by supply and demand for capital. This explains why a startup deemed promising is a highly valued startup. But what are the determinants of this valuation? While the mortality rate of startups is particularly high, some start-ups regularly emerge with exponential growth rates, valuations increasingly important sometimes unpredictable. How then to deny, a significant part of subjectivity in the valuation process? Finance has been developing more and more precise calculation models since Gordon Shapiro in order to obtain the most reliable share price possible. What place do investors really give to its valuation methods facing unpredictable companies however? In short, to what extent is the valuation of a startup the result of a rational process?

Investing in a startup is a subjective decision.

A study conducted by Early Metrics in 2018 shows recurring characteristics among startups who have successfully completed their fundraising at the desired value. These characteristics, of qualitative nature, show the strong impact of subjectivity in the valuation process. They relate to indicators, management, and the process of trading valuation. The indicators. Among the indicators with high impact for the investor, we observe the degree of innovation of the startup. The higher the degree of innovation, the more the valuation will be impacted.  

Nevertheless, several questions emerge: how to accurately and rationally evaluate the degree of innovation between two startups in the same sector? Is there one type of innovation more valued than another? The perception of innovation seems preponderant. Another indicator relates to influence in the press and in social media. Is it possible to distinguish two startups through the number of articles or media outlets, or through the engagement rate on social networks, how to measure the real impact of this influence? Indeed, a product can be widely publicized without really marking the opinion, when another less influential media will impact its market more. How to make this data appear in the valuation? From this difficulty in accurately assessing each of these parameters, the investor will make assumptions. The impact of management. The investor pays particular attention to the team, complementarity of skills, financial and technological competence, and ability to execute quickly. But is the investor sure to have a successful business strongly valuing all these features? A team with all these characteristics could be overly arrogant, compared to a less complementary but more unified vision team with an exponential learning curve. Moreover, in phase seed, how to measure and value with certainty each of these characteristics in a few interviews? The difficulty will also be to put a figure on the degree of complementarity of the team, which depending on the sector of activity may vary. The team is decisive in the valuation process, and rightly so. The success of the entrepreneurial project depends on it, as well as the good working and long-term relationship with the investor as well. Nevertheless, the difficulty of deciding justly on each of these points again shows the decisive nature of subjectivity.

The Process of Trading Valuation.

This is to control the risk for the investor. Risk may be related to dilution, if it is one of the first investors, or the loss of the investment itself in case of failure of the startup. It can then negotiate certain clauses within the shareholder pact that will protect it and on which it will accept in return an evolution of the valuation. For example, it may be a ratchet clause, or the purchase of shares preferably with specific liquidation conditions. Its impact on valuation is therefore entirely the result of negotiation between the entrepreneur and the investor. The opinion that an investor has of a startup is fundamentally based on extra-financial characteristics, the impact of which on valuation is initially rather unreasonable. However, investors will often complement this first step with more traditional valuation approaches.

A decisive impact of traditional financial valuation methods There are two main valuation methods generally used in the world of finance: DCF valuation and multiples valuation. To value startups, investors will use these methods, adapt and combine them. They will often serve as the basis for negotiation between entrepreneurs and investors.

A combination of these approaches with contextual assumptions gives rise to a third method that some call the VC method.

The DCF Valuation Method

This approach involves assessing future cash flows for shareholders or the company. They are updated by taking into account the risk for the investor. The evaluation difficulties related to this method are due to the lack of perspective on the history of the startup to establish reliable forecasts, and the inability to define stable growth on financing rounds in Seed and Serie A To circumvent this difficulty, investors establish shorter forecast periods, with a greater focus on the exit value than on the terminal value, and a consideration of the specific risk in the Internal Rate of Return. They often combine this method with the multiples valuation method.

Multiples Valuation Method

This time it is to establish a multiple through comparable companies within the same sector. Despite the difficulty of comparing a startup with other mature companies in the industry and establishing relevant benchmarks, investors are adjusting their benchmarks. The product, the growth potential, the maturity, the P&L, the cost structure are fundamental in the evaluation of the startup.

The VC Method Valuation Method

The VC method is a synthesis of several hypotheses established on the startup, and a multiple applied on certain aggregates of the P & L to give an exit value, while applying a discount rate according to the level of risk of the startup. Liquidity risk, the risk of bankruptcy and the risk of dilution are identified. This method is today the most used by VCs. The adaptation of each of these methods to the process of valuation of the startups shows the attachment of the investors to a base of decision which rests partly on the rationality. First, because it allows the investor to reassure himself. The mortality rate of startups is very high. The very uncertain nature of their success and therefore the relevance of an investment requires that part of the decision be based on proven methods in order to better understand any mistakes made and correct them later. Second, because it allows the VC to be able to establish processes. As the fund's dealflow is becoming increasingly important, competition is becoming stronger, establishing processes that allow more deals to be made, faster and with greater financial performance is almost a competitive advantage. It also makes it easier to convey good practices. Finally, we observe that this process of valuation is mainly a process that combines a maximum of assumptions both financial and extra-financial, both objective and subjective. It is the combination of all these factors that minimizes the risk and then works for the better.

by Yoro Fall, student at Audencia Business School, involved in the Chair


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