How we value startups

Rob Vickery

Whether you, the founder, are trying to do it or an investor, setting a valuation for your startup is probably the most emotional part of the fundraising process.

Here in New Zealand, it is probably question number one from a founder and the most common topic from mavens, startup nerds, and doomsayers in the Aotearoa startup economy. Some thought leaders have even gone as far as to call it a ‘dark art’ or imply that it simply lies in the lap of the Gods. 

At Hillfarrance, we think that setting a valuation is not determined through black magic or devising a money-ball algorithm for valuing startups. We believe the critical thing is to end up with a fair price to the buyer and the seller and start our new partnership in the most positive way possible. We want our portfolio company founders to feel good about the terms, the people funding them, and how we will work together as we advance.

What goes into Hillfarrance’s ‘fair’ valuation methodology?

While I was drafting this piece, I came across two interesting perspectives that show a diaspora of opinion on the topic in this country:

“Investors will be looking to drive down the valuation and the founder to keep it high.” It’s vital in valuing a startup company consideration be given to the impact of follow on rounds and dilution of key shareholders, particularly the founder.

Angel Association of New Zealand.

“The higher your seed valuation, the less risk and uncertainty that investors will tolerate.”

Leo Polovets. General Partner at Susa Ventures.

The first perspective seems to imply that there is Godzilla vs King Kong-level battle between two kaiju (the investors and the founders) to find a happy medium. 

The second is more akin to our methodology. We seek to understand the nature of your business model and who you are as founders to come to a mutually agreeable valuation. Referencing Leo’s viewpoint, our methodology factors in several areas so that we can accurately assess potential risk and reward. These factors are not weighted equally, and some are more qualitative than quantitative. For visual learners, here is a cheeky little chart that sums up the parts of our valuation methodology:

It is the people.

At Hillfarrance, we have absorbed into our kaupapa the timeless Maori proverb of “what is the important thing in the world? It is the people. It is the people. It is the people.” This philosophy is our first port of call when it comes to assessing valuation. We are looking for founders to display a range of characteristics, including:

  • The credibility of the founders is paramount. We love receiving pitches from entrepreneurs who have come from the market they are targeting and deeply understand the problem that they are solving. Knowing the culture and eccentricities of a sector is essential before trying to sell a product into it. 
  • The courage to ship a product that barely works and release it into the world for criticism or massive success. We see far too many founders who continue to tinker on a base product and build numerous features they think their customers might want. A founder willing to get something out there to test their thesis and either double down if it is a success or pivot quickly if it is not is hugely investable to our firm. 
  • The knack of sales. If a founder can release a slightly ropey product and convince someone to part with their budget, it is indeed a special person. The danger of unpaid pilots or early customers aligned with the incubator that you are just left (hello, Y-Combinator) is that they do not show the proper adoption behaviour of your target market. Pitching your idea cold to an unknown prospect and then convincing them to pay for it is again a rare skill and one that impacts our perception of risk in a potential portfolio company.
  • The ability to hire people that could quickly go elsewhere and earn three times as much. It takes an exceptional leader to convince a graduate or an experienced engineer to come and work for a startup with a limited runway and a salary that would pale compared to what Google or Facebook might pay. This all comes down to the founder’s ability to project a compelling vision that captures high-value candidates’ imagination and inspires them to jump in the waka with you. 

Audacity of vision

We have said this many times before, but I don’t think we have referenced it from a valuation perspective—a founder who has a wildly ambitious vision influences the enterprise value of their business. 

Founders with aspirations of just expanding across the ditch or staying domestic are unlikely to fit the venture capital returns model. Equally, founders who build technology that imitates or only slightly iterates on another company’s products become harder to fund. 

Founders who have a clearly defined ten-year plan to build something that the world has not seen before or build a sandbox for other companies to be born from are immensely interesting to Hillfarrance. Ultimately, we need to see that this has the potential to become a multi-billion dollar business. 

Regarding how we assign a value to this, I think it is less of a fiscal component; it is more of a hurdle that we need the founder to help us jump before we even start the quantitative aspects of due diligence and eventually setting a valuation. 

How much do you need?

We like companies and founders who have bootstrapped their way to MVP, generated some revenue along the way, but also have the impatience to take what they have already accomplished and turn the growth dial-up to 220c. The primary fuel for this growth is brilliant, connected capital that can help you achieve this milestone. Setting a valuation when considering this factor is based on how much money the founders need to smash the milestones out of the park. 

Again, we aren’t looking for five-year financial projections; we want to know: 

  • how much time/runway you will need to prove that your current business model works.
  • How you gain the greatest return on investment 

Undercapitalised companies that continue to raise multiple sub-$500k rounds to try and cautiously test the market before going too far are just not in our wheelhouse for a bunch of reasons:

  • Purposefully under-funding (not in a negative way) your company’s development slows down or hamstrings your pursuit of achieving signs of product-market fit. Go big or go home. 
  • Unless you like fundraising, the founders will have to regularly go back out to the market to raise capital, which takes their eye off the growth of the business and, therefore, increases risk. 
  • The founder dilution that occurs after each small round creates one of the most significant risks for the company’s ongoing success. We have been collecting data over the past two years, and here is a comparison of what we have noticed when it comes to founder ownership in New Zealand and compared against the rest of the world

Dilution

High valuations have two significant perks for founders:

  • Less dilution. This means that you own more of your business, you have more room to create a sizable ESOP to attract world-class talent, and that you can sell more later for the same level of dilution.
  • You can obtain more money for the same dilution. If you are selling 10% of your business at a $5m valuation, you will get $500k to invest in your startup. If that round is at a $10m post-money valuation, you get $1m to invest. That will take you a LOT further in your business plan.

When it comes back to our assessment of risk in a startup business, a higher valuation is buying you two of the more essential things in business:

  1. Time
  2. Talent

Higher valuations also reduce the risk for future founder attrition. If you are heavily diluted in the earlier rounds, you will start to feel more pain as time goes on and future rounds occur. As those of us who have been founders know, the startup grind is very real, and one of the few things you can be left with after a 90 hour week and the associated stress and pressure is your ownership of your business. The psychological, even spiritual, connection with ownership of something can help make up for some of these challenges. We believe that Founders without a healthy ownership percentage have a greater risk of burnout and more of a reason to call it quits and take that well-paid job at Google, with less pressure and more downtime. 

In terms of the negatives associated with inflated valuations, they could be:

  • A strained relationship with your investors and their expectations. This strikes at the heart of our goal at the beginning of our article. If an investor feels like they paid the odds for their investment into their round, their expectations might be unfeasibly high and their more-than-regular assessment of if you, the CEO, are the right person for the job.
  • It may make it harder to subsequent rounds of venture capital. VCs are looking for multiples of at least 2x the previous valuation to demonstrate to their LPs that the risk they took on your startup was a wise one. That higher valuation you secured in the last round might have just gone and set the bar for the next one unfeasibly high. 
  • The increased risk of a down-round. If you have not hit your performance milestones and cannot raise a subsequent round of capital at a higher price than the previous one, then it is likely you and your investors will incur a down-round. A down round is when a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in earlier financing. This means everyone on your cap table takes a haircut on the value of their investment in your company. This is not a good outcome for all, and you can best mitigate this by raising the previous round at a rational, fair valuation.

Down rounds do not necessarily kill your business.

By their very nature, down rounds can carry the risk of bearing a mark of shame: a company can be thought of as less valuable than it previously was, and entrepreneurs have not been able to generate enough value. Tall poppy culture loves down-rounds. We don’t believe these occurrences signal that a company is in trouble any more effectively than raising funds at a high valuation signals that a company will crush it. 

For one, a private company valuation tells you very little about how well a business is doing. Compare this to publicly listed companies valued every second of the day as people buy and sell shares; private companies are valued infrequently —only when they raise funds. That valuation will be determined by one lead investor and is based on what she or he is willing to pay to seal the deal.

You can’t escape the bare-faced fact that if a down round occurs, any investors who made their investments at a previously higher valuation will find their shares have a lower sticker price. Suppose the startup investor is investing in companies with a long-term investment realisation and ultimately believes in the business’s future potential. In that case, the impact may be less severe. If this is you then a down-round and you are an investor who believes in its mission, this is a unique opportunity to purchase more stock. If the investor is looking for more of a quick turnaround, then this will hurt. If you invest in startups for a fast return, you might want to take yourself to one side and have a challenging conversation with yourself because that is not how this form of investing works. 

The fact is that most startups fail, not just those that are well capitalised (take a look at the journey that Magic Leap went on). There are plenty of situations where companies can be forced into situations where they must raise money at lower valuations than they did before and yet will still become successful. I hope that we can think twice before associating failure with down-rounds. Sometimes it is quite the opposite. 

How much can we help you?

A highly engaged investor with a defined and active network within a market that a startup is targeting can be genuinely transformative to a young company. Unlike investing in public stocks, VCs and angel investors have a unique opportunity to influence a startup’s destiny and early outcomes directly. In my tenure as a VC, I have deeply enjoyed identifying and securing new critical hires, introducing multi-million customer leads for our portfolio companies. 

When determining the valuation that we set in our term sheets, we will consider the potential incremental revenue generated from our introductions and network. 

We will also consider how likely it is that subsequent rounds will be lead by top-tier international venture funds. A Series A led by a household name fund in Silicon Valley will carry a significant uplift in valuation. We like to gauge early on if the startup we are valuing will generate interest with these investors. 

Competition

We tend to be more inclined to take competition risk over product risk. When we say we are less comfortable with taking product risk’, we refer to the number of similar products that may exist in your target market. As an avid follower of the Blue Ocean Strategy, we like products and services that can be first to market with a new technology or, even better, build new markets due to their innovation. We are more than comfortable backing founders entering an existing market with several legacy companies servicing the same customers with an inferior or outdated offering. We get a somewhat uncomfortable sense of joy when we find this! When a startup is looking to gain market share in a space that is heavily populated with successful, established companies that their founders still run, we do have concerns when a startup is looking to gain market share. Founder-run companies, both privately-held and publicly listed, like Facebook, Salesforce, and Space-X, are forces of nature and have a very different set of motivations to lead their market. This can be different from a hired CEO who was not at the inception of the company (exceptions to this include Satya Nadella and Bob Iger).

Unit-level economics 

We invest in founders who can define, understand and optimise the value of a single unit of their business. 

The “unit” in unit-level economics is the fundamental minimum piece of your business that you can measure to understand where and how you derive revenue from. It’s whatever best represents the exchange of value which drives your business. For example, a unit for a SaaS startup is most likely to be a paid subscriber; for a VR arcade, it might be the number of visitors.

To assess the unit-level economics of a startup that is pitching us for funding, we are going to want to know:

  • The cost is acquisition (CAC) of winning a customer 
  • The lifetime value (LTV) of a customer 

To get to these numbers, we will need to understand:

  • The annual revenue earned from each customer.
  • Gross margin.
  • Your sales and marketing costs – not just pay-per-click ads but also how much a sales associate might cost and the cost of your CRM subscriptions etc. 
  • The volume of new customers that you have won over a period of time and how many expect to close within the next round of funding. 
  • How long you expect a customer to remain a customer of your business—what is their lifespan?

The unit-level economics of a business are tailored to your own business. The weighting of gross margin is likely to be more critical to a hardware startup than impressions from a Facebook advertising campaign. 

Traction

One of the most binary ways to calculate a valuation is to apply a multiple to any existing revenue that a startup might have. Depending on numerous variables (average contract value, CAC, retention rate, LTV etc.), we will apply a revenue multiple of somewhere between 6-10x when considering the valuation. Suppose you are generating services revenue (such as consulting services or one off projects). In that case, the multiple is more likely to be from 1.5-3x as these are typically non-scaleable/repeatable income sources. 

If you are a pre-revenue company, then traction can also be measured by the activity within your new business pipeline. By reviewing your pipeline or CRM reports, we can understand the dynamics of your sales process:

  • How many new leads are being generated, and by whom and how?
    • If you are using an external lead generation source, then expect this to hurt the potential valuation. Leads generated by the startup itself add far more enterprise value to your business than paying someone to do it for you. 
  • The cost of acquisition of new prospects.  
  • The speed at which your prospects are moving through the courtship process.

If you are a consumer app or platform, then it is vital to demonstrate the network effects that business and its activities are creating:

  • New users of the product.
  • Length of time on the product.
  • Repeat usage of the product.
  • Advertising revenue (if that is how you monetise).
  • Organic referrals to the platform. 
  • The geographic diversity of your user base.
  • Converts from free to paid. 

X-factor

If you had built a startup before and exited it successfully, you should experience a step-up in valuation as some investors will consider you as a ‘safe pair of hands. We also believe that if you had built a startup before that failed, you might also be able to attain a higher valuation than someone fresh into the startup grind. 

The x-factor of previous employees of successful businesses building their first startup can also have an uplift in your valuation. We have to be clear, though, if you are employee #10,001 at Google, then it is not quite as impactful as if you were engineer #2 at Rocketlab. Even if they are not the founders, people who have been a part of a startup journey are exciting and immensely valuable to a company. 

Comps

A valuable but not essential contributor to setting a valuation is gaining a view of how comparative startups within your sector or vertical have been funded in the recent past. When it comes to Silicon Valley-based startups, we have to apply discount factors to remove the hubris and dominance of such a market; however, it is still a useful proxy. 

In our case, the funding and valuation pattern of Qualtrics was a handy barometer when we were working with Yabble to set the terms of their seed round. 

Size of the Market

We are interested in a few data sets when trying to understand the size of the market you are playing in:

  • TAM – Your Total Addressable Market is determined by adding up all of the revenue from companies/competitors in your market or by having a pop at calculating the potential lifetime value of a customer and multiplying it by all of the customers in your market. The latter is helpful if you are first to market or building a new market.
  • Serviceable market – the subset of your TAM that is within your geographical or technological reach.
  • Serviceable Obtainable Market – how many customers within your SOM can you sell within the next 18 months. 

Many variables affect your ability to capture your market. Still, the above data points are a good starting point for understanding how big your startup can get in the short and long term. 

Intellectual Property (IP)

You might think that IP is perceived as the most tangible aspect of valuing a startup; however, it is a lot more nuanced and hypothetical than that. 

The most obvious place to start when valuing IP is assessing how much someone might want to pay for it. But we also bear in mind that what is valuable to one customer is useless to another. The value of IP is really in the eye of the beholder. 

Let’s use Salesforce’s almost-finalised $27bn acquisition of Slack as an example. Given Salesforce’s dominance as a sales, service, and marketing platform, it does to some degree make sense that the company would turn its focus to what drives all three disciplines: communications. Salesforce did try to conquer this with the acquisition of Chatter; however, this didn’t achieve the success that they expected. 

We’re just beginning to see an increase in the use of communications tools with external parties. But we have yet to see a collaboration platform that fully integrates internal employee communications and document management with external customers seamlessly and securely. It is this IP that we believe is driving the aggressive sticker price of this acquisition. 

Using this example, you can see value creation by an acquirer who sees a new symbiotic, value-adding relationship with the potential acquisition. 

When it comes to startups and their IP, it is complicated to value an intangible asset in the abstract. What we can do is peer into the crystal ball, identify who is gaining the most value from your product, model out what such a future acquisition might look like, and trackback from there. 

Summary

We hope you find this helpful. Whilst this isn’t an exhaustive list, it is a starter for ten if you want to have a go at attaching a value to your business before you start raising capital. It is much better to go into an investor pitch with this in your back pocket than to let them set it for you. No one likes negotiating with themselves! 

Best of luck

Rob