Unraveling the Magical Mystery of Valuation Math – How Do VCs Price Private Companies?

In the venture capital class I teach at Haas, the one topic that never fails to confuse is valuation, or how a private company is valued in an investment transaction.  I’m not sure if it’s because math is hard, because valuation is based largely on not exactly math, or because it’s hard to keep track of so many zeroes coming BEFORE the decimal point, but whatever it is, people find the concept of valuation confusing and hard to grasp.

How can it be, they ask, that valuations seem so subjective when there are numbers involved? Why is one company deemed worth “x” while another is deemed worth “10x” when they seemingly have similar characteristics and no profit?  What the god-given-hell is a decacorn?

All great questions, and to answer them, we must turn to what amounts to a dart board informed by history and a little math, and then dive like lemmings into syndicates who love extra commas more than reason.  It’s a tough class to teach in these current times when everything seems to be over-valued and the traditional concept of “standard multiples” is out the window.

For the uninitiated, the meaning of “valuation,” at least in this context, is the amount of money a private company is deemed “worth” before and after a venture capital transaction. Another way to define it is thusly: what is the value of each or all of the shares of stock in a private company given the outcomes they have achieved to date?  For the record, stock is the same thing as equity.  Lots of people don’t realize that.  There is a bucket of jargon affiliated with venture capital that would bring you to your knees if you had to carry it five feet. And let me clear up one more big piece of jargon:

• A company’s pre-money value is what the company’s equity is deemed to be worth, in the aggregate, before a new investor puts money in. This can also be called Equity Value.
• A company’s post-money value is what the company’s equity is deemed to be worth, in the aggregate, after a new investor (or group of investors) puts money in.

The math is actually pretty simple:  Assume that the pre-money value is X and the amount to be invested is Y.  Z will be the post-money value in my equation: X + Y = Z.

In other words, if everyone agrees that a company is worth $1 billion (we will call that X, or the pre-money value) and investors are going to invest $500 million into it (we will call that amount Y, the investment amount), then the post-money value is $1 billion + $500 million, or $1.5 billion.  And that means that the new investors own 1/3 of the company’s equity, because they own $500 million of the total $1.5 billion (the total valuation post-money), aka, 33.3%.   It can get more complex than this, but not that much.  Sometimes there are little diversions in the calculation to account for stock options or performance metrics, or the cash needed to feed the unicorn, but basically the math is simple enough even for a political scientist to do.  That would be me.

And speaking of Z, there are zillions of startups are out there raising money (aka seeking cash in exchange for equity ownership in the company) and when money is offered, there comes a negotiation about what the company itself is valued at before the new transaction (aka, what is known in the biz as the “pre-money value”).  This negotiation takes place between the management of the startup – for our example, let’s call the company Unicornucopia, Inc.—and the people who will invest new money into Unicornucopia, Inc. in this particular round of financing. A round of financing is a transaction at a moment in time (and the time may even be spread out over months or longer), where investors trade cash for stock ownership in a company at a particular price.

In general, entrepreneurs think that it’s better for them if the valuation of the company is as high as possible.  In general, venture capitalists think it’s better if the valuation of a company they are interested in is as low as possible….until they’re a shareholder and are trying to sell the next round of financing to the next guy.  In general, both entrepreneurs and venture capitalists (VCs) spend way too much time trying to perfect this equation.  In truth, it’s not always better for entrepreneurs to command the highest valuation possible and it’s not always better for investors to push for the lowest valuation possible.

Entrepreneurs who demand (and get) a valuation higher than is really warranted may live (or die) to regret it.  If their results don’t allow them to grow into that juicy price, they may find themselves in the position of that one musical chairs player who doesn’t end up with a chair when the music stops.  VCs who demand (and get) a valuation that is lower than reasonable put themselves at odds with the entrepreneurs with whom they should be aligned.  Considering how long entrepreneurs and VCs are stuck to each other after typical transactions, it’s better to feel the love than the resentment – ask any divorcee.

Given all that, how are valuations set in private companies?  Well, that’s an interesting story because the answer is they are entirely made up out of fairy dust and dreams.  There are multiple methods for getting to the “right” price, although that in itself is an ephemeral concept, kind of like “how much is too much ice cream?” – the answer will never be known, but there is no perfect answer other than “when there is no more ice cream.”

There are multiple ways that VC’s determine what valuation to propose. Usually, it’s the confluence of these considerations, at least in theory:

• Value of comparable companies – Basically, in this approach you look at the world of public companies to determine how similar companies priced and use that information to give you some indication of metrics for how Unicornucopia should be priced. This approach can be somewhat informative but isn’t great because public companies are generally a far cry from private ones, especially early-stage private ones.  And it’s usually hard to find a public company that is truly comparable, especially if the startup is really original. I mean seriously, what company looks as good as Unicornucopia?  It stands alone!  Or so management would have you believe.
• Value of comparable transactions – This is a way of looking at recent financing transactions of private companies to determine how have similar companies been priced in VC financing and/or M&A transactions in order to determine whether those metrics are a good proxy for how Unicornucopia should be priced. This can be a handy approach, but the truth is that every company has its own unique plusses and minusses and it is very hard to really know what you are comparing yourself to.  Comprehensive information on private companies is hard to come by so pricing can be somewhat devoid of context, making it hard to rely upon.
• Discounted cash flow analysis – This is basically a mathematical way of figuring out what the value of Unicornucopia’s future cash flows would be worth today. A good description of this model, often referred to as a DCF, can be found HERE. It’s basically a way of taking into account the time value of money, as in the style of Wimpy in Popeye—would his payment to you on Tuesday have been a good investment of your hamburger today?  If you don’t get  this reference, you are not watching enough old cartoons. A problem with this approach is that it assumes profitability happens along the way before exit.  Based on the way current market is going, that is no longer a thing, so it makes this a tougher math problem than usual. By the way, and a total non-sequitur, I love that when I looked at the page linked above on DCF, I got served a bunch of ads about bras.  In general, where there are a lot of DCF calculations happening, there are generally few bras present.  #irony
• Previous company valuation as a directional indicator of price – This is where you look at what prior investors paid for the equity of Unicornucopia in the last financing round, specifically, and try to determine if the company has progressed or regressed since that last round. You then eyeball the situation and come up with a price that is, usually, more than the last round but seems “reasonable” given what you know about Unicornucopia.  This is probably the most common approach and, in many ways, the most useless, frankly. Just because some sucker bought something at a high price last time doesn’t mean that you should pay even more.  And just because some aggressive vulture capitalist jammed a low price down the throats of desperate-for-cash-in-the-moment entrepreneurs doesn’t mean the next funder should pay a low price.
• Backing into price based on what you want to own of the company – again, not exactly based on the rigors of real analysis, but commonly used (especially for early stage companies), this approach is often in evidence on Shark Tank, the TV show. When someone from that show says, I’ll give you the $500,000, but I want to own 50%, it basically means that they would be willing to give you the money you asked for, but only if you concede that the valuation is that which would leave each party with 50-50 ownership, at least in this example.  In other words, if Unicornucopia went on Shark Tank, Mr. Wonderful would propose a royalty while Barbara Corcoran would say something like the above, which would imply that the company’s valuation is $1 million.  Some VCs have their own internal guidelines about how much of a company they need to own to make it worth their while; others like to limit their ownership to under a certain percentage for financial reasons. Whatever the reason, this is a more common approach than is often discussed.
• Whatever your mystical object of choice tells you it is – Ouija Board, Dart Board, Wheel of Fortune, Crystal Ball, Lottery Ticket Numbers, Magical Markings on a Piece of Toast, whatever. Often times VCs and entrepreneurs just KNOW (or, in truth, think they know) what a company is worth based on some mix of reality-based experience and magical thinking.  You do what you can with the other methods above, and then you adjust based on gut feel and tea leaves.  In the end, here’s the right answer: the proper valuation is what someone will pay for your equity and what the entrepreneurs agree they will accept to sell a portion of their equity.  In other words, valuation is price by agreement, based in history, future/guestimation, and magic fairy dust.  Welcome to private company valuations.

The answer to “how does valuation work for private companies?” is essentially this: it’s sort of a made-up number loosely based on facts, assumptions, gut feeling and ego. And for this reason, it drives my MBA students and lots of first-time entrepreneurs mad.  How can a hard number be based on so much squishy stuff?  How could Unicornucopia possibly be worth Z when it sounds like an F?    But hey, like with much of life, there is no roadmap, only a path through the woods with very poor outlines, the occasional blueberry and possibly a hungry bear.  So, entrepreneurs and VCs do their dance showing each other their favorite kind-of-sort-of-math until they reach an agreement based on “that’s close enough.”  I have made up my own Venn diagram to explain it in more detail:

And by the way, a “unicorn” company is one that is valued at over $1 billion.  The nickname used to make a lot of sense because there were so few companies worth $1 billion and thus the designation was incredibly elusive.  And then it wasn’t.  Don’t get me started on that one.  The newest craze is to aspire to be a “decacorn, “ which is a company that is valued over $10 billion.  We apparently needed to dream up a new mythical creature because so many companies were achieving unicorn status.  Go figure.  Good thing that valuation math is intrinsically intertwined with magical thinking.