By Abdulrahman Mansour

A startup’s valuation is probably the most critical term startup founders and investors come to agree upon when entering a partnership. It directly impacts the founder’s dilution at each stage, and it has a profound impact on the investor’s return multiples at exit.

Too low a valuation may hurt valuations at future stages. Too high a valuation may add excessive pressure on the founder to live up to and grow into that valuation to avoid that shaming down round.

At each funding stage, valuation methods will differ. The later the stage the more standard the methods. These standard methods include discounted cash flow (DCF), comparable price multiple, and precedent transaction multiples. In a very simplistic form, DCF involves taking expected company-free cash flows and discounting these cash flows using a discount rate to reach the value today. The latter two include calculating the value multiples on a range of different company numbers. A comparable company is a company with similar characteristics as the startup we are trying to value. A precedent transaction is a transaction where a comparable company was acquired. In the case of price multiple comparables, these companies need to be publicly listed or private but with publicly released numbers and fundraising values. For precedent transaction comparables, the transaction details have to be publicly released.

All methods come with their shortcomings. DCF is based on projections of future cash flows, which as we all know, are almost impossible to accurately predict and startup value is hypersensitive to the discount rate. Shifting the discount rate by just 1% can change the value by millions and billions for high-value companies. The two methods with comparables fall short in that multiples are directly impacted by market sentiment. In an overly hot and liquid market, multiples will be inflated. In a distressed market, multiples will be deflated. They also fall short in that it is very difficult to find a truly comparable company. 

This gets even more complicated in the earlier stages. At earlier stages, you don’t have enough historical data required for accurate forecasting for DCF to work nor will you have clear-cut comparables or publicly released information for multiples to work. What happens at these earlier stages is that it ends up boiling down to a tug of war between how much equity a founder is willing to give up to investors at this stage for the investment amount, and how much return an investor can expect to make considering the investment amount and stake owned at this stage.

This comes with its own complexities. Too high a stake for the founder might mean depressed multiples for the investor at exit. Too high a stake for the investor and you run the risk of disincentivizing the founders in later stages as their stake gets diluted.

There is no one rule for valuing a company. The trick is to keep all parties at stake in mind when negotiating and not let personal greed drive the process. Collective greed considering everyone at stake will allow all parties to make better decisions that suit not just each party, but that suit the company and all its stakeholders.