If you are a startup founder, or have been remotely associated with raising capital, you probably would have heard a (lazy) heuristic around valuation multiples.
The company shall be valued at 5x revenue or 7x ARR, for example. Rings a bell?
Through this post, I want to be able to help you dissect what is the meaning of 5x or 7x. I want to be able to help you have an intelligent conversation while valuing your business. Most importantly, I want to be able to help you understand how to think about valuing your own business, should multiples be used, forget having externals (VCs) value it.
But, early stage startups are valued on ownership
It is a misconception that VCs value early stage startups on the basis on multiples. Rather, valuations are a function of ownership.
For a fund that is making 25–30 investments, typically 1 or 2 investments make up most of the return. Thus, it is important for VCs to optimize for high ownership upfront — typically 15–25% range.
An investor is usually planning for owning 20% upfront that will allow them to be at 10% at the time of exit. This 10% ownership must return 1–2x of the entire fund? so a $2M for 20% ownership puts the valuation of the company at $10M.
What I am trying to assert is this that the valuation for an early stage startup is an outcome of more endogenous factors — fund design & portfolio construction philosophy of the VC, than exogenous factors — the revenue, ARR, margin profile etc.
Multiple are generally irrelevant at the early stage and maybe somewhat useful during growth stage.
It is however important for VCs to sometime understand what multiple are they paying, more like for a back handed calculation.
For example, the same $10M valuation may mean that they are paying 50x. And they may want to negotiate the valuation downward with 50x being too high, so they may say $1.5M for 20%, implying $7.5M valuation.
The math to arrive at valuation is always around ownership. VCs are also okay to increase the check size but not compromise on ownership.
For example, if the same deal were to become competitive, they may want to give you $3M for 20% ownership, implying a $15M valuation. Forget, now paying 75x multiple.
The key is to get into right companies and have a meaningful ownership
This post is however, about multiples which might become relevant during the growth phase of your company. When the discussion is to say value the company at $100M or at $200M, for example, for 10–15% dilution.
But hey, who am I to say anything. The industry has become very expansive, there are many capital providers who like to value businesses the way they want to, irrespective to stage. And it is their right to do so.
Multiples, thus are a relevant topic where we like it or not. That is why this post to dissect them and bring some science to help founders.
Multiples are nothing but an easy way to value the future cash flows of the company.
Show me the cash flows.
The value of the business is nothing but the present value of future cash flows of the company. More simply, what is the future worth today.
One method, and most prominently used, is the Discounted Cashflow Method (DCF). where a discount rate is used to discount these future cash flows as given below.
I will not get into details of explaining details of DCF; there is so much literature written on it. What I am going to focus on the technicality of it; making the correlation between multiples and DCF (cash flows), that is.
Multiples are just a compromise to not run a complicated and must I say, time consuming, DCF. What it really means is:
- That someone (the market) would have run DCFs for comparable companies (the comp set) and would have priced that company accordingly.
- Your company`s business model is very similar to these comparable companies (the comp set), so we can use proxies. If they are worth $1 Billion at $100 Million revenue, you could be worth $100 Million at $10 Million revenue. Implying, 10x revenue multiple.
I am not going to focus on #1 as markets are usually efficient in pricing companies. It is #2 which is worth challenging as you can see a lot of assumptions are baked in —most importantly, the business is similar to incumbents.
VC funded startups are usually disruptive businesses and could be different from comparable businesses (comp set).
Terminal value estimation is where most moving pieces in the DCF are
One of the biggest components of valuation using the DCF method is the estimation of Terminal Value (TV) — cash flow in the terminal year, which is a way to project the cash flow of the company in perpetuity.
One can only project cash flow for 5 or 7 years but the company will be a going concern so a proxy is used to project cash flows unto endless time. It is given by the below formula where:
- FCF is Free Cash Flow in the nth year (5th of 7th, for example).
- ‘g’ is the growth rate of the industry / market that the company operates in
- WACC — defined as weighted average cost of capital and also the discount rate.
We will discuss them one by one.
Your Free Cash Flow structure could be different for many reasons
Free Cash Flow (FCF) is not EBITDA. It means how much (free) cash you could generate every year after paying the debtors (interest), government (taxes), and among other things, factoring in the working capital.
You could assert with investors that you are building a business where cost structures are disruptive. For example, AI driven automation could mean massive cost level efficiencies for a modern company. Thus, your company could see a better (say 30%-40%) than the market.
This itself gives you a 1.3x better FCF margin than comparable (industry), all else hitherto equal.
Where things can be unequal for example, are tax rates. Say the comparable are US companies where the tax rates are 21%, and you are an Indian company where it is 30%. This would mean your FCF margin would reduce. While you have 30% upside on EBITDA but you will have give ~33% of that upside (~10% in absolute terms) towards taxes.
Baking two such variables — better EBITDA but higher taxes, your net upside on FCF structure is 20% 1.2x of the comparable companies.
Note that this kind of argument only works when the comp set is low on standard deviation, as something I have explained below
Note: The EBITDA Margin Column 3 has HIGH S.D. and not LOW. I am unable to locate this file to correct it.
‘g’ is probably the most critical assumption your valuer is thinking wrong.
Higher ‘g’ means expansion of multiples with respect to the comp set.
‘g’ signifies the growth rate of your cash flows into perpetuity. And forms the most critical element of estimating terminal value
New industries, or categories should mean higher ‘g’ as these market one could be growing faster
For example, one is operating in Automotive industry which is an age old industry based on ICE engines. Now, a new EV startup could argue that EVs (because of multiple factors) are going to grow faster than the industry in general — say 2x faster than the industry in general. Thus, one must give you a 2x multiple than the industry, all else equal, if what you have in comparable set are also traditional manufacturers.
Growing (developing or emerging) markets should mean higher ‘g’ as they are growing faster.
People often mistake this. For example, in the US, I have seen ‘g’ being used at 2 to 3% rate, which in a way means that at perpetuity the business must grow similar to that of economy.
Naturally, emerging markets (India) will grow at higher rates so the ‘g’ must be higher. Say 6–8% range? It is also a reason why Indian public companies trade at higher PE (Price of Earning) ratios often at 20x+ where as those in the US are 15x+. It is about the growth.
In addition, one can also take a lens that certain sectors are growing faster than the overall economy so ‘g’ must even be higher. This is the combination of the above two.
Honestly, DCF is as good as your estimation of ‘g.’ And they are bunch of assumptions. So, it even asserts my point that there is a lot more to multiples if you look. One simple thing is to ask what is in your comp set.
Cost of capital (or discount rate) bakes in uncertainty that investor may have about micro & macro conditions of the company
Higher cost of capital, as compared with comp set, means multiple compression
WACC is the cost of capital (blend of equity and debt) for the company. Also called discount rate.
More intuitively, this is the discount rate by which future cash flows and terminal value of the company is being discounted to today to estimate the valuation. Discounted — Cash Flows (DCF).
Cost of debt is usually straightforward and is defined by what is the cost of your borrowings. While, cost of equity gets very tricky.
For mature companies, it is defined by the hurdle rate method: what could the investors make if they were to deploy this capital elsewhere — say an Index fund which S&P 500 or NIFTY50. This is typically 8–12% in the US.
Some sophisticated investors also add uncertainty risk to cost of capital. Uncertainty could be on account of regulations in the target market, currency fluctuations, and, among other things, inherent risk in the sector.
For example, if the cost of capital for a company operating in “X” country is say 10%, and there is suddenly some new regulation in the country that could pose a risk on currency prices, investors could add another 2% (for, example) to the cost of capital.
Uncertainty is also challenging to estimate. For example, there is lot of talk about Software multiples being low in the US public market. One way to explain them is that investors are uncertain about the future of Software in wake of AI, and are baking that in their discount rates, hence multiple compression.
In case of an early stage startup, a good way to estimate cost of capital is purely the hurdle rate / expected return for investors. VCs expect to make 25%-30%+ IRRs (more, if they are a seed stage investor as there is more risk; lower, if they are a growth stage investor).
Intuitively, since startups have lot of uncertainty risk, hence they have higher discount rate.
VC money comes with high expectations and thus cost of capital & discount rate is 25%+
Multiple are often misleading. Some examples of interpretations
As you can see, how multiples and their upstream DCFs have some many moving parts.
Interpretation#1 We often compare mature companies that are growing slowly (lower g), often operating in different geographies (different tax rate, and market risks), and operating at very low cost of capital (lower discount rate) compared with your early stage startup.
Interpretation#2 The multiple expansion a startup must get through high growth rate ‘g’ is often negated or dragged down by higher discount rates, baking in the added uncertainty (risk).
Interpretation#3 Emerging markets have higher ‘g’ but at the same time higher discount rates due to higher benchmarks (NIFTY50) and added uncertainty (cost of regulations, for example)
Interpretation#4 If someone is paying a similar company higher multiple than others, that means they could be seeing something that others are not. Perhaps, higher a higher ‘g.’ Perhaps, they have some insight that allows them to find this sector less risky (some regulatory insights, for example) to have lower discount rate.
Interpretation#5 Serial & successful entrepreneurs, command very high valuations early on because inadvertently someone is pricing less uncertainty or low discount rate (they have been there, and done that) and buying all the growth (g) upfront, as they have previously demonstrated the same.
There is no easy way to say this, that sometimes multiple are nothing but garbage in and garbage out. Someone, somewhere, is being lazy.
This article is not to dissuade you from using multiples, but to put forward a framework to help you understand what undergoes in coming up with a multiple, or rather what actually means to be a 7x rather a 3x revenue multiple company.
Hopefully, next time when some heuristically, or lazily, mentions giving you a 5x multiple, you can ask them why? And, use your own math to come up with why not? Ask for comp set.
More sophisticated VCs, however, do not value early stage startups using multiples as I have already stated above. Do comment, if you specifically would like me to go deeper into that with a separate piece.
Until then..
..there is no such thing as a free lunch.
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