Tackling venture valuations in an uncertain market

In a private roundtable hosted by Juniper Square, over a dozen CFOs and managing partners from leading venture capital firms discussed one of the most pressing challenges in today’s investment landscape: valuations.

Many obstacles stand in the way of VC fund managers seeking to establish reliable startup valuations:

• Pre-revenue early startups often have little meaningful data to disclose

• The cooled-down market means any competitive data is likely stale

• Companies face more pressure from auditors due to increasing scrutiny from the Public Company Accounting Oversight Board (PCAOB)

Since valuations drive so many investment decisions, the lack of available data has become a huge obstacle for VC fund managers seeking to make smart investment decisions for their partners and for their portfolio companies.

The experts at the roundtable shared their views on the challenges—and how they’re figuring out solutions.

Valuing early-stage startups, especially pre-revenue companies, continues to be one of the toughest hurdles for VCs.

“None of the traditional valuation methodologies work for startups,” one CFO stated. Valuation methods such as Discounted Cash Flow (DCF) or market multiples simply don’t work when startups lack revenue, EBITDA, or historical data to reference.

Without robust financial data, early-stage investors often turn to qualitative factors to assess value, which can be difficult to quantify and are highly speculative.

These may include:

• The founding team’s experience and reputation: A strong management team with a track record of success can significantly bolster a startup’s valuation.

• Market opportunity and scalability: How large is the potential market, and how well-positioned is the startup to capture it? Fund managers may focus on the startup's ability to scale rapidly, which is a key driver of valuation.

• Milestones and traction: Non-financial metrics like user growth, partnerships, or product development milestones may also provide some insight into the startup’s progress and potential future value.

At this stage, valuation becomes more of an art than a science, assessing potential over performance.

In a more active fundraising environment, companies would typically raise new rounds every 12 to 18 months, giving investors a fresh marker for valuation. But with the current market slowdown and longer fundraising timelines, companies may go much longer between rounds.

“My benchmark is 17 or 18 months but beyond that, you’ve got to do something to the value. You can't just rely on stale data,” one venture partner mentioned.

Holding at the last round’s valuation doesn’t account for market shifts, and relying on valuations established during an overheated market can lead to overestimating a company’s value. One managing partner noted that some companies raised at what are now considered inflated valuations, and they’re struggling to maintain those valuations in today’s downmarket.

With last-round pricing no longer a trustworthy reference point, firms are adopting additional strategies to ensure a more accurate valuation:

• Discounting last round valuations: Some VCs may apply a discount to the last round price if no major milestones have been hit.

• Increased scrutiny of runway and burn rate: If a company is burning cash faster than anticipated, firms may adjust their valuation accordingly to reflect the risk of running out of capital before hitting key milestones.

• Establishing an industry benchmark: One co-founder and CEO recommended the Market Indexing Method, a two-step process. First ‘tease” the company's value from its last transaction that points to value, even if that dates back two years. Then, pick comps from the larger industry and assess whether those values have risen or fallen. This establishes a benchmark (of sorts) of market valuation shifts in the previous two years and a basis for educated judgment calls about the company’s current valuation.

The participants agreed that they’re seeing more pressure and interest from government auditors such as the PCAOB. Although the PCAOB ostensibly addresses public companies, it appears to be cracking down on VC firms that haven't kept up.

Changes approved in September give the PCAOB the power to hold auditors more accountable. Previously, someone who contributed to an accounting firm’s violations would have to show “recklessness” to shoulder responsibility. According to The CFO Magazine, that’s been reduced to “negligence,” so there’s more reason for auditors to take extra care effective immediately. That follows the first new PCAOB auditor guidelines in more than 20 years to streamline auditor processes, as reported by Reuters.

Auditors moving faster and shouldering greater responsibility for mistakes might contribute to the trickle-down impact VC fund leaders are seeing.

One tactic for handling auditors suggested at the roundtable: Review questions that arose last year, then weave updated answers into this year’s valuation memos.

Other suggestions endorsed by the participants included:

• Standardize data collection and reporting so information is more readily available. One firm shared its success using software to implement a data collection system that automatically gathered financials and KPIs from portfolio companies, significantly streamlining their audit process.

• Document the methodology used to reach assessments so auditors have some assurance around due diligence and thoughtful frameworks. One VC partner talked about developing valuation memos that captured both the financial data and the story behind the company’s performance to explain the underlying assumptions and company-specific factors that influenced the valuation.

• Negotiate with startup leaders to gain access to partial information.

The roundtable members largely agreed that no perfect answer exists, just strategies for drawing from the margins to make more educated assessments.

Lacking reliable, actionable valuation data, SAFEs (Simple Agreements for Future Equity) and their associated valuation caps can offer a tempting data point around which to create valuations. But, argue the roundtable participants, they’re actually not the best marker because they’re more about protecting current investors than assessing the true market value of the company.

SAFEs allow companies to raise capital without immediately determining a valuation, deferring that decision to a future funding round. Applying a valuation cap and then a discount, often around 25%, is a common practice to safeguard against dilution when the SAFE eventually converts. In previous years, marking to valuation caps wasn't uncommon. Since 2023, however, the tighter market has demanded more accuracy than SAFEs or value caps provide.

Since the 25% is essentially an educated guess, in reality the value of the business could be 35% or 65% less, one leader noted. "The valuation cap is just one indication, but we don't know what the floor value is," he said.

Another challenge: SAFEs and valuation caps serve as protection for share owners against market fluctuations and dilutions. That means SAFEs and value caps are debt instruments, noted one leader. As top-level safety markers, they're inaccurate benchmarks for pegging the value of the company at any specific time.

The post-money from the last round has long served as a rule-of-thumb for establishing company valuations, but that, too, has its challenges, especially in a tight-money environment. All post-money calculations ignore the fact that venture capitalists typically receive preferred stock, thus overvaluing the company. As an example, if a venture capitalist invests $5 million for 10% of a company, the implied value is $50 million but that assumes the investor receives common stock. Instead, the preferred stock has more value than the common, which means the investor received more of the company’s value than the 10% implies, reducing the valuation.

In times of tight money, the most recent round’s share price might be accompanied by “gingerbread” terms such as multiple liquidation preferences, participation, or favorable anti-dilution protection. In such a case, the company's value is even less than it would be if calculated using the simple methodology since the implied ownership is higher. Moreover, simply because the company needed to offer such attractive terms, its value has likely fallen.

The current market remains tricky when it comes to investor valuations. With so little fundraising today compared to two to four years ago, much of the data that could inform valuations to keep auditors and VCs happy remains stale.

Successful CFOs will create valuation methodologies that address current market needs and remain savvy about the data points they use to evaluate the worth of prospective investments. Simply having readily accessible information on prior rounds, pricing, and terms can be a good starting point!