“Record-breaker: Halter raises $377m at $3.3b valuation” - NZ Herald

“Kiwi startup Partly almost a unicorn after Series B raise” - NBR

“Fintech Caruso’s valuation soars in new funding round” - AFR

Three attention-grabbing headlines from recent months. For the startup curious, or the downright sceptical, the bigger question is the one rarely answered: how are these businesses possibly worth that much?

We know they’re not profitable; that’s why they’re raising capital. They rarely have tangible assets – like land, property, buildings, equipment – that reflect anything close to the headline number.

Valuations

Realistically, they’d have a difficult time selling their companies at those ‘massive’ valuations.

As the reader, we’re trying to apply conventional business logic to these numbers. Desperately looking for the spreadsheet, the financial model, the calculations that all boil down to a precise valuation. I’m afraid we’ve been misled to look for certainty that doesn’t exist.

I have to break it to you: valuations aren’t a calculation, they’re an opinion. Valuations do include financial analysis, but they’re as much influenced by market psychology, negotiation, and, frankly, storytelling.

This isn’t unique to startups. Apple’s business hasn’t grown by ~50% in the last year, but its valuation has. At the same time, Nvidia’s business has grown much faster, about ~85% at the time of writing, and its share price is up less than Apple’s. What gives?

In the case of Apple and Nvidia, millions of people representing billions of dollars buy and sell their shares, expressing their opinions on valuation every day.

In venture capital, where firms buy shares in private fast-growing startup companies, you might only need one investor (“valuer”) who believes in the valuation and is willing to invest on that basis. Rather than investing every day, they do so about every 1 to 2 years. So, how do they reach a valuation?

Comparables and Rules of Thumb

The longer investors operate and the more deals they see, the greater their hidden advantage: data. Every deal they see, whether they invest or not, is a data point. Investors don’t need to start from scratch each time because the shorthand is comparing to other companies with similar features at similar stages.

A software company raising $10-20m in a Series A round that earns $10m in annual recurring revenue? That’s probably going to be in the $60-120m valuation range. However, venture capital is pursuing growth outliers. Growing faster than 5x year-on-year at that scale, in a popular category, and you might instead be raising $30-50m at a $300m+ valuation.

We can also reverse-engineer valuation from the typical dilution (how much of a company is sold) that occurs when a company raises capital.

Dilution tends to start at ~20% per round in the earliest stages and reduces as companies mature. Say a company raises a $5m round and sells 20-25% to do so, then 20-25% is worth $5m and 100% is worth $20-25m. That’s the valuation.

The amount of dilution may be influenced by an investor’s views on founder ownership (how much ‘skin in the game’ they need to stay motivated over time), their evaluation of the quality of the company, and how capital intensive the business is. Hardware, medical devices, and ‘deep tech’ typically have larger or binary capital requirements so may raise rounds that are more dilutive than software businesses, for example (there’s rarely a rational plan to run half of a clinical trial, so you either raise the total required or nothing at all).

Working backwards

Now for a sanity check. It’s not about what the company is worth today, but what you predict it will be in the future, either at a future round or at the end of the journey. If you can estimate that, then you can work backwards.

Let's imagine a company at its earliest stages, aiming to raise $1m today. Based on the market it's targeting and the unit economics it predicts, I think it could be worth $500m if successful – but I'd give it only a 10% chance of making it.

To justify the risk I’m taking, I would like to make a 30x return on investment if it succeeds. I’d therefore need $30m back.

Sound greedy? Across a portfolio (or fund with 10+ underlying companies), a 30x return with a 10% success rate is only a 3x return in total. That’s less than the S&P500 for the last decade, before compensating for the risk and illiquidity involved!

Back to the valuation. If the company exits at $500m and I need $30m back, I need to own 6% at exit. But future funding rounds will dilute my ownership by ~50%, so I need to buy 12% today. If $1m buys me 12% of the company, the maximum valuation entry point I am willing to buy in at is $8.3m.

Anything less and I’m happy as an investor. Anything more and one of my assumptions has to give. This is where storytelling and psychology play a greater role.

What if the company can convince me that they’ll be worth $1b, not $500m? That they’re incredibly efficient and can grow with very little additional capital? That they’re so talented that they’re much more likely to succeed?

Perhaps I’ll even convince myself. That AI will enable in three years what used to take ten, or that in a “Saaspocalypse”, success will come from backing deep-tech hardware that can’t be replaced by Anthropic’s next model release.

Milestone and scarcity

A startup chooses when to raise capital and from whom. This scarcity of investment opportunities can factor into the valuation, bringing forward recognition of milestones before they’re achieved.

Suppose a company has only $1m of revenue today, but they have customer contracts that are likely to grow this revenue to $10m in six months’ time. The company is not going to accept a valuation reflecting their current revenue, while I’d prefer to wait six months and see those contracts turn into real revenue.

If I miss out today, the next opportunity to invest mightn’t be for another two years, by which point they could have flown past that $10m milestone, and I’ll end up paying much more. This scarcity drives negotiation and compromise.

The market "clearing price" 

Relatively few investors go it alone. They know that companies will benefit from more capital than they can provide alone, and other investors bring more to the table than capital. The need to build a syndicate of investors serves as a quasi-marketplace mechanism. Every investor will land on different figures, but ultimately, enough investors need to say “yes” to hit the target the company needs.

Even if I’m willing to invest at a higher price because I believe in a brighter outlook than other investors, this won’t lift the valuation unless I either have the dollars (and perhaps lack of sense) to go it alone, or the mana to attract followers irrespective of their own views on valuation.

Value for upside, not downside

Never forget that headline valuation is accompanied by investment terms that don’t make it to the press release.

Most venture capital investments take place using “preference shares”, typically meaning an investor receives their original investment back first before founders or other earlier shareholders receive a return in a downside scenario. Valuations tend to reflect assumptions about upside but are premised on protection for lower downside.

An honest summary

Startup valuations are not a scientific, precise measure of worth. They are negotiated numbers that reflect supply and demand for capital at a particular moment, filtered through investor expectations about a highly uncertain future.

What can they reflect? The traction and momentum of a company. The calibre of a team, and the size of the market they’re pursuing. Competition between investors and comparable businesses.

Put as much weight in who’s behind the valuation than the headline number and ask yourself what that number means to them. A $1b venture fund writing a $1m cheque shows a completely different level of belief than when they’re writing a $100m cheque.

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Jack McQuire is a Partner at Icehouse Ventures, New Zealand's most active venture capital firm. Icehouse Ventures is on a mission to transformative investors in transformative Kiwi companies. 

This article represents the personal views of the author and does not constitute financial advice. Past performance is not indicative of future returns. Readers should seek independent financial advice before making investment decisions.

Connect with Jack here.