How venture capitals and private equities value startups

Kenneth Ma

Most startups nowadays are involved in “New Economy” sectors such as fintech, biotech, tele-communications, medicines, shared economies, blockchain, and artificial intelligence.

Compared to traditional investors like commercial banks and mutual funds, which emphasise historical trading records and stabilised or foreseeable growths when they are making a lending or an equity investing decision, venture capital and private equities are more concerned on the prospects and potential growth of startups. Unfortunately, these startups in general share the following characteristics which render valuations difficult for decision making:
  1. They are pre-profit companies;
  2. Their business ideas or business models are new and there are no comparable products, services or companies in the market that could serve as valuation benchmarks;
  3. There are no reliable methods to project future revenue or earnings.  Whether the business could breakthrough often depends on the availability of subsequent rounds of financing; and
  4. The business is asset light that sometimes the core assets of the company may consist of only several computer workstations or servers.
What makes valuation for these enterprises complicated is that even it takes a long time for startups to become profitable, these companies may have already been serving hundreds of millions of customers, covering virtually all places around the world. With the internet, new markets could be opened in a single night and such customer base or market potential should not be ignored in their valuation just because they are not making any profits yet.

Traditional methods including price multiples like P/E or P/S under the Market Approach, the discounted cash flow method under the Income Approach, or the replacement cost method under Asset-based Approach apparently lacks the ability to value startups. Venture capitals and private equities would instead also consider the following metrics:
  1. Average Revenue Per User (“ARPU”), for example:
    • App stores: the monthly revenue from users who purchase apps;
    • Books, magazine or newspaper platform: the monthly revenue from subscribers; and
    • Online games: the revenue from gamers who pay monthly subscription fees, pay for gaming points, or purchases inside the games;
  2. Monthly Active User (“MAU”): The figure is usually analysed in line with ARPU under the same time period. The revenue in the period is then simply a product of the ARPU and MAU. A commonly adopted valuation metric is P/MAU, which could be adopted even when the subject enterprise is not making any profits;
  3. Customer stickiness: This relatively new jargon could be understood as customer loyalty, and is commonly quantified as the average total hours a user spends solely on the services or products of a company. The market often refers valuations based on customer stickiness as “Stickiness Valuation” and this also applies to the valuation of conglomerates such as Tencent (700.HK); and
  4. Customer life time value (“LTV”) and Customer Acquisition Cost (“CAC”): LTV refers to the discounted value that a customer could bring to an enterprise in his/her life time. Meanwhile, CAC refers to the costs that an enterprise needs to spend in order to acquire a new customer. Suppose an enterprise has a LTV/CAC of 1000, this means if it spends HK$1,000 as CAC, it is likely that it will be able to get a present value of HK$10,000 in return.
The world is ever-changing and so does the valuation world. To truly reflect the value of a business, it is recommended not to do everything by the book, but always update the primary and complementary valuation metrics for companies across different industries and development stages.

For more information on how we can assist you with startups valuation, please contact our Director – Corporate Finance and Valuation, Kenneth Ma.