How companies value startups before acquisition

One of the unspoken rules in acquisitions is that both sides pretend that money is not the key motivating factor.

While I will defer to the politeness of maintaining this approach, I can assure you that on the company side, most deals only make sense if they cost less than a certain amount. On the startup side, most deals only make sense if the price is above a certain amount.

So, let’s not kid ourselves. Price is definitely a — if not THE — key consideration.

The question is, “How does the company come up with this price?” The process a company uses to determine a proposed valuation for a startup tends to be opaque to most founders.

The first thing to understand is that price is subjective. There is no one intrinsic “correct” value. Valuation is fundamentally based on forward-looking projections, so, by necessity, is driven by certain assumptions of what will happen in the future.

If two parties have different expectations of the future, they will arrive at different valuations.

For example, one company may be better positioned to cross-sell the startup’s product to their customers than another company. This means they will generate more revenue than the other company using the same product. As a result, each will arrive at a completely different valuation, each “correct” based on the assumptions they have made.

While all companies will have their own particular process in order to determine the right valuation, they will almost certainly employ some combination of the following valuation techniques.

Valuation Method 1 — The DCF Model

The first step taken when valuing a startup is usually to build a financial model. This model will reflect all the company’s assumptions about the startup, how the products will be integrated, and their best guess of how future events will unfold.

The company begins by projecting the customer(/user) and revenue numbers out several years (typically five). These estimations may then be factored to reflect the probability the startup will actually achieve these numbers.

Then, the expenses required to achieve these revenues (staff salaries, equipment, marketing costs, hosting fees, licenses, rent, etc.) are estimated. The expenses are subtracted from the revenues to provide the expected cash flow.

This cash flow is then discounted back to today’s value to provide a single number that represents the “discounted cash flow” (or DCF) of the company’s future earnings.

Sometimes, this DCF model is derided as being divorced from reality.

However, developing a strong financial model can be a great disciplining process to force all parties involved on the company side to agree on the core set of assumptions that drive the deal and subsequent integration.

Valuation Method 2 — Comps

The next common valuation method is to use comparables, or “comps.” The best way to think about comps is to imagine that you are buying a house, and you are trying to determine how much to offer. The list price is definitely one piece of data you’ll use, but another option to determine the value of your offer is to look at how much similar houses were sold for and use that.

You might get lucky and find a house in the neighborhood you like with the same configuration that was sold recently. That is a really good comparable and provides clear guidance. However, using comparables is not an exact science. You usually have to “triangulate” the value.

It should be intuitive that a bigger house will cost more than a smaller one; one with a garage would cost more than one without. The transaction date is also important as the price can vary significantly over time, especially if there is any kind of market contraction or expansion.

When it comes to companies, we can use comparables and make similar adjustments based on team size, users, revenue, market, and date to triangulate the startup’s valuation. There are three different “comps” typically used:

Comparable transactions

Recent acquisitions where the valuation has been disclosed. The closer in time, size, functionality, and market segment to the current deal, the better.

Comparable financings

These are recent investments into similar companies where the valuation is disclosed. The company’s last investment valuation can also be considered.

Comparable public companies

Pick a “basket” of publicly-traded companies in the same market segment and compare their valuation to the prospect regarding some metric like users or revenue. Public comps can be less relevant due to relative risk and growth rates.

Valuation Method 3 — Multiples

Another way used to derive a valuation number is to use an industry multiple. While generally less sophisticated than the other techniques, this is a “back of the envelope” calculation, which can typically be quite indicative and accessible.

A simple Google search will generally return several reference sources for multiples in the right market segment. For example, Thomas Tungsten and Dave Kellogg both used to do a great job of periodically collating multiples for SaaS companies in their blogs.

Multiples can form a good starting point for the discussions — i.e., if SaaS companies are understood to trade at 5–8x revenues currently, why do the founders think their startup is worth 10x?

There might be a very good reason. Their sales or user growth may significantly outpace that of similar companies. Their market may be growing much more quickly or be recognized as being more valuable in some respect.

The company will likely know this, but this is definitely the type of “new information” founders want to be sure they are aware of and can then share to reinforce their case during negotiations.

So, the way the process typically works (or should work) is that all of the above techniques are used, and the outcomes then arranged on what is known as a “football chart” to determine the valuation range for the deal.

The idea is that no single one of these techniques provides a definitive answer, but taken together, they inform a range for the valuation discussion.

Sometimes there are really good data points that help inform a tight range that both the company and the startup can agree on.

Other times (especially with early-stage companies), the range can be broad, and the discussion can be more subjective and driven more by how much the company wants to make the deal happen.