Pre-Money And Post-Money Valuation

Pre-Money And Post-Money Valuation

India has become the new startup hub, and almost every startup receives enormous funding from VCs. As a result, I see more startups achieving unicorn status. Though this is good news for the economy as startups generate colossal employment, we need to be cautious about the valuations of these startups.

I believe VCs do not value startups; they price them, and this pricing does not in any way reflect the company’s intrinsic value. Therefore, for inherent value, we estimate the cashflows and their growth (length of the growth period) and then assume the company to be a going concern to arrive at the terminal value. Finally, the cash flows are discounted at the cost of capital to arrive at the intrinsic value.

The way VC prices startups are in complete contrast to the DCF valuation:

1)First, VCs forecast revenues and earnings for not more than three years and then apply the exit multiple (usually industry average earnings multiple) at the end of three years. If the company is not profitable, the exit multiple is the multiple of revenues.

2)VCs focus on the target rate of return to discount the future earnings of startups. This rate is much higher than conventional discount rates employed in DCF. Target rates vary depending on what stage of corporate lifecycle the startups are in; for instance, in the Series A round, the rate would get as high as 50%, and for IPO, the discount rate is 25-30%.

3)Another big fallacy in VC pricing is the new capital infusion for additional equity. For any new capital infusion,

Post-money valuation = Pre-money valuation + additional capital raised.

Propotion of equity to new investor = Additional capital infusion/Post-money valuation

However, in my observation, most of these new capital infusions are used by existing investors to cash out and not reinvested back into the business. In this scenario, the post-money valuation should not increase.

High discount rates, using exit multiples at terminal value, and projecting earnings/revenues for not more than three years make VC pricing fallacious and dubious and do not reflect the business’s intrinsic value.