At the beginning of last year (2023), news came from Elon Musk's sensational company, Space X. According to information obtained by CNBC, the valuation of Elon Musk's company for the production of reusable rockets and satellite Internet SpaceX has reached 137 billion US dollars. At the same time, on the opening date of the American NASDAQ exchange on January 3, the market capitalization of Elon Musk's other company, Tesla, resumed at least since 2020, reaching $ 341 billion. 

What does the capitalization of the company mean? In simple words, the capitalization of a company is the value of that company. Does this mean that you can buy a company for this amount? Probably not, rather than yes. At the time of sending the offer by the same Elon Musk, an offer to buy Twitter for $54.20 (it is a weed joke) per share, they were trading at $48 per share on the New York Stock Exchange. So, the capitalization of a company is the value of all shares of a company at current prices.

If shares of a public Tesla company are traded on the stock exchange daily and from this price it is possible to calculate the capitalization of the company on a certain date, then there is no such market for shares of a private Space X company. So, how do we know that the valuation of Space X has reached 137 billion? The calculation takes place exactly according to the same scheme as with public companies – the value of all shares of the company at the price of the last "trades". Thus, as part of a new round of financing, Space X is raising $750 million, estimated at $137 billion. From here we know that the company, which was valued at 140 billion when Elon Musk offered his shares at $77 per share, is now valued slightly lower.

But all these discussions do not explain to us where the valuation of a private company comes from? Why investors, led by the venture capital firm Andreessen Horowitz (also known as a16z. A and Z (the first and last letters of the founders' surnames and 16 letters between them) gave an estimate of exactly 137 billion. The price of shares on stock exchanges is formed as a result of the interaction of supply and demand for a particular share. When more people want to buy shares than sell them, the price goes up, and when more people want to sell shares than buy them, the price falls. Company performance, market conditions, general economic conditions, and even a sex scandal with the head of the company are examples of factors that affect supply and demand. Shares of private companies are not traded with such frequency that the price depends on supply and demand in real time. 

How much does the idea cost?

If you come to a potential investor and offer to invest in the business of buying used cars from Lithuania and sell them at a premium in Bishkek, the investor is likely to have an understanding of the profitability, and possibly the unprofitability of such an undertaking. It is much easier to calculate and show the required amount of investment and marginality of the business. At the idea stage, investing in startups is a financial industry with significant high risk. If now it seems to you that the idea of letting a stranger into the house from the Internet for payment is quite safe and a good additional source of income, then imagine what the reaction of investors was in 2008, when they first heard the idea of Brian Chesky and Joe Gebbia, the founders of Airbnb. This is exactly how the founder of Y Combinator, Paul Graham, reacted, who did not like the idea itself, but was surprised by the resourcefulness of the founders on the way to raising money for his startup and still accepted Airbnb at YC.

So, how much is my startup worth?

Before talking about evaluation, it is worth mentioning the stages of startups. Startups can be divided into categories depending on the funding rounds (pre-sees, seed, Series A, B, C, etc.). Attracting funding and categorizing them is often closely related to the following stages of their development:

Idea/concept stage: At this stage, the founders have an idea for the business, but it has not yet been tested and tested.

Research and Development stage: At this stage, the founders test an idea, develop a product or service, and collect data about the target market.

Prototype stage: A startup creates a minimum working prototype (MVP – minimum viable product) to demonstrate the viability of a product or service.

Launch stage: A startup officially launches its product or service and begins to acquire customers.

Growth stage: The startup is experiencing rapid growth in revenue and customer base.

Maturity stage: A startup reaches a stable state with a mature product, an established market position and a more predictable revenue stream.

The stage of decline: unfortunately, this also happens, and a startup's revenue and market share decrease, and it must either change the direction of activity or cease its activities. In fact, a change in direction or termination of activity happens at any of the above stages.

A conditional assessment of a startup can be set at any of these stages, when the first investments are attracted. The valuation of a startup, as I have already indicated above, depends on how much investors are willing to pay for a share (shares) in a startup. Usually, a round of financing with an assessment takes place on Series A. This round is usually attended by institutional investors (venture capital firms, etc.). In this round, investors buy preferred shares and all investments attracted through SAFE or convertible loans at early stages are converted into shares at the price of such a round (or at a discount provided for in such documents).

Assessment methods

Venture capital companies use a variety of methods to evaluate startups. If the startup is at a more advanced stage, this process includes a thorough financial analysis by financial analysts-MBA graduates of all available indicators (metrics, metrics, metrics) of the startup. But I got the best answer on the startup evaluation method from the managing partner of Andreessen Horowitz, the author of the book Secrets of Sand Hill Road and a lecturer at Stanford Business School, Scott Kupor. When I asked how Andreessen Horowitz evaluates startups, he replied that often the evaluation of startups is more related to art than to financial analysis of indicators. In fact, the subjective opinion of the firm's partners about the future of the startup in which the firm wants to invest plays a greater role than financial or other indicators.

In their analysis, investors usually use a combination of financial and qualitative criteria to evaluate startups. Some of the most common criteria include:

Finance. Startups with proven track record of increasing revenue, profitability, and positive cash flows are often more attractive to investors.

The size of the market. Investors are looking for startups that can break the established rules of the game in large growing markets. At the same time, the volume of markets should be more than $10-$20 billion. After all, you can't grow a unicorn on a market worth a couple hundred million dollars.

Competitive environment. The presence of experienced players and the level of competition in the market can affect the evaluation of a startup.

Intellectual property. Startups with patented technologies or unique intellectual property may be rated higher.

Startup management. Experience, skills and track record of management (founders) A startup can have a significant impact on its valuation.

A vision. Founders must have a vision, and they must be able to sell their vision from the earliest stages.

Product compliance with the market. Investors are looking for startups that have demonstrated strong alignment between their products or services and their target markets. This is called product-market fit.

Attractiveness. Startups that have already been able to find paying customers, build partnerships, or show other signs of attraction are often more valuable to investors.

Growth potential. Startups with the potential for rapid growth and scalability are often more attractive to investors. They always expect you to make at least 10 times the profit.

These criteria are not set in stone, and each investor may have their own unique approach to valuation, but these are a few of the most commonly used factors. In addition to the subjective assessment and factors influencing the assessment, startups are recommended to pay attention to the ratio of the attracted (or desired) amount of investment and the intermediate stages and indicators that they need to achieve by the time of such fundraising:

Of course, in addition to the subjective opinion of the partners, the decision to invest is the long-term work of financial analysts of venture firms. In their analysis, investors use one of or a combination of several of the following methods:

The method of market coefficients: A method of evaluating a startup by comparing it with similar companies in the same industry and determining a multiple of income/profit or by analyzing available information on mergers and acquisitions (M&A). For example, if a newly acquired company had an income multiple of 4, a startup with a similar income potential could be valued at 4 times its projected income.

Future Valuation Multiplier method: A method for evaluating a startup based on future revenue forecasts and applying a multiplier to these forecasts. This approach assumes that the startup will grow at a certain rate and generate a certain level of profit in the future, and the multiplier will be based on these forecasts.

Reproduction costs: A method of evaluating a startup by determining the cost of reproducing its assets, products, and intellectual property. This approach assumes that the cost of a startup is equivalent to the cost of creating a similar business from scratch.

Berkus Method: A method of evaluating a startup based on factors such as idea, market opportunities, management team and competition, and assigning points based on these factors. This approach is subjective and depends on the judgment of the appraiser.

The method of venture valuation. As the name suggests, the venture valuation method is a method used by venture capital companies to assess the value of startups. This method is used to evaluate startups at an early stage that do not have significant financial results, and is based on the assumption that the company's future results will be much better than its current performance. 

Return on investment (ROI) = terminal cost = post-investment valuation

Post-investment valuation = final cost ÷ expected return on investment

In the end, I would like to mention that there are venture capital firms, angels and accelerators that invest according to pre-established conditions. Regardless of the stage or performance of your startup, such investors offer a standard set of valuation limits and investment size for your company. Below are examples of the investment conditions of the largest accelerators:

Y Combinator invests $500,000 in each company on standard terms. The accelerator invests in two tranches:

$125,000 on SAFE in exchange for 7% of the startup's post-investment valuation

$375,000 on SAFE with no valuation limit, with a provision on most-favored-nation treatment.

Techstars writes that the accelerator invests up to $120,000 in exchange for 6% of the shares of each participating company. But it's not that simple. This amount of investment is also divided into tranches:

$20,000 in exchange for 6% of the company's ordinary shares

$100,000 investment on a convertible loan (at the discretion of the startup).

At the same time, it should be borne in mind that a convertible loan from the accelerator has an annual interest rate of 5%. The valuation limit for a convertible loan is $3 million (this limit can be increased to 5 million).

This material was prepared within the framework of the Project "Stimulating productive Innovations" with the support of the International Bank for Reconstruction and Development and the Ministry of Digital Development, Innovation and Aerospace Industry of the Republic of Kazakhstan.