How do VCs value a startup?

We spoke to Patrick Harmon about how VCs go about valuing a startup

Contxto – “Always be aware of what’s going on in your industry”, said Patrick Harmon—an investment professional at Dalus Capital—when asked how founders should value their startup.

For how Dalus Capital approaches this subject and what the current state of the Mexican ecosystem is in terms of market caps—read on, friends!

Contrary to popular belief, most VCs are not the great white sharks most people think of when they hear the word “capitalist”. Dalus Capital’s approach to valuations comes from a point of mutual understanding between the fund and the founders looking for investment.

Its goal is not to buy the biggest stake in the company for the least amount of money, but rather to find a fair price to buy, based on the stage the company is currently at.

“We always try to get a sense of what the founders think their company’s value is.”

—Patrick Harmon, Dalus Capital

When asked about their valuation process, he said, “We prefer to be on the same page before we even start to negotiate. That’s why we ask founders where they see their current valuation at, what their projections are and what is driving those projections. That way we can adjust their assumptions and drivers based on our own estimations.”

Valuation process is quasi-scientific

Most of the times Dalus uses the Comparable Companies Method, aka Comps, and the Precedent Transactions Method. They also tend to use operational ratios and pivot tables to better understand what the company is offering and how it compares to other startups in the same marketplace.

This is not necessarily the only approach. Although some firms consider the famous DCF analysis to be quite inaccurate—because future cash flows are nearly impossible to predict in the early stages and a little detail could change the whole valuation—there are some other firms who do use this method.

Other firms, even in mature markets such as the U.S. use some basic algebra to arrive at a general valuation. The rule of three is quite often used in capital-abundant markets where valuations are not the main point of discussion in deal negotiations.

This rule is helpful to visualize the amount of money being raising as a function of the company’s value. It helps investors predict the potential exit value they’re going to get at the end of the investment.

The beauty of the comps method and the precedent transactions is that the emotional factor is taken out of the equation, leaving the value of the company in purely empirical terms. My venture capitalist friend is very clear: “Many entrepreneurs tell us they’re better than their competitors because of the team or the brand or any other intangible asset quite difficult to quantify; and the comparable method subtracts that factor since the market is the one determining the value at the end.”

• Related article: Nail your pitch with these 6 VC approved hacks!

It’s super important to have a valuation in mind even before approaching an investor

Not doing so just slows things down for both parties and it opens the door for miscommunication. “Always be thinking about the value of your company”, he said. From day zero, founders need to be aware of this matter, because a suboptimal valuation could either result in unnecessary dilution or increase the risk of a down round in further liquidity events. 

Patrick also mentioned the importance of being aware of your specific location and market. “We’re seeing an overall increase in Mexican startup valuations. Foreign investors are coming from countries with greater cash availability, more mature capital markets, and greater consumer spending potential. As a result, the inherent valuations of their local companies are higher than their Latin American counterparts where raising bigger rounds is much harder.”

Therefore founders are starting to think about their companies as if they were in Silicon Valley, and of course that is not the case.

Now, before you start thinking: “Hey, what’s wrong with that? I will get more money for less equity, isn’t that great?!” Well, go back and read our previous post about down rounds so you get an idea about why high valuations aren’t always a good thing.

If you’re still a bit confused about where to start, here are Patrick’s top three steps for getting started with your valuation.

Startup Valuation 101

Step 1: Always be aware of your comparables and competitors. Identify the key players in your industry, both in local and foreign markets.

Step 2: Create a spreadsheet of at least 5-10 comparables and get rid of the outliers. Get as much information as you can about their burn rates, runways, operating margins, revenue, valuations, etc. Understand their funding rounds as a function of these metrics. You can take a look at our database of similar companies here!

Step 3: Identify the main drivers of the industry. Why does X company have a higher valuation? Why does Z have a lower one? Look at what factors and metrics affected those valuation spreads, and finally set a target valuation for your company.

Stay tuned for more articles on this subject, and reading material to help you all find the right number for your term sheet negotiation!

– VC