DCF or VC, which is the best startup valuation method?
By Arthur Puig - 29 April 2021
It can be hard to know what is the best startup valuation method for a specific deal. Following our article “What you should know about early-stage startup valuation”, we dive into more depth into the pros and cons of two specific valuation methods. The discounted cash flow (DCF) and venture capital (VC) methods are among the most used approaches to value startups. In fact, they are part of the four valuation methods used by Early Metrics in the Investment Scan and are also among the most complex.
For the DCF and VC methods, our analysts draw a startup’s Business Plan for a forecasting period of five years. This allows us to estimate the startup’s Free Cash Flow generated annually and the revenue expected in 5 years. Indeed, we need to forecast this last financial ratio since to determine the terminal value of the DCF method, we multiply expected revenue in 5 years by a revenue multiple. We also undertake the same principle to compute the exit value from the VC method. Depending on the type of startup valued, analysts will weigh these methods differently to give a final valuation.
What is the rationality behind their choices? Why would they prioritise one method over another?
Benefits of the DCF method
A startup can attract an investor if it has the potential to cut its costs over time or increase cost-efficiency. The Free Cash Flow (FCF) and consequently the DCF method might be an important factor in the investor’s decision then. A startup’s cost-cutting process should be rewarded and reflected in its valuation. Indeed, they should compare favourably to other startups that may be able to meet the same potential revenue within the forecasting period but through more intense cash consumption.
Let’s take an example:
A corporate venture capital (CVC) fund is benchmarking two startups with the same value proposition, the same revenue predictions for the next 5 years, and the same level of revenue generated at present. What can tip the scale in this scenario is that one of the two startups has better profitability perspectives. This can be due to a more easily scalable technology and process. Expected positive or negative Free Cash Flows (FCF) within the next five years are good indicators to assess several risks. Thus, the CVC should give a greater value to the ventures with positive profitability forecasts.
As an investor, if you invest in ventures with short-term profitability objectives, you are more likely to invest only once. You can therefore avoid having to:
– undertake financial bridges
– bear the bankruptcy of your investee
– incur dilution from future financial rounds
– deal with R&D budget cuts that can threaten the venture’s innovation.
Additionally, a more profitable startup is more likely to offer a good financial exit to its current investors. This is due to the fact that a highly profitable startup is a more liquid asset on the financial market.
Issues of the DCF method
Some startups will burn a lot of cash in the short to mid-term. These often have a very high growth potential or are evangelising a market, in competition with other startup initiatives. Thus they need to acquire as many customers/users as fast as possible, which entails costly digital acquisition strategies. Other startups with a high Capex could also have a very low FCF. In such cases, the terminal value will not compensate for a negative FCF. The valuation could therefore be negative or very low, which is not completely appropriate.
We can conclude that predicted FCF is not the best metric to value cash-intensive startups. While the DCF method marginally takes into account this financial stress warning for investors, the VC method should be given a stronger weight in the final valuation to avoid penalising the startup unfairly.
Benefits of the VC method
In traditional private equity firms, analysts use the current revenue of a target and multiply it by transactional or trading peers to value the company. But when a VC fund invests in a startup, its interest lies in its future performance and not only its present one. Some startups are just beginning their commercialisation, so current revenue should not be the only criteria. Some startups target niche markets, others disrupt pre-existing and large ones. In turn, this affects their growth potential. Hence, to measure the value of a startup it’s best to consider both current and future revenue generation.
A successful startup investment process is close to this method mindset computing the future value of a startup to obtain its current value. As a CVC could have ROI objectives, the current startup value (what price they/the market are ready to accept to buy shares) depends on its potential value in 5 years, and thus on its future revenue generation. The classic and successful paradigm for a CVC is first to target and invest in a startup generating low revenues. Then this startup, boosted by their fundraising, grows in terms of revenue within the next 5 years and offers an interesting mid-term financial exit.
Discount models for the VC method
Nevertheless, forecasting revenue generation to value a startup through the VC method is far from being 100% accurate. At Early Metrics, we have proprietary discount models to actualise a future exit value in 5 years into a current value.
When applying the VC method, three main risks should be taken into account to discount the value:
– Bankruptcy within the next 5 years (in relations to the venture’s current revenues, team size and years of business)
– Illiquidity in the next 5 years (e.g. investor appetite may falter if the technology developed by the startup becomes obsolete)
– Dilution (the startup might meet its revenue targets, but may need to raise several times to do so because their business is capital intensive and/or the team have a cash burn strategy which results in a high cost of client acquisition or R&D capex).
Overall, the VC method is well-suited for the valuation of startups with strong growth potential.
Issues of the VC method and how Early Metrics is able to mitigate them
Conducting a potential revenue generation forecast is a very difficult exercise. Who can predict future revenues with absolute certainty? Thankfully, an analyst leading such forecast at Early Metrics will have already rated over 100 startups. They are therefore fully able to mitigate overenthusiastic assumptions made by entrepreneurs.
Challenging the entrepreneurs’ business plan
Early Metrics holds impartiality and independence as core values, which are reflected both in our business model (startups don’t pay to get rated) and in our practices. Analysts will always challenge a startup’s Business Plan. That is not to say that the startup’s founders are not to be trusted, but by redrawing it with our own hypothesis, we offer a more objective view. All analyses are peer-reviewed to balance, confirm or challenge the analyst’s financial hypothesis and scenarios.
To go even further in quality assurance, Early Metrics’ statistical models are continuously improved. Indeed, we compare our rating results with the real growth experienced by rated startups. To do so, we interview entrepreneurs once a year for the 5 years following their rating in order to check if the reality matches our forecast in terms of bankruptcy, revenue and team growth. Thus, every year, we adjust our statistical models to correlate more closely the growth potential to our ratings.
Building a relevant multiples database
The second challenge of the VC method lies in creating a relevant multiples database associated with startup deals. A vast majority of fundraisings, if there are ever announced publicly at all, don’t release the revenue multiple used in the transaction.
However, when they are rated by Early Metrics, entrepreneurs share their last fundraising ratio. Of course, all these revenue multiples are completely anonymised and are not shared with anybody other than the analysts. We have legal commitments towards rated entrepreneurs and confidential data they share with us is safe.
Thanks to this, we have been able to collect more than 800 multiples in every sector, at every stage of maturity, globally and for every associated business models. We update this database every 6 months. To do so, we remove revenue multiples coming from deals older than two years and we add new deal-related revenue multiples collected during the previous semester. This constitutes an up-to-date data goldmine. Analysts can then choose relevant multiples associated with startups and innovative SME deals.
CVC funds sometimes don’t have this type of database to lead their valuation. Hence, Early Metrics’ rating data helps rationalise the startup valuation and due diligence process.
Which startup valuation method is best suited to whom?
There is no single best startup valuation method. Hence, the choice of method should vary depending on the type of startup assessed. Also, the final valuation calculated should always be taken with a pinch of salt. After valuing more than 200 startups for international CVC and VC funds, Early Metrics would be pleased to help you streamline and structure the difficult process that is startup valuation.
Depending on your investment thesis, you could put an emphasis on one of these two methods:
– DCF method to favour startups with better profitability prospects (this could be better suited for Family Offices)
– VC methods to support startups that prioritise high revenue growth and fast market penetration over short-term profitability (this would be more fitting for traditional VC funds than the DCF)
As it is a theoretical exercise, the final output is often a bracket of valuation and not one precise number. What makes Early Metrics’ process unique is that, in parallel with the valuation process, the analyst conducts an extra-financial analysis. Thanks to our database of startup ratings, we can refine the valuation bracket in relationship to the startup’s positioning compared to other rated businesses. For example, if a startup has a score that ranks it among the top 10% of all rated companies, we will select the highest range of the valuation bracket. If it ranked in the top 50%, the median will be picked and if it is in the bottom 30%, the 7th decile of this valuation bracket will be chosen.
If you wish to complement your due diligence process with Early Metrics’ startup ratings and valuations, reach out now: firstname.lastname@example.org