Valuation of a startup
A startup investor’s ownership percentage is based on the company’s valuation relative to the amount invested. In order to determine how much of their company the founders have to “give away”, a company valuation is required.
Mature companies are usually valued on the basis of the cash flows to be generated (discounted cash flow method) or by direct comparison with the market valuation of similar companies (multiplier method).
But how do you evaluate a startup that, after all, usually has no sales (let alone a positive cash flow)?
First of all: A startup rating is not the result of an arithmetic operation. Instead, it is primarily the result of the investor’s subjective assessment and negotiations with the founders.
The investor will therefore draw on his experience and intuition to classify the idea and its protectability, the founding team, previous development progress and the competitive environment. The balance of power between the parties then plays a decisive role in the negotiation of the company valuation.
This calculation tool will help you to get an initial idea and to check the figures discussed for plausibility.
When creating the business plan, it is important for a founder to understand how the plan figures there affect the investment expectations of the investor. An early-stage investor will typically aim for an ownership interest of between 10 and 40 percent. The planning figures must therefore at least give an approximate indication of this in relation to the targeted investment and the possible return for the investor.
Important : Non-fund investors will often settle for a lower cash-on-cash return because they have a lower internal hurdle rate to overcome. Corporate VCs, in particular, often have lower CoC requirements because, in addition to the immediate return, the possible later technology transfer is also important to them (strategic value of the investment).
Also good: The calculation tool updates itself dynamically when entering data. This means that it can be shown very quickly how the results change, for example if the exit year changes or if the sales/profit targets are not reached. This gives you a feeling for the range of possible meaningful participation rates.
How does it work?
The tool works on the basis of the so-called venture capital method .
In the first step, a company value is estimated at the time of exit. Sales multiples are often used here, since the sales expected in the event of success can be forecast most easily. However, the tool can also be used with an EBIT multiple (in this case, of course, enter the planned gross profit in the corresponding field instead of the turnover).
This estimated company value at the time of exit (terminal value) is then calculated back to the time of investment. A high calculated target return (internal rate of return) is used here, which reflects the uncertainty of success.
The current company value determined in this way is set in relation to the required investment in order to determine the investor’s participation rate .
- The tool is designed for early-stage financing. Things often get more complicated in later rounds of financing, since, for example, different liquidation preferences have to be taken into account.
- The calculation assumes that the investor’s stake does not decrease in the period between investment and exit (no dilution). However, if the investor expects to be heavily diluted, they will seek a higher initial holding.
- Years until the exit : The exit is the realization of the increase in value of the investment through a private sale of the investment ( trade sale ) or in the course of an IPO ( IPO ). A startup investor typically wants to make a profit in the foreseeable future and is therefore not interested in only collecting dividends for decades. Instead, he is exit-oriented. The average holding period of a VC fund is 5-7 years. In addition, it is generally not possible to make a serious financial forecast for more than 5 years.
- Turnover or profit : results from the financial planning in the business plan. The estimates of the founders are often used as the maximum value. However, an investor will also calculate alternative scenarios for only partial target achievement.
- Multiple : The sales or EBIT multiple is selected by comparing it with other, comparable companies or transactions. Professional investors maintain their own data collections for this. As a rule, however, a deduction should be made from the FINANCE multiples, since these apply more to highly tradable company investments (which a startup investment is not). This is generally true for multiples derived directly from publicly traded companies. For a software startup, for example, you could calculate with a sales multiple of around 1 or an EBIT multiple of around 7. If the start-up has invented the next eBay and long-term above-average growth can therefore be assumed, significantly higher multiples can of course also be justified. However, to give some perspective: Smaller companies up to € 20 million in sales per year are traded (on average across all sectors) somewhere in the range of an EBIT multiple between 4.5 and 6.5.
- Risk assessment : venture capitalists expect high internal rates of return (IRR, internal rate of return) at the investment level in order to enable a risk-appropriate return across their entire portfolio (i.e. at fund level). For many scenarios, the preselected 50% IRR should represent an acceptable thumbs-up value for inherently risky early-stage financing. (Note: Some also assume a lower IRR, but then calculate the default risk elsewhere, e.g. by correspondingly high discounts on the expected sales price.)
- Investment : The investment sum results from the capital requirements of the start-up, which is derived from the financial planning in the business plan. In an early-stage financing, not all liquidity gaps are usually filled until the exit, but only those for the immediately upcoming development phase (e.g. until a significant development step is reached, such as the market launch of the product). There are later follow-on rounds of funding that will (hopefully) be completed at significantly higher valuations as exit is nearer and risk has been de-risked. However, the early-stage investor must take foreseeable future financial needs into account, since he can only prevent a dilution of his stake if he also invests in the follow-on-Rounds provides more capital.