Subscribe
Share
Share
Embed
Telling the stories of startup founders and creators and their unique journey. Each episode features actionable tips, practical advice and inspirational insight.
00:00:00:00 - 00:00:28:05
Welcome to the Founders Journey podcast. Inspiration education for Founders by Founders. I am Greg Moran from Evergreen Mountain Equity Partners in the Founders Collective. One of the trickiest aspects of angel investing is understanding how to value a startup. It's something that, you know, even professional investors wrestle with all the time because their early stage the company is just the more subjective it really becomes.
00:00:28:06 - 00:00:54:22
There's no real clear earnings history or stable cash flow. So valuing a startup can really be like a guessing game. In today's video, I'm going to guide you through some of the most common startup valuation methods. So in Tips, we're going to get into tips for evaluating fair value and ways to negotiate terms that make sense for both you and the founders and help you avoid some of the common mistakes that occur when you're trying to invest in early stage companies.
00:00:54:22 - 00:01:34:06
So by the end of this, you can have a strong foundation for assessing valuations in your own investments. Let's start here. Unlike really established companies, startups don't have a stable revenue stream. They may have revenue, but it's not necessarily something that you can really rely on in many cases. Or it's very new or and they're just really it's not a scalable, really predictive revenue stream in many cases, let alone profits which of which, you know, really if ever, are they going to have any early stage valuations are essentially trying to predict future potential then actually measuring current performance, which makes it really difficult.
00:01:34:08 - 00:01:57:13
This and it also what it does it makes it really subjective. So start of valuation methods really usually rely on assumptions about growth potential, about the market opportunity and about the quality of the founder in the team, which are really kind of paramount to when you're looking at trying to assess what is the long term potential of this company and in your investment.
00:01:57:15 - 00:02:28:23
So when done well, though, valuation really helps align a founder and an investor around the expectations. And really what it does is it allows both parties to set terms that are mutually beneficial and helps the company in the long run to scale, whether that's, you know, bring out enough capital, bringing in future capital, things like that. These become really important areas where that early stage valuation has a lot of downstream impacts that, you know, without if you don't have experience, you are hard to see coming sometimes.
00:02:28:23 - 00:02:54:18
And many founders don't really understand that and really just look at it as the highest valuation I could possibly get is the best one. That's often not the case at all. Let's get into some of the ways to look at valuation of early stage startups. One popular method is the comparable company analysis, or what's called a CCAR. So what this does is it looks at valuations of similar companies in the same industry and stage.
00:02:54:20 - 00:03:19:20
Now oftentimes you may if you're making investments in technology, you know there's usually a track record you can follow. There's you know it's healthcare tech or it's fintech or something like that. And by comparing recent investment and similar startups, you start to get a ballpark valuation for the target company. Now things can move, but it will put you within a reasonable radius of knowing if you're in the right.
00:03:20:02 - 00:03:37:09
If you're right in the area. So, you know, give you an example. If you're looking at a health tech startup that's really early stage, you can check recent valuations for other health care company or other health tech companies that are at similar stages. Look at the ranges of those valuations. That's going to give you a good ballpark to start your negotiation.
00:03:37:09 - 00:04:02:00
So some pros and cons here cause it's really straightforward. It provides market based valuation. So it's a pretty easy standard method to get a to get a range. But the downside is it can be challenging to find comparable companies, especially if your target startup has a unique model or it operates in like a really niche sector. Sometimes the data is just not really there to use as a comparison.
00:04:02:01 - 00:04:33:23
You want to consider just from a tip, if you're thinking about using k as a as a valuation method, consider the unique qualities of the target startup as well compared to its competitors. Getting those comps doesn't necessarily tell you the exact number or the exact valuation, because you do then want to start to look at those inequalities, things like the experience of the founder of the team, the technology, scalability, differentiation, things like that, and then you can adjust your valuation expectations, accordingly based on those things.
00:04:33:23 - 00:05:01:15
So the second method that we're going to talk about is what's called the S method. And this is really useful if you're dealing with a very early stage startup. So with Burke is method does is it assigns a value based on five core factors sound business idea like which quality the business idea. The prototype is there one in which quality of that the quality management team, like the quality of the management team, is a strong management team.
00:05:01:17 - 00:05:29:15
Strategic relationships that maybe the company has partnerships, things like that, that give it a unique advantage. And then the product rollout. So if the each factor is given a monetary value, typically up to say $500,000, right, resulting in a maximum pre-revenue valuation around 2 or 3 million, it's kind of how you would look at this, right? So it's sort of putting a cap on it saying, okay, we're going to value each one of these five factors at $500,000.
00:05:29:17 - 00:05:51:15
And if we've really maxed out the scale there, we're going to give it full value of say, the quality of the management team for 500 K. Maybe there aren't a lot of strategic relationships, which is another one of those factors. And maybe you're not going to value that as highly give, but you end up if if all the factors were maxed at, you know, around 2 to 3 million and you kind of go downwards from there based on what's occurred.
00:05:51:15 - 00:06:12:14
Again, this is a really helpful way for pre-revenue companies where you can't value the revenue stream at all. It doesn't it doesn't exist. The nice part with the cash method, it's really easy to apply, and it's ideal for startups that have no financial history at all. Right? It just kind of brings some objectivity to something pretty subjective at that point.
00:06:12:16 - 00:06:37:13
The downside really is because it is so subjective, you really have to look at each factor value, and it's really going to come down to your judgment as an investor rather than any kind of financial model. It's a good approach, though, if you're dealing with a pre-revenue company, but you got to be realistic here. You really avoid inflating values unless the startup clearly meets or exceeds each factor.
00:06:37:14 - 00:07:03:07
Again, I would sort of call it object to subjectivity, but it gives you something to use for pre-revenue investments. Next one we're going to talk about is, something you may be familiar with discounted cash flow or DCF method. And this is much more suited to later stage startups that have some revenue history. So what this does is it projects future cash flows and then discounts them back to present value on a risk adjusted rate.
00:07:03:09 - 00:07:21:07
DCF is actually used in larger companies as well. Essentially what it does is it asks how much is the company's future revenue worth? So what do I believe the future revenue is going to be? And then what's that worth to me today to buy that revenue potential? So give you an example because this can be kind of theoretical.
00:07:21:07 - 00:08:00:06
If a startup is projecting $5 million in revenue in five years, then what DCF does is it helps calculate today's value of that revenue after accounting for risk. Let's say we think in five years that revenue the company's going to be at 5 million. Well, there's a lot of risk in getting to that 5 million. So what today do I believe maybe if it did actually get to that 5 million, maybe worth four times that 5 million or something like that, but you're obviously not going to pay that today when you start to put in the risk, maybe that, you know, example of 5,000,000 in 5 years times four by multiple of four on that
00:08:00:06 - 00:08:18:23
20 million. But maybe you think today like, hey, there's you know, there's probably only a 20% chance of going to achieve that. So then you're looking at, you know, something like a $5 million valuation or something like that. Right. So there are different ways to do this. But again what you're looking at is what what do you believe that future revenue is going to be in some period of time?
00:08:18:23 - 00:08:42:01
What DCF does is it provides a really detailed quantitative valuation. You can use the company's own financial model if you believe the company's financial bottom to be true. That's also the downside. It requires really solid projections. You have to believe them. And this is why it's often used for later stage startups, because early stage startups often don't have reliable projections.
00:08:42:01 - 00:09:08:03
Their guesses and those things, those guesses then become really highly sensitive to that whatever discount rate you're going to apply. So the more reliable revenue history exists, the more DCF becomes a really good way. So if you're investing in really early stage startups, use it cautiously. If the revenue projections seem overly optimistic or assumptions really feel shaky, or there's just not a history to go on to know if these things are realistic at all.
00:09:08:03 - 00:09:26:05
If you're going to use DCF, you want to make sure founders are using a conservative scenario, or you may just want to use another another method, the venture capital method. This is something that we use as well as a at Evergreen Mountain Equity Partners, a venture capital firm. It's popular among early stage investors and it's based on target returns okay.
00:09:26:05 - 00:09:45:10
So this is something that we one of the ways that that we value companies. So first we're going to look at what do we believe the exit value is. What's the potential of that exit value. So the potential value at the time of sale or IPO or whatever we use our own exit value. Right. Not not necessarily. We're early stage investors.
00:09:45:12 - 00:10:08:19
We may not be in it until IPO or something like that. So we're looking at what do we believe the exit value is to us. Then we kind of work backward to really calculate today's value based on that target return. So let's say if we want to return and we believe the company could exit at 100,000,000 in 5 years, ten years, seven years, whatever it is.
00:10:08:21 - 00:10:34:22
Today's pre money valuation would be 10 million, right? Ten x return 100,000,010 into 100 million, $10 million would give us the will give us the potential of a ten x return at 100 million. So again one way to do it. The nice part is it aligns with the expected returns, which makes it really attractive to investors. But the downside is it relies on a really speculative exit value.
00:10:35:03 - 00:10:58:14
And it could be overly optimistic if market conditions really change along the way, which again, our hold periods can be, you know, five years or more. So you will have market cycles in there, which means you, you know, you really want to be able to get your exits when the market is, it's at its best. So when you use the, the VC method, you want to really ensure that the exit assumptions are realistic.
00:10:58:16 - 00:11:17:11
But what do we really believe that this could be? And then you want to validate that exit value based on similar companies that have successful exit. So this is where you start to kind of combine it with that CA model. Right. Look at other companies. What did they exit for is the assumed valuation that you're using on exit realistic.
00:11:17:11 - 00:11:35:04
If nobody is ever exited in this space for more than 100 million, there's probably not a good factual basis to believe you're going to exit for a billion. So just things to look at. The last thing I want to talk about is, is a little bit different, right? Because the valuation methods that I all talked about are focused on numbers.
00:11:35:10 - 00:11:58:23
But the thing that it doesn't account for is the quality of the founder and the critical role that the quality of the founder plays in valuation, especially in early stage companies, gets less important as a company gets more mature. But at an early stage, it's it's really key. A great founder can increase the likelihood of success and improve the company's valuation over time.
00:11:58:23 - 00:12:31:09
There's no doubt it's often one of the top, if not the top determinant of the future value of a company. So at Evergreen Mountain Equity Partners, we've got we built a proprietary founder assessment that really evaluates essential traits like resilience, adaptability, strategic accountability in other ones, because we really believe that founders who demonstrate these traits are much better positioned to navigate challenges and grow the company, which has a huge outsized impact on the long term valuation.
00:12:31:09 - 00:12:50:15
A founder with a really strong track record and the right qualities can justify a higher valuation. We will pay a premium for that if we have a lot of conviction around the ability of this founder. Conversely, if we think that the founder lacks these qualities, we probably won't invest. Or maybe they do have these qualities, but they don't have experience.
00:12:50:15 - 00:13:08:08
We may negotiate a little bit lower valuation because the risk is a little bit higher. Before we close, I want to talk real quickly about just some tips on negotiating a fair valuation. So once you've determined a reasonable valuation range it's then comes down to negotiation. So here's a few tips to really keep in mind when you got to be transparent.
00:13:08:08 - 00:13:29:16
Share your valuation assumptions with the founder and talk it through. What it's going to do is it's going to build trust. It's going to build a collaborative approach. When you arrive at these numbers, quite frankly, you know, people get really carried away with with negotiating valuations. In an early stage company, a million, 2 million in either direction is not going to make a long term difference to your return.
00:13:29:18 - 00:13:48:03
Really share the assumptions that you're using in your valuation to make sure that there's alignment between you and the you and the founder. The next step is you want to really highlight risks and the adjustments you're using. So if you believe that the startup has a higher that is higher than average risks, maybe you believe that there's regulatory challenges, things like that.
00:13:48:09 - 00:14:18:07
You want to really factor these into the to the valuation. Again, be honest. Be transparent with the founder when you're going through this. Third, you want to consider non-monetary terms. If you can't agree on valuation, what you can do is propose other equity like based compensation or milestone based tranches that align with your risk tolerance. This is something that we have done a lot at evergreen, where maybe the founders looking for a much higher price than we are willing to pay.
00:14:18:07 - 00:14:36:21
At that point. What we have done, and we routinely do this is then structured to say, okay, we'll invest less today. And if you go hit these milestones, we'll give you the number, the price you're looking for with the second tranche or something like that. So you can stage these things out a little bit as well and put some proof in there.
00:14:36:23 - 00:14:58:00
To make sure that, you know, the founder is able to go and execute along the, to support a higher valuation. If they do great pay, the higher valuation. Negotiating doesn't always mean just lowering the price. Sometimes it's it's about structuring the investment in a way that really aligns interests and mitigate risks. To wrap it up, you know, startup valuation is part art.
00:14:58:01 - 00:15:26:11
It's part science. It's definitely more art and science. But by understanding these methods, like comparable company analysis, the book is method DCF. The VC method, they give you some tools to use in your toolbox to better equipped to assess the fair value of a company. Remember, a great founder can add value well beyond the numbers, which is why we at Evergreen Mountain prioritize founder selection and the assessment of founders in our valuation.
00:15:26:11 - 00:15:53:21
So if you're interested in exploring more about startup investing, learning more about valuation strategies, or our unique approach to founders assessment at Evergreen Mountain Equity Partners, or adding venture capital, early stage investing, seed level stage investing in a diversified portfolio as part of your asset, allocation strategy. Reach out to us. Go to mepa. We'd love to talk to you, discuss how we can support your investment goals.
00:15:53:23 - 00:16:11:03
And, thanks for watching. Don't forget, please take a moment like, subscribe, hit the bell. Turn on the notifications to get more content like this and feel free. Please to leave any questions or comments below. Thanks! See you next time!