Not the usual article!

This article is not the usual article you can find in our blog. Instead this is an essay on startup valuation that I wrote a couple of months ago. It presents a completely new way of looking at startup valuation and division of equity. The answers to a survey on valuation are presented first while later on the new framework and its advantages are discussed. Do you want a complete new and detailed point of view on startup valuation? Read the following!


The purpose of this paper is to present a new framework of startup valuation and division of equity. This framework is based on the intuition that the process of investing can be interpreted as a merger between the company and a firm that has cash on its balance sheet. This intuition clarifies the notion and the importance of synergies in this operation as well as the outcomes. Indeed, without a proper identification of the synergies amount, the investor will push for a lower valuation in order to get a higher percentage of equity. This can create frictions with the other party and lead to a deal break. Given the strong financial constraint of a startup, this inefficiency could lead to the anticipated termination of the activity, even when positive NPV projects could be pursued. Other minor implications are also discussed. The paper will also present the results of a survey conducted to investigate how the valuation is done in practice and will compare these results with the new framework.

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I. Introduction to the problem

Valuation of startup companies is usually problematic because of three factors. First, often the company does not have revenues, stable cash flows or even a market share, since the novelty of its idea. Second, the entrepreneur’s knowledge about finance and valuation is seldom deep enough to be able to use proper valuation metrics and to forecast future cash flow. Third, these firms are already financially constrained and they often cannot afford a formal advisor to help in this respect.
These conditions lead to the fact that valuations in this environment are not sophisticated enough. Furthermore, this situation creates opportunities for sophisticated investors, like venture capitalists and business angels, that can use their deeper financial knowledge to lower the valuation computed by the entrepreneur in order to obtain a larger amount of equity in return for their investment.

From internet research and a survey, it appears that the most widespread procedure to calculate the equity percentage to assign to the investor is a simple calculation: the investment over the valuation of the company (as the money was effectively at its disposal) plus the investment. The denominator is referred to as “post-money valuation”, while its first term, the valuation, is referred to as “pre-money valuation”. The method would be correct into a competitive market where all the synergy premium is attributed to the seller and the buyer pays the fair price. However, for startups, the market is less competitive and a more sophisticated technique is required.

The technique proposed in this paper is based on M&A theory and on the fact that investing into a company can be assimilated to the M&A process of merging the standalone company to a new-co which only asset is a certain amount of cash in the bank, the investment. From this framework, we can already add an important distinction to the process outlined above. This distinction concerns the stand-alone valuation of the company and the merged-valuation, being the first the value of the company without any external financing, and the second the value of the company as if the investment was possible but not still on the balance sheet (pre-money valuation). This distinction has its focus point on the concept of synergy. Synergies, in M&A theory, are all the value improvements that the two companies can obtain being merged and that enhance the value of the merged entity compared to the value of the two separated companies. These synergies are particularly important in the startup process since the fact that the company is strictly financially constrained, and thus the infusion of capital is critical and creates important financial synergies. As discussed further on in the paper, the splitting of synergies between the investor and the entrepreneur is of utmost importance in determining the percentage of equity to assign to the investor. This split is determined, among other factors, by the bargaining power of the two parties.  The new framework allows the identification of problems and frictions created by the old one and improve the understanding of the true value of the company and of the bargaining positions of the parties involved.