Version française/French version: LINK
Valuing early-stage startups is a delicate art. At this stage, relying on discounted cash flow (DCF) models is an illusion. Financial projections are built on assumptions about growth, margins, and discount rates that are far too fragile. It’s wiser to use more pragmatic approaches, such as sector comparables or the ‘VC method,’ which better align with investor expectations. Ultimately, your valuation will depend above all on the credibility of your team and the confidence it inspires.
The valuation of an early-stage startup or an innovative project lies at the intersection of art and science.
Yet, some entrepreneurs reason with dreamlike arguments that risk discrediting them, or even trapping them if their project falters technically, commercially… or financially.
A stack of assumptions about investments, costs, revenues, and various highly uncertain sources of funding often leads to fanciful financial forecasts. These, in turn, fuel discussions that become all the more detached from reality as many stakeholders themselves only have a limited grasp of financial projection models. Far too often, people still rely on projected profit and loss statements alone, without taking into account capital expenditures or working capital requirements.
A cash flow–based approach is essential to anticipate your funding needs. That said, at the seed stage, producing accurate long-term financial forecasts is a tall order. Valuing an innovative project based on its future cash flows is therefore particularly perilous.
And yet, that is precisely what valuation methods based on discounted cash flows (DCF) attempt to do. While the theoretical foundation of DCF is robust, the results it produces are highly volatile and can swing wildly depending on a number of factors.
Forecasts Driven by Your Growth Assumptions
Young, innovative companies have limited financial track records. Forecasting operating and investment cash flows over 5 to 10 years is an even greater challenge when small changes in your growth or margin assumptions can create vast discrepancies in valuation. The same applies to the choice of the “perpetual growth rate” used to calculate the terminal value, which is added to the discounted cash flows of the initial 5 or 10 years.
A Largely Arbitrary Discount Rate
Given that startups are inherently risky, investors typically apply a high discount rate, often above 30%, which significantly reduces the present value of future cash flows. Entrepreneurs, on the other hand, tend to downplay this infamous discount rate, which corresponds to the weighted average cost of capital (WACC). Reaching agreement on a realistic rate becomes a highly subjective exercise, often leading to irreconcilable debates.
Initial Cash Flows Are Usually Deep in the Red
Most seed-stage startups are burning cash and do not generate positive cash flows for many years. DCF analyses typically offset these early losses with sizable operating cash flows projected for 5 to 10 years down the line, an assumption that is hardly realistic when one considers the actual trajectory of median VC-backed success stories. Basing a valuation on such fragile assumptions about a supposedly radiant financial future is highly questionable.
All of this led François Auque, former CEO of Airbus’s Space Division, later Chairman of Airbus Ventures, and now Partner at InfraVia Capital Partners, to say that valuing seed-stage startups via discounted cash flows is “complete nonsense.”
Two Alternative Methods
Even though startup valuation sits somewhere between hard-nosed bargaining and financial modeling, there are more widely accepted approaches:
- The Comparables or Market Multiples Method involves valuing your startup in relation to recent transactions in the same sector. This could be a multiple of your Annual Recurring Revenues (ARR), 10x or even higher for certain startups.
- The Venture Capital (VC) Method is also worth knowing. It starts with the return on investment that motivates VC firms. This method involves estimating the future exit valuation (via acquisition or IPO) and discounting it back to today’s value using the return multiple expected by investors. This approach provides a logical basis for discussing how much equity to give up in a funding round.
In conclusion: steer clear of DCF valuations at the seed stage, they may well undermine your credibility or back you into a corner. Opt for more pragmatic methods grounded in comparable transactions. And when the valuation serves as the basis for bringing new investors into your company, make sure they have a realistic shot at tripling their initial stake, a threshold that, in reality, fewer than 10% of deals ever surpass.
Ultimately, your startup’s valuation will hinge above all on trust, that is, the credibility of your team and your ability to transform a promising yet risky idea into a genuine industrial, commercial, and financial success.
