The difference between Pricing and Valuing a startup

Determining how much a Startup is worth is a hotly debated subject. Investors think valuations are too high, while founders think they are too low. The question is, who is right and more importantly, how can you determine who is right?

A common saying is that valuing is more of an art than a science. In my opinion, this is confusing pricing a startup versus valuing a startup. Valuing is more of a science, while pricing is more of an art.

Valuation is a science

So what is the difference between valuing an asset and pricing it? You can only value an asset that has either a positive cash flow stream/or assets that are relatively easy to sell second-hand. Everything else you need to price. For a valuation, you need to determine the future cash flows and discount these for risk and opportunity costs. A Discounted Cash Flow Model (DCF) is a commonly used method. You determine the future income and then use the Weighted Average Cost of Capital (WACC) to determine the present value. The WACC takes into account the risk and the opportunity costs.

For instance, if someone asks you, would you like £1m today or £2m next year as long as the generous giver is still alive? You then need to calculate two things: how likely it is that the person will survive for a year, and what you could do with £1m now versus £2m next year. Both can be easily calculated to determine what the £2m next year is worth today. With a Life Table, you can determine what the average mortality rate is for a person, and you know what the expected return on a savings account or investment portfolio is. If the Present Value of the £2m is higher than £1m, you will wait (unless you are highly risk-averse)

You can also value the assets, such as stock, machinery, and debtors. Most of the time, a discount is necessary depending on the asset's marketability. In rare instances, the book value of the asset is lower than the market value. This might happen with assets like real estate. Generally, Intellectual Property (IP) like patents can not be valued but need to be priced as the market is not transparent enough to create a liquid secondary market.

Assets like bonds, real estate and cashflow positive companies can therefore be valued. The more predictable the cash flow, the more accurate the valuation, but even the value of an asset like a bond with its predictable interest payments can fluctuate if there is a change in the interest rate. The less predictable the cash flow stream and/or discount rate(WACC) is, the lower the quality of a valuation, as different assumptions have a big impact on the outcome

Pricing is an art

Assets like art, cryptocurrencies, and companies with no/negative cash flow streams cannot be accurately valued. The expectation is that the price will rise because there will be a greater demand for that asset in the future, or it will generate positive cash flow far away in the future and then have a value instead of a price. An investor does not need to worry too much if the asset is priced right as long as they think they can sell the asset for a higher price, also known as the "greater fool theory". This leads to market bubbles that can lead to great riches (and great losses).

Many startups are priced in the following way. The company is looking for a certain amount of money, let's say £500,000 and is willing to sell a percentage of its shares. Let's say 20%. The Post-Money valuation is then £500,000 divided by 20% equals £2.5m, with a Pre-Money Valuation of £2m.

Some other pricing mechanisms are the Berkus Method and the Scorecard method, where the investor rates the company on factors such as Market Risk and Quality of the Founders and assigns a monetary value to the score. Personally, I'm not a big fan of these methods as they feel artificial and subjective. They feel more like Ex Post justifications of why an investment was or wasn't made.

Another often used tool to price, which is more useful, is the sector Multiples. The company is loss-making in the foreseeable future, but does have revenue. The price of the startup might be four times the revenue. Another often used multiple is Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) for companies that are operationally profitable but cannot generate sufficient free cash flow for their investors.

Multiples are sector-dependent. Sectors with strong growth, high margins, low Capital Expenditure and negative working capital have high multiples as they are able to return more cash to their investors than businesses with low margins, high capital expenditure, and higher working capital needs. Remember, a sector multiple is just a proxy. An individual company might perform significantly better (or worse) than the sector, and using a pricing tool like multiples might undervalue (or overvalue) the company.

Using the Venture Capital method to price a round

The Venture Capital method is a pricing method that uses multiples. It calculates the future exit price by multiplying by metrics like Revenue, EBIT, EBITDA and/or Net profit with a multiple that is in line with the sector.

It then discounts this exit value to its present value. In the example from my Financial Model. The expected exit price is £4m in year 5. The expected dilution is 36% and the required return is 40%. On a £100,000 investment, the pre-money valuation would be £470,000.

Multiples can be useful, but should not be used by themselves, as they are better at capturing market/sector sentiment than the value of an individual company. Multiples are high in the good times and low in the bad times.

For a startup, this makes it even more difficult as the exit is in the future, while the multiples are based on the attractiveness of the sector today. The attractiveness of a sector might change significantly in the future.

Conclusion: Be a scientific artist

Theoretically, the intrinsic value over time should drift to its price over time. A pre-revenue startup should first get revenue, and then become cash flow positive. At that stage, the company can have a proper valuation. Until that time, you need to price the company. If there is a lot of money available because of low interest rates, like in 2021-2022, Prices(valuations can be high). In 2025, however, money is tight, so prices need to be low to attract investors.

The first big sale for many startups is a percentage of their shares in return for the investment capital. A rudimentary understanding of how to price and value a company is important to certain investors (especially if money is tight). Any company sharing a financial projection automatically shares their valuation, as you can use these in a DCF model. I guess most startups don't realise this and never sanity check this.

Quite a few startups price their own startup above their valuation without realising this, which makes little sense as the expectation is that the valuation will grow to the price, not vice versa. In my model, you will have all the tools to help you price and sanity check your valuation.