Start-Up Valuation: Advanced Concepts

In the previous articles, we have already studied the basics of start-up valuation. We are also aware of the basic concepts such as pre-money valuation and post-money valuation which commonly affect the funding received by startups. However, the cases mentioned until now were very simple. These cases are only presented for the student to gain a theoretical understanding.

In practice, the valuation of startup companies is more of an art as compared to a science. This is because of the several complications which are usually part of start-up valuation. In this article, we will have a closer look at some of these complications and how they must be accounted for:

  1. Preferred Stock: In our previous examples, we considered all stocks to be the same when we were calculating the pre-money and post-money valuation. However, the reality is that venture capitalists and angel funds seldom accept common stock in return for their funds. It is common for these investors to demand preferred stock in lieu of their investment. Now, this complicates matters quite a bit.

    Preferred stocks may have several different provisions such as priority in dividend payments and also during liquidation of the firm. This makes them more valuable as compared to common stocks. However, it is not easy to determine the value being provided by such priorities in monetary terms. This is one factor that makes it challenging to value start-ups.

  2. Stock Warrants: The biggest complication with regards to start-up valuation is generally related to stock warrants. Warrants provide investors with the right to buy a specific amount of stocks in the future at a price that has already been determined.

    It is common for investors to ask for warrants which allow them to buy stocks worth 10%, 20%, or even 100% at a future date. Now, these warrants are a liability for the firm but not for the investors. The investors can decide whether or not they want to exercise these warrants at a later date.

    Now, if the stock warrants are exercised, the number of shares that exist can change dramatically. It is possible for the number of shares to double! Some stakeholders will get a higher percentage of these newly issued shares as compared to others. This is what makes stock warrants difficult to value. It is possible for the warrants to be utilized either partially or fully or not be utilized at all. Hence, the experience of the founders and investors comes in handy to predict what the possible outcome will be in the future.

  3. Kickers: Kickers are another tool used in startup financing which ends up complicating the entire process thereby making valuation difficult. Kickers are often used in conjunction with stock warrants.

    For example, investors may have the right to buy 5% of the shares as compared to their original amount if they exercise the warrant in the first year. However, they may be given the right to buy 12% of the shares if they wait for the second year to complete. An incremental schedule is often drawn up with various timelines. This is what makes it difficult to predict when the investors will actually use the warrant and what their impact on startup valuation will be.

  4. Contingent Valuations: It is common for investors to offer complicated valuation methodologies to their investors. For instance, investors might provide the company with a certain valuation. This valuation could be 10× of the current revenue of the company. They could also stipulate that the valuation will be reset to 10× of the revenue each year.

    Hence, if the revenue of the company increases, then the investors will have to pour in more funds to maintain their valuation. On the other hand, if it decreases, the investors might end up getting more shares in the company. There are several other parameters based on which, the firm can decide on the valuation of the startup firm.

  5. Control over the Board: It is also common for investors to demand a certain number of seats on the board of directors. This is very important from the control point of view since the board of directors is involved in the day-to-day operations of the firm.

    Hence, by obtaining board seats, investors obtain control over the operations of the firm. It can become very difficult to consider factors such as board seats while valuing a startup firm. This is because it is difficult to assign a monetary value to the benefits which will be reaped by having such perquisites.

  6. Dividends: It is also possible for the investors to stipulate that a certain amount of dividend needs to be paid out to them. This dividend could either be paid out in cash or it could accrue in their respective accounts at the firm.

    In both cases, the investors would have a higher guarantee of dividends as compared to the common shareholder. Most investors do not intend to exercise this right to obtain dividends but want to make provisions for the same in the paperwork since it makes their shares more valuable in the event of an exit.

The bottom line is that startup valuation can become a very difficult and complex exercise. It is not just a mathematical formula. There are many grey areas where the valuation will be based more on investor experience than on mathematical formulas.

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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to and the content page url.

Startup Finance