Rise of startup valuations: how to make sure the price is right
By Margaux Cervatius - 18 February 2022
2021 was a record-breaking year for the global startup scene. Many startups raised significant amounts of money with impressive valuations, sometimes reaching up to a billion dollars or more. According to Crunchbase, global VC investments rose to $643 billion, compared to $335 billion in 2020, a 92% increase year on year. In Europe, investments in startups more than doubled between 2020 and 2021. Indeed, they had already reached €49 billion by the end of June 2021.
How can we explain the spike in startup valuations in such a short space of time? More importantly, how can we ensure these startup valuations are as accurate as possible?
VC investment is booming
After a feeble 4% increase in 2020, global investments in startups bounced back in 2021. Average tickets for investments are rising and mega-deals of over $100 million have become increasingly commonplace. The cumulated 20 biggest fundraisings of 2021 amounted to €20 billion.
As a result, startup valuations rose as well. 596 new unicorns were born around the world in 2021. This amounts to more than 10 new unicorns per week. By comparison, in 2020, only 167 startups reached unicorn status. At the end of 2021, all 1,148 global unicorns were collectively valued at $3,8 trillion.
Heading towards a new speculative bubble?
This surge can be explained by the abundance of liquidity on the market to finance startups. The number of VC funds keeps on rising and they come with impressive financial means. In general, startups do prefer to stay in private markets. As a matter of fact, between the years 2000 and 2020, the number of stock-listed companies in the US decreased by 27%. Entrepreneurs can obtain higher investments more rapidly by resorting to VC money. Furthermore, this allows them to keep a larger amount of control over their business, compared to publicly listed companies.
The competition grew between investment funds, and led to a valuation boom, especially in Europe. In terms of amounts of money invested, the Old Continent had not been able to keep up with the US and China for a long time. However, it has started to catch up with them. Non-European investment funds, accustomed to impressive fundraisings, tightened their grip around Europe and are now driving the average tickets upwards. For instance, the large Japanese investment company Softbank participated in a $680 million once-in-a-lifetime fundraising of the French startup Sorare, in September 2021.
In the face of this startup buzz, some economists have started to sound the alarm. According to them, the startup world could be facing a speculative bubble, doomed to pop. It then becomes essential to differentiate the true gems from the fake ones and to value startups at the right price.
Different methods for a fair valuation
It’s remarkably difficult to value early-stage startups because of the high level of uncertainty of their business model and financial projections. Thanks to its experience in this area, Early Metrics has set up an independent and reliable method that allows its clients to accurately value young companies that generate little to no revenue.
At Early Metrics, we use several well-known valuation methods, which we adapt to better reflect the potential of a startup:
- Discount cash flow, or DCF, aims to determine the value of the company by evaluating the future discount cash flow perceived by the shareholders or the company;
- The revenue multiple method (which is based on internal and external data) estimates the company’s value by comparing it to similar companies in the same industry, the same economic model and business maturity;
- The pre-revenue method, inspired by the Berkus method, determines the value of a company, which is not generating any revenue yet, from extra-financial criteria and highlights the startup’s progress areas;
- Finally, the VC method offers a theoretical future value (or the output value) according to several growth scenarios.
We also consider the expected valuation given by the entrepreneurs and their bargaining power with investors. Often neglected; this factor can give a clear idea of the entrepreneurs’ ambition. The right price must reflect the value and the potential of the company, but above all else, it must lead to an agreement between investors and entrepreneurs.
We then balance the weight of each valuation that resulted from these methods, based on the nature of the company, its development stage and the market on which it is blossoming. This gives us our final suggested valuation.
The importance of extra-financial factors
Early Metrics’ valuation method is not only adapted for startups but also combines several methods of valuation. It uses extra-financial criteria to precisely assess a startup’s potential.
Before investing in a startup, it is essential to understand the project, but also those at its head. It can be interesting to analyse the following:
- The startup’s business plan
- Its business model
- Its targeted market and competition
- The entrepreneurs’ profiles, their previous experiences and their skills (commercial, technical, managerial)
- The startup’s commercial and technical advancement
- The investments already secured and the profile of existing shareholders
This in-depth analysis can prevent future setbacks. One textbook case to keep in mind is that of the American startup Theranos. It was offering a medical diagnostic tool supposedly capable of detecting hundreds of illnesses from one drop of blood. At its peak, the company was valued at almost $10 billion. A few years later, it was revealed that the machine had never functioned properly and that its founder, Elizabeth Holmes, had lied to her team and investors. She was found guilty of fraud in early 2022. This historical decision could lead investors to ask entrepreneurs for more safeguards.
The number of investment funds, the average amount raised, and startup valuations all skyrocketed in 2021. Nonetheless, in their frantic race for the best startups, investors should not confuse speed and haste. Due diligence must not be neglected. If investors lack time or expertise, they can outsource their analyses. Those offered by Early Metrics combine financial and extra-financial elements, in order to determine with precision if the investment price is right.