Startup Valuation – How Are Startups Worth Billions? (14:10)

How Are Startups Worth Billions of Dollars?

“I don’t understand how tech startups can be worth billions of dollars – many of them aren’t even making money yet!”

“How can an unprofitable company that isn’t even generating revenue possibly be worth so much? Doesn’t this violate all the principles of valuation?”

We get questions like the ones above all the time. The short answer is NO, startup valuation doesn’t violate all the principles.

You can still use standard methodologies such as the DCF, but you have to use radically different assumptions that make the analysis less grounded in reality.

For the numbers to work, the startup has to start making A LOT of money very quickly in the NEAR FUTURE.

If it takes 10-15 years to generate revenue, it will be almost impossible for the numbers to work; but if it happens in the next 2-3 years, it might be plausible.

As an example, we look at Pied Piper in this lesson, the fictional company from the HBO show “Silicon Valley.”

They make money with a file compression and storage app, and they’re aiming to get hundreds of millions of users and then get a tiny percentage of them using their paid services.

So if they currently generate no revenue and have just received $100 million in funding at a $1 billion valuation, is that crazy?

A DCF for Pied Piper

We assume massive app download growth in the early years, with the company reaching ~500 million annual downloads and ~150 million paid users by the end of Year 10. Revenue goes from 0 to nearly $2 billion over that time frame, which implies massive Year-Over-Year (YoY) revenue growth rates.

The company goes from negative Operating Income to nearly $500 million (25% margin) and almost $300 million in Free Cash Flow.

We use a 100x EBITDA multiple to calculate the Terminal Value (arguably fair for a $2 billion company growing at nearly 40% per year).

These assumptions are highly speculative, and so we also have to use a much higher Discount Rate: 50%, compared with the standard 8-12% figures you see for mature companies.

As a result of all this, far more value comes from the Present Value of the Terminal Value: 99% here, vs. 50-70% for normal companies (and ideally less than that!).

The whole valuation is dependent on a huge number of assumptions that are impossible to know in advance: Will billions of people download the app? Will ~5% of users convert to paying customers? Will the company be able to monetize in only 2-3 years’ time?

These assumptions might turn out to be true, but there’s a very high chance they might not be – which explains the 50% Discount Rate.

Startup Valuation Myths

So the DCF does “work” for startups; it’s just not that useful because of all the required assumptions and the inability to guesstimate the numbers for a pre-revenue company.

For a valuation to make sense, the company has to start generating money *very quickly* – if it takes ten years for that to happen, the numbers will be even harder to justify.

And since the majority of the implied value comes from the Terminal Value, the Terminal Multiple and Terminal Growth Rate are incredibly important. They matter more than long-term profit margins because almost no value comes from the Present Value of Free Cash Flows.