Supercharge Your Startup Valuation: A comprehensive guide for entrepreneurs and investors to value Startups and Scaleups

Disclaimers and Copyright

The information in this book was correct at the time of publication, but the author does not assume any liability for loss or damage caused by errors or omissions.

Other than cited case studies, sample scenarios in this book are fictitious. Any similarity to actual persons, living or dead, is coincidental.

Copyright © 2022 Sivapalan Vivekarajah

All rights reserved. No part of this book may be reproduced in any form or by any means without prior permission from the copyright holder.

To request permissions, contact the author: vivekarajah@gmail.com

eBook ISBN 978-967-11767-3-3

First eBook edition June 2022

Edited by Gregory Kong Sze Wern

Cover art by LogoDesignCreation

https://www.logodesigncreation.com/

Published by

Dr. Sivapalan Vivekarajah

Kuala Lumpur, Malaysia

For more material on valuation visit my website at:

https://www.docsiva.org

Table of Contents

Disclaimers and Copyright

Dedication

Preface

1.      Introduction

1.1      Is it an Art or a Science?

1.2      Not an exhaustive list

1.3      Where do I start?

2.      Key Investment Terminology and Instruments

2.1      Investment Terminology

2.1.1      Pre- & Post-Money Valuation

2.1.2      Determining ROI

2.1.2.1      ROI Multiple

2.1.2.2      Internal Rate of Return (IRR)

2.1.3      Stages of Fund-Raising

2.1.4      Share Dilution

2.1.5      Valuation Adjustment Mechanism/Clawback

2.1.6      Exit or Liquidity Event

2.1.7      Liquidation Preference

2.1.8      Right of First Refusal

2.1.9      Tag Along Clause

2.1.10      Drag Along Clause

2.2      Investor Documents and Instruments

2.2.1      Term Sheet

2.2.2      Convertible Note

2.2.3      Simple Agreement for Future Equity - SAFE

2.2.4      Due Diligence

2.2.5      Subscription and Shareholders Agreements

2.2.6      Type of Shares: Ordinary and Preference Shares

2.2.7      ESOP

3.      Improve Your Pitch

3.1      Benchmark Your Business

3.2      Make Defendable Assumptions

3.3      Validate Your Data and Projections

3.4      Get Your Timing Right

3.5      Foster Some FOMO (Fear of Missing Out)

3.6      Make Investors Chase After You

3.7      Build Good Relationships with Your Investors

3.8      Avoid (Or At Least Mitigate) Cash Flow Problems

3.9      Ensure the Scalability of Your Business

4.      Positively Increase Your Valuation

4.1      Pursue the Factors That Increase Valuation

4.1.1      Obtain a Patented Product or Technology

4.1.2      Build an Experienced and Highly-Regarded Team

4.1.3      Build Compelling Market Leadership

4.1.4      Create a Defendable Market Share

4.1.5      Maintain a Captive Customer Base

4.1.6      Engender a Monopoly or Oligopoly Market Situation

4.2      Avoid Factors That Decrease Valuation

4.2.1      Poor Assumptions

4.2.2      Lack of validation

4.2.3      Weak Team

4.2.4      Highly Competitive Market

4.2.5      Low Margins

4.2.6      High Risk, Low Returns

4.2.7      Low Visibility for an Exit

5.      Manage Your Risks

6.      Outline of Methodologies

6.1      Valuing Early-Stage Pre-Revenue Startups

6.2      Valuing Late-Stage Startups or Scaleups with Revenues

6.3      Choose the Right Method for the Right Fund-Raising Stage

Early-Stage Valuation Methods

7.      Early-Stage or Pre-Revenue Methods

7.1      Berkus Method

7.2      Scorecard Method

7.3      Risk Factor Summation Method

7.4      Comparables Method

Late-Stage Valuation Methods

8.      Customer-Based Valuation

8.1      Comparables

8.2      Industry Benchmarks

8.3      Customer Life Time Valuation

9.      Asset-Based Methods

9.1      Tangible Assets

9.1.1      Land and buildings

9.1.2      Machinery, Plants, and Equipment

9.2      Intangible Assets

9.2.1      Intellectual Property

9.2.2      Brand or Reputation value

9.2.3      Customer Base Valuation

9.2.4      Market Share

9.2.5      Talent and Acqui-hire

9.2.6      Concessions

10.      Later-Stage Post-Revenue Methodologies

10.1      Financials for Revenue Multiple and Price-Earnings Ratio Methods

10.2      Revenue Multiples

10.3      Price-Earnings Ratio (PER) or Price-Earnings Multiple (PEM)

10.4      Discounted Cash Flow (DCF) Method

10.4.1      Why not use profits?

10.4.2      Why Cash Flow?

10.4.3      What is Free Cash Flow?

10.4.4      Projections

10.4.5      Reliability of Projections

10.4.6      Time value of money

10.4.7      Terminal Value

10.4.8      Discount Rate

10.4.9      Applying the DCF Method

11.      Balancing Risk: The First Chicago Method

12.      Venture Capital Method

13.      Mature Company Valuation Methods

13.1      Enterprise Value (EV)

13.2      Book Value

14.      Exit Valuations

14.1      Sunk Cost Model

14.2      Replacement Cost Method

15.      The Art of the Investment Deal

15.1      How much to raise?

15.2      When to raise?

15.3      How much equity to give up?

15.4      How to get a good valuation?

15.5      What type of Investor to raise from?

15.6      How to negotiate a good deal?

Summary

Conclusion

Share your thoughts

Appendix

List of Tables

Glossary

Bibliography

Dedication

This book is dedicated to all the entrepreneurs and investors I have worked with on my almost 40-year journey as an entrepreneur and investor.

I also want to thank my friends Premesh Chandran (the former CEO of Malaysiakini) and Karamjit Singh (the CEO of Digital News Asia) for their comments and suggestions on how to improve the book.

Special Dedication

This book is also especially dedicated to my wife Lily for her patience and support throughout my wild entrepreneurial journey of successes and failures.

Preface

I’ve been working with entrepreneurs and investors for two decades, and have coached or mentored more than 2,000 entrepreneurs via long-term coaching programmes and accelerators. One of the hardest problems they face is how to value their companies, especially when fundraising with angel investors and venture capitalists (VCs). I’ve also been asked about valuations on the many occasions when entrepreneurs have had the opportunity to do an exit via a trade sale.

In these discussions, I have to probe and ask them many questions before I can advise them on how to value their business. Over time, I’ve discovered that I’m always asking the same questions and giving similar advice (which they have found to be very useful). Over the last decade, I’ve also run training programmes on valuation for angel, venture capital, and corporate investors, and entrepreneurs. The issues faced by all sides are similar, albeit from different angles – investors try to get lower valuations and entrepreneurs try to get higher valuations – but other than VCs, the others often don’t really know how to do a proper valuation.

The other problem is that the traditional valuation professionals, especially accountants and some corporate finance people, don’t really know how to value early-stage technology companies, i.e. the typical start-ups. They’re used to valuing conventional brick-and-mortar companies and late-stage companies, with predictable revenues and expenses. For most start-ups this is almost impossible, because revenues and expenses and even their business models are highly unpredictable. In the earliest stages, it’s well-nigh impossible; especially when there aren’t even any real revenues to speak of, and when the company comprises a small number of staff still building out their technology without a proven business model.

It’s not that there aren’t any models we can use for early-stage companies; there are, as I’ll show here, but these professionals are not used to working with early-stage companies, and aren’t trained to value them because they’re used to conventional valuation techniques and models.

As an entrepreneur and angel investor myself, I can truly appreciate the struggles of both entrepreneurs and early-stage investors. While they have always found my advice invaluable, they still struggle with valuations, as they still don’t have a proper method to follow and lack the necessary skills to do a proper valuation.

I feel sorry for entrepreneurs, especially because this can be a life-defining moment, and they aren’t even sure whether they’ve got their valuation done right. It can be extremely stressful if you don’t know for sure whether you’re undervaluing or overvaluing your business. Undervalue it, and you receive less money than you deserve; overvalue it, and you may lose the deal because the other party doesn’t see the justification in the valuation. This is one of the most stressful times for an entrepreneur.

Hence the decision to write this book! I want to provide both entrepreneurs and investors with several methods for them to do a proper valuation, so that both parties can come to a fair and justified valuation for any deal, be it an angel/VC investment or an acquisition, so that all parties are fairly rewarded.

The key is a fair valuation for all parties based on models that apply to the particular stage of growth of each individual company.

Additionally, as you’ll see in a later chapter, I recommend that all parties use more than one method to determine the valuation of the business. By using several valuation methods, you’ll also be able to justify to the other party what the fair value is, based on all the assumptions you’ve made. This makes it a lot harder for the other party to reject your valuation, because you now have a basis and several methods to ‘prove’ to the other party how you came up with this valuation.

Not only can you justify this valuation, you’ll also reduce the friction involved in valuation negotiations, as the other party will find it harder to reject your valuation if you can show them how you came up with it.

I believe that with the different valuation methods I provide in this book, you’ll be able to determine what the fair value of your business is, which will reduce your stress levels and also help you with negotiations on valuation.

Additionally, I’ll advise you on how you can ‘SUPERCHARGE’ your valuation for each of the methods. By doing some extra work, you can increase the valuation of your company no matter which valuation method you use. This will help you get a better deal for your business venture.

I’ve also made this book and the explanations as simple as possible so that anyone can use these methods without having to be an expert or an accountant. There are many books on valuation, but most are complex – designed for accountants and professionals – and thus not easy to understand, especially for entrepreneurs and angel investors who aren’t trained accountants.

There is no end to the different types of valuation methods, and creative accountants and investors will come up with all sorts of methods or models to justify their valuations. I don’t claim to cover all the different methods in this book; probably no one ever can. However, the methods in this book cover most of the more common – and perhaps some uncommon – valuation methods, and are more than sufficient for any entrepreneur or investor to value a business. Even if someone uses an uncommon or newly-created method, you’ll still have sufficient ammunition (in terms of the various methods outlined here) to provide a justified valuation to counter any that the other party can come up with.

When I started to write this book, it was going to be purely about valuation. However, in discussions with friends, entrepreneurs, and investors, most also felt that I should also explain some of the terms and instruments that investors use when finalising an investment. Some of them found such information seriously lacking, and agreed that it will help founders with understanding not just valuation, but also how startup investments work.

Hence, I’ve dedicated at least one-third of the book to explain the intricacies of investment deals.

I hope you’ll find this book useful in your entrepreneurial or investing journey.

[Contents Page]

I

THE

FUNDAMENTALS

Introduction

What is a valuation? According to Investopedia, which bills itself as the world's leading source of financial content on the Web, valuation refers to the analytical process of determining the current (or projected) worth of an asset or a company. (Chen, Valuation Definition, 2020)

Almost all entrepreneurs need to raise funds for their businesses at some point, especially if they want to expand their businesses, hire talent, purchase equipment or assets, and spend on sales and marketing. There are essentially two sources of funding; namely, debt and equity. Conventional companies with a track record, perhaps of 2-3 years, can access the debt market for a loan via either banks or other lenders. They can also seek equity funding by giving up a share of their business to investors.

Startups, however, find it harder to get debt funding. This is because they often take years - possibly even a decade – to turn a profit, and their business models may not generate reliable cash flows for some time. Thus banks and other lenders find the risk too high to lend to startups.

Equity funding is therefore the ‘go to’ method for startups, where they pitch their business idea to investors, and give up a stake in their business for a certain amount of money. To determine what percentage of equity they give up to investors, they have to value their business; and this is the subject matter of this book: how do you value your business and what percentage of shareholding in your business do you give up to investors?

Can you avoid making valuations? You can at the very early stages, with instruments like a SAFE agreement or a convertible note; but sooner or later, you will need to value your business, so that even SAFE or convertible note investors can convert their investments into equity (you will find explanations for SAFEs and convertible notes later on in this book).

It is therefore critical for all entrepreneurs to understand how to value your business, and investors need to know this as well when they invest in startups. This book will help you determine your startup’s valuation.

Valuation is neither an art nor a science; it is a mix of both.

The ‘science’ is in the different methods that a founder or investor can use to determine the company’s valuation. These methods provide structures and methodologies including formulas to calculate a valuation. That is the ‘science’ part of valuation.

For example, in a discounted cash flow (DCF) valuation, you have several elements; the revenues of the company, both operational as well as capital expenditures, then you have the surplus or deficit, and you will need to plot these financial numbers over a minimum period of 5 years.

Once you have done this, you will ‘discount’ this usually using the cost of capital (there are several methods on how this can be calculated), and finally there is a mathematical formula to calculate the nett present value (NPV), which is the current valuation of the company based on the DCF method. (You will learn more about this later).

All of these constitute the ‘science’ part of valuation, as it is a method that applies to all DCF valuations.

The ‘art’ part of the DCF valuation is how you forecast your revenues and expenditures for the future 5-year period. What are your assumptions, and how do you validate these assumptions? For example, based on your estimates and your belief in how you plan to grow the business, you may project a 50% annual revenue growth rate and maybe a 30% expenditure growth rate.

This raises the question: how do you project something 5 years into the future when you do not even know what the future will be like? What makes you so sure you can achieve a 50% revenue growth rate? How do you justify this? Do you base it on historical trends, or is it based on a strategic plan that may itself be dependent on many factors like the funds and talent available, the business environment, the economy and how this performs, or even government regulations? Historical trends may not repeat themselves in the future, there may be new competitors, an economic downturn may happen, or maybe your projected innovations may not go according to plan.

There are many different factors that can affect your projections and plans, so what you project for your cash flow is based on multiple assumptions. This really is an art; to come up with assumptions that can be justified, and something the investor will accept as a fair projection.

Investors will likely make adjustments to the projections based on their own assumptions and estimates, and these will also need to be justified by their team of analysts so that they can present their assumptions as comparisons to what you have done, before both parties agree on the final cash flow numbers.

All valuation methods have a scientific element to them, but they will need different assumptions to be made with corresponding justifications – hence the ‘art’ aspect of the valuation.

This book will share the methodologies and will explain the science part of each of the methodologies, and we will also discuss the different assumptions and justifications needed to determine valuations, no matter the methodology chosen.

There are many different methodologies in this book; some for startups, others for scaleups, and most can actually be used for any type of business – even for conventional businesses. I have also tried to provide a variety of methodologies for different stages of a company’s growth, different circumstances, and also both quantitative and qualitative methodologies.

If you are a business, there are likely several methodologies that will apply to your particular circumstance.

However, human ingenuity knows no bounds, and I am sure there are other valuation methodologies being used by different parties and probably some that have not yet been invented.

Hence, the list of methodologies in this book is never going to be an exhaustive list. As a reader, you may have come across some method or other, and may wonder how it applies to your company. I would be happy to include it in a future edition of this book if a reader highlights it to me. You can email your suggestions to me at: vivekarajah@gmail.com .

However, the methodologies I have covered here probably account for 90% of the valuation methods used globally for startup and scaleup valuation. You have sufficient material here to determine a good and proper valuation for your company.

If you are a newcomer to entrepreneurship, and are either considering starting a business or have just started one, then just go on to Chapter 2 and continue reading, as you will need to know all the key terms and instruments in a fund raising and valuation exercise.

If you have been in business for a while, but are only now considering raising funds for your business, then you too should just go to Chapter 2 and continue reading.

If you are familiar with the key terms and instruments, but you are preparing for a fund raise or for a pitch, then go to Chapter 3 and continue to read from there.

If you are a seasoned entrepreneur, and you are already familiar with the above, and only want to know about specific valuation methods, then go straight to Chapter 6 and depending on whether your business is early-stage or late-stage, select the chapters that are relevant to you.

[Contents Page]

2. Key Investment Terminology and Instruments

With some investors, especially some sophisticated angel investors and especially VCs, there are some special terminology and several different instruments that they use in relation to making investments. It is useful for founders to learn more about some of these key terminology and instruments, as this will give them a better understanding, and some insight into how to craft a better investment decision and/or agreement.

We will consider these in two separate