There’s a transition that occurs in the life of a company, where it graduates from being a “dart-up” to a “company” and the valuation methods that are applied to a company at each stage can be very different. There should be a convergence of between the potential public market valuation that a company could receive and the private market valuations that a start-up will receive very early in its life. Founders need to understand how this journey progresses to avoid taking on an untenable preference stack.

Early in the life of a start-up the valuation is typically arrived at based on the amount of capital needed to reach the next set of milestones and a reasonable level of dilution for that capital. Depending on the funding source, which determines the balance of power, that funding will typically cost somewhere from 10-30% of the company. This means that if a company wants to raise USD2m, they will typically be giving away 20% and receiving a USD10m post-money valuation. There are also reasonable metrics that need to be taken into consideration at each stage of funding, which are typically based on rules of thumb, which are derived from a more thoughtful valuation process, which isn’t the subject of this article .

This process will typically be repeated several times with the dilution and liquidity preferences increasing throughout the later stages of private funding. However, at some point the private market valuation that the company receives should converge with the public market valuations that similar companies receive.

Personally, I’ve always found it unusual that venture investor seldom consider their opportunity set when analyzing investment opportunities. This could be because their mandate limits their mindset, but I’ve always tried to look at capital as being able to pursue the best opportunities regardless of where they are. This means that we will typically consider what an appropriate terminal valuation is for a business if it were to exit via a trade sale or Initial Public Offering. It’s reasonably easy to see what similar public companies trade for either via stock screeners or indices like the to get means, medians, and reasonable ranges.

As a company progresses through the funding process, ideally the delta between the private market valuation and public market valuation should start to converge. In practice, this means that the valuation will be more heavily weighted towards factors that are a derivative of the value created early in its life. However, the valuation will be almost entirely determined by the value created as exemplified by the economic rents accrued later in its life.

Over the last few years, this seldom happened, and we had some IPOs that saw the adjustment happen in the secondary market. Investors in public equity markets will rarely give benefit of the doubt for potential and prefer to value realized efforts.

The switch should happen gently throughout the life of the company rather than a janky public demise. This was made more difficult over the past few years as there was a lot of capital that was seeking a home in higher risk alternatives. This meant that private investors were willing to buy at ever higher valuations in the hopes that there would be a marginal buyer at a higher level and they wouldn’t be left holding the bag when the music stopped.

Private companies will favour vanity metrics that might represent a second derivative of economic value created (think “eye balls” or “registered users”). This is then represented by a Price/Sales ratio, which is generally favoured as a gauge to understand where a company should be valued. However, before the company enters the public forums, the valuation should be able to be justified based on the potential earnings. This means that Ev/EBITDA and Price to Free Cashflow ratios become more important to gauge the value of a company. There are some exceptions to this but they’re more nuanced and require an understanding of .

The companies that form the exception have found expansive niches to exploit. Most businesses that have raised large amounts have not been able to generate significant economic rents and bare more similarities to industrial companies, which require marginal capital to expand revenue opportunities.

Conclusion

It’s easy to say “Don’t get caught up in the hype” as the shine starts to fade but founders need to understand that their outcome will be based on market forces. Acquirers will look at the economic value that they can buy and are not concerned about the amount of dilution that founders have previously experienced, or the amount of capital invested into a business. If the capital can’t be applied to activities that are able to exponentially increase the value in the business, then the growth should be considered.