How to Value a Startup Company from a Trillion Dollar Investor

How to Value a Startup Company from a Trillion Dollar Investor

Venture capital is the oxygen almost all startup companies need to survive the “Valley of Death”.  The price paid by the entrepreneur for this essential ingredient to his fledgling company’s success is, like the price in any arms-length transaction, the result of a negotiation based on facts, emotions, and circumstances unique to each negotiation.  Is the price paid by the entrepreneur really based on the “value” of his project?  Finance professors in academia are likely to argue that the “value” of a startup project can be determined empirically, if only the necessary information can be gathered.   Then does “value” exist apart from a market-determined price derived from a specific negotiation?


In this post I will cover briefly the techniques academics would use to calculate what they might call true value, and in the process illuminate the practical problems that make these tools only marginally useful to venture capital investors.  This realization leads to my central point: what some people call “value” is more properly a “price” set by a marketplace under a specific set of conditions and circumstances.  Very few things have true intrinsic “value” that can be established so precisely that there would be no disagreements among participants in an open marketplace so that there would be complete agreement on the price at which a transaction could be done.  Even the broadest markets for common commodities with complete information sometimes trade with a wide spread between bid and offering prices.


So, the search for a true value for a startup company is probably a fool’s errand.  What needs to be developed is a price at which investors are willing to risk capital, and at which an entrepreneur is willing to share the rewards of his great idea with those investors.  Whether or not this price is anywhere near true value (even if such a thing could be determined) is completely irrelevant.  If there is no agreement on price, there is no investment, and thus, no new company.  This leads to my personal opinion of the bottom line of new venture pricing that I will flesh-out in more detail later:


Venture Capital Pricing =       60% Negotiation

20% Personal Evaluation of the entrepreneur

20% Numerical Analysis


Almost all of the factors in venture pricing are based on experience, intuition, domain knowledge, and unique circumstances.  Most are qualitative assessments.  The two parties to the negotiation, the investor and the entrepreneur, often come into the discussions with very different levels of bargaining power.  Marketplace conditions will very likely change markedly both during and after discussions.  But, in order for a deal to be struck, both sides will need to be comfortable that whatever price is set will allow each to meet his financial objectives.  That is the art of the deal.


The Science of Establishing True Value: Classical Finance Theory


One of the most accepted facts of investment finance is that the value of an asset is the sum of all future cash flows from that asset adjusted for the time value of money and the risks associated with those uncertain future cash flows.  In math terminology:




V = Value of an Asset or Company

n = Year

CFn = The amount of cash flow available to equity owners in Year n

R = Discount rate

8  = Forever


In order to use this formula to value a startup, we would need to make the following estimates:

  • Annual earnings available to equity holders for every year that the new company exists, forever ….
  • If the company is acquired at some point in the future, the acquisition price
  • Market interest rates for each year in the future that the company exists
  • Some rational method for adjusting for the following risks:
    • Estimation risk for all those future numbers
    • The risk of company failure; timing of failure
    • Dilution risks from required future capital infusions


Right …..


I won’t go through all the problems associated with coming up with reasonable estimates of these numbers.  Most would agree that forecasting even 3 to 5 years into the future at this detail level is extremely difficult, even for an established company, but for a startup?  Just the process of developing these estimates might actually lower the confidence of a potential investor with any humility.  If you want more details on the advantages and disadvantages of this approach, refer to thisthis, or this.


The Science of Establishing True Value: Practical Approximations


Recognizing the futility of deriving the necessary estimates to apply the classical finance valuation tools, some investors fall back to what is often referred to as the “comparable multiples approach”.  This approach takes advantage of the fact that capital markets exist to allow investors to trade securities, and that the prices set in these free markets are the best approximation of true value at any point in time.  This means that simple multiples (ratios) such as price/earnings or revenue/price are available for a wide variety of publicly traded companies.  All one needs to do to value a non-public company is to find a comparable publicly traded company, and then apply the public company multiples to the earnings or revenues of the non-public company to derive the estimate of the non-public company price.   Practitioners look for young public companies in the same industry, with similar capital structures, as the startups they are trying to value.


Of course, the problems with this approach in valuing startup companies should be obvious.  Startups are unlike publicly traded companies in many important ways: they are much more fragile in that they typically rely on a single product and a small management team, they are often breaking new technological or business model ground, and are far less liquid than public companies.  For these reasons alone, despite the fact that this approach appears far more reasonable than the classical finance valuation approach, it will, at best, provide only a gross approximation of the true value, or even the appropriate market price, of a startup company.


So, where does this leave the valuation issue, art or science?  I think it’s clear that almost all company valuations, and especially valuations of startups, are solidly in the art, or more correctly, negotiation camp.  But, investors and company owners can’t just pull numbers out of thin air and hope to reach some sort of agreement on price, so valuation theory must play a role, albeit as a check on reality rather than as the definitive method of reaching agreement.  Practitioners in venture capital, and to a lesser extent private equity, have developed techniques that bridge the art versus science valuation gap to assist the negotiations between themselves and entrepreneurs to set startup company valuations.


 Practical Valuation: The Venture Capital Model


It is worth reiterating a central concept at the heart of the so-called venture capital valuation model: the “value” of a startup company is nothing more or less than the “price” agreed by the entrepreneur and the investor team.  The price is decided through negotiations educated by valuation parameters and the experience of the investor team.  The venture capital model valuation process has four essential parts:


  1. Work with the entrepreneur to develop reasonable financial projections for the next 3 to 5 years or until expected profitability. These projections focus on the essential ingredients for success for the particular company being evaluated.  In some cases, the essential factors will be market penetration and share, in other cases the factors might be profit margins or cash burn required to sustain the expected growth.
  2. The investor team then translates the numbers from the financial business plan in step 1 into an expected “market value” that could occur from a public offering or a trade sale of the company at the point of profitability estimated in step 1. This translation typically uses the more simplistic comparable multiples approach described above rather than a full-blown discounted cash flow model.  There is also typically much back and forth between the entrepreneur and investor teams about this projected value, with the entrepreneur usually trying to demonstrate why the investor numbers are too low.
  3. Throughout steps 1 and 2, the investor team assesses the quality of the entrepreneur team to determine if additional talent will need to be added immediately at some additional expense, and how much help and guidance will be required from the investor. An important purpose of this assessment is to gauge a key element of the overall risk to the investment.  It is only fair to point out that, at some level, this becomes a binary assessment.  That is, there is an absolute minimum level of perceived entrepreneur team quality below which no deal can be done no matter how attractive the project.  This level is, obviously, different for each investor team.  Some investors may try to work with the entrepreneur to shore up the team; others will just walk away.  In any event, it is in the investor’s best interests to get to this assessment as quickly as possible so that there is no wasted team time on a project that just is not going to get financed.
  4. The final step is to translate the future “maybe” value of the company to a price the investor is willing to pay today in the form of a capital investment. Mathematically, this is a simple process:



CV0 = Today’s Value

FVn = Expected future value at year n

n = Year at which future value is calculated

R = Investor’s required annual rate of return


Perhaps the most important variable in this formula is R, the required return to the investor to finance the project.  The investor’s required return is a complex function of expected time to payout, confidence in the numbers from the financial business plan, confidence in the entrepreneur team, competition from other investor teams for the deal, the negotiating skills of the entrepreneur, general capital market conditions, and often, factors unique to the investor team such as how performance has tracked on other investments the team has made from the fund that would be making this investment.


Typically, an investor team would work from a basic pricing matrix similar to the one below as a starting point (this matrix is for example only and may not be indicative of current market conditions) and then make adjustments based on the factors listed above:



Defining each column in the matrix:


State of Company Development:  As a practical way of consolidating several risk factors, investors typically categorize the development level of an investment prospect company.  In this example, the diagram below illustrates how a venture investor might define a set of such categories:

(R) Required Annual Rate of Return: This is the discount rate at which the future expected value of the startup company will be discounted to compensate for the time value of money and for the risks associated with the investment, including the possibility of total loss, to determine the price the entrepreneur pays today to obtain the capital he needs to build the company.  This is the annual return the investor would receive if the future worked out exactly as planned.  In fact, that would be a rare event.  Some investments do better than expected; some do far worse.  The returns venture investors actually have received, on average, are far lower than the numbers shown in the table.  Total losses do occur, and investors must assume that they will.  So, they naturally build a bit of a cushion into the prices they pay for investments to make up for the disappointments.   On the other hand, the entrepreneur tries to keep the cost of capital as low as possible so that he can enjoy the rewards of his idea.  This is the area where give and take (typically hard negotiations) occurs to get the point where both sides are satisfied with the price to be paid.  The numbers in this table are definitely not static, either across time or across venture investors.  They are subject to a wide range of situations and market conditions, and are very difficult to “observe” without actually being in a negotiation.


Implied MOIC:  MOIC is an abbreviation for “Multiple of Invested Capital”, which is simply the total value of an investment at some future date divided by the original investment amount.  This return measure is preferred by some investors because it captures the effects of both annual return and the time period over which the return was earned.  An investment capable of delivering a 100% annual return over 5 years (MOIC = 32.0 times) would obviously be preferable to an investment capable of delivering the same 100% annual return, but only for 3 years, not 5 (MOIC = 8.0 times).  Since 100% annual return investments are very rare, almost every investor would prefer the 5 year investment to the 3 year investment.  The MOIC columns in the matrix translate the annual return expectations to MOIC expectations over a 3 year and a 5 year time horizon.


With all the pieces in place for a Venture Capital Method Valuation, take a look at the example below:



  • “Pre-seed” development level company
  • Expect to make a trade sale (through acquisition) of the company when it becomes profitable in 3 years
  • Confidence level in projections is average
  • Entrepreneur team is good, but not great, and will require some hands-on assistance from the venture team


With these assumptions, the investor team is likely to require pricing so that it can achieve an annual return at the upper end of the return range, for a “pre-seed” company, say 70%, leading to the valuation for today of $61 million as shown below. This is known as the “Pre Money Valuation”.


Note that if the entrepreneur is able to convince the investor to accept a mid-range required return for this investment through effective negotiations, the today valuation would increase to more than $73 million.


The final calculations to be done are “Post Money Valuation” and the amount of equity the entrepreneur must give up to raise various levels of venture financing:


Post Money Valuation = Pre Money Valuation + Capital Provided by Investor


% of Equity Acquired by Investor = Capital Provided by Investor / Post Money Valuation


The table below provides examples of these measures for various levels of venture investment:



This table clearly indicates that while it is very important for the entrepreneur to negotiate the best deal he can with the investor regarding valuation, it is far more important that the entrepreneur limit the amount of capital he accepts to the amount he actually needs to reach the three-year milestone.  Frugality here will pay off handsomely three years down the road!


One of the most important tools in REXtm to accelerate the development of new products and companies from scientific research is the Launch Moneytmportal created to help entrepreneurs raise pre-seed investment funds for their projects.   Within Launch Moneytm, there are guidelines to assist entrepreneurs in setting the prices at which equity shares can be offered to investors.  These guidelines are based on the Venture Capital Model described above.  However, since entrepreneurs using our Launch Moneytm portal will not be negotiating one on one with an experienced venture investor, but will instead be posting offering prices for investors to take or leave, we will provide current readings of the marketplace to assist entrepreneurs much like the “Required Rate of Return” matrix shown above.  By providing this information to entrepreneurs we hope to assure investors that the offering prices on Launch Moneytm are fair and reflective of current market conditions.


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