Venture Capital Valuation of Startups is Broken Comments Off on Venture Capital Valuation of Startups is Broken 415

TokenMarket’s Head of Research, Jay Pazos, describes his internal scoring matrix to determine the overall effectiveness that VCs have when valuing startups.

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Many businesses face problems that arise as they begin to grow and become successful. For some, this could be delivering a great product to their chosen market, or ensuring that their service is the best that it can be. For most businesses, however, the issue of funding is one that is often “make or break”, forcing companies to take on investment from Venture Capital firms or try and crowdfund in order to gain the funds they need.

Jay Pazos has over 20 years of experience in the world of private hedge fund management; working with disruptive technologies at great length. Jay’s vast experience with understanding how startups need to be managed, as well as valued, saw him begin his career with McKinsey and Co, one of the world’s largest management consultancy firms. Now, Jay plays a crucial role in the work that TokenMarket carries out, acting as Head of Research, responsible for evaluating early-stage investment candidates.

Jay is an alumnus and active member of the community of the University of Chicago Booth Business School and recently published a manuscript in the Journal of the British Blockchain Association titled Valuation Method of Equity-based Security Token Offerings (STO) for Start-Up Companies; a brilliant piece of research that outlines how startups can use STOs to change the status quo of funding.

TokenMarket sat down with Jay to give readers a brief yet detailed explanation of how this groundbreaking research will be able to give startups the tools they need to succeed.


Hi Jay, thanks for sitting down with us today. Can you give us a bit of background information about yourself?

No problem, thanks for talking to me. As a researcher, I like identifying companies and technologies that would be enablers, beneficiaries, and leaders of innovation. I am interested in learning about disruptive technologies, industries that get affected by those technologies and I like to figure out which companies will emerge as winners. I am especially interested in distributed ledger technologies (DLT) and blockchain technologies. In my previous job, and for 20 years, I worked in the private hedge fund industry in positions which included Chief Investment Officer and CTO. Somehow, I have always been conducting research in some area of finance. Also, in the past, I have experience as an entrepreneur in the software industry and as a management consultant for McKinsey and Co., I recently joined TokenMarket as Head of Research, acting as one of the main gatekeepers for all prospective clients who wish to work with us.
What are some of the highlights of your recently published research?
The manuscript published on January 25th describes a valuation method on security token offerings (STOs) for startup companies. The highlight of the manuscript is a novel formula to calculate the discount rate for valuing a startup. As far as I know, up until the publication of the manuscript, there was no scholar article that described a formula to calculate the discount rate for startups. The formula discovered takes into account the fact that in the early years of a startup, the probability of survival descends rapidly and is an exponential function, and in the later years, the probability of survival descends at a slower rate and has a power function characteristics.

In the study we found that for the total of all startup firms considered, the highest discount rate had a range of 27.0 to 31.8% which is considerably higher than the observed rate for mature firms (approximately 7.5%). However, this discount rate is considerably lower than some published discount rates for startup projects financed by Venture Capital firms (40.6 to 70% range). Most importantly, the results show that for many firms, equity STOs could be an economical alternative to raise capital.
How do companies currently justify their share price?
The truth is that most startups are not valued, they are “rudimentary priced.” Most Venture Capital (VC) firms I know don’t use the Discounted Cash Flow method (the gold standard of valuation) to value companies. What many VC companies do is to forecast some sales or earnings figure in the future for the startup and apply a multiple similar to that of firms sold in the recent past, in the same sector or industry which is a way of “rudimentary pricing” companies, not “valuing” them.
What are the problems that startups face?

Startups face all sort of problems and if they don’t face problems is because they are not moving fast enough. I believe that there are three main problems that startups face: building the right team, thinking through the problem they are trying to solve and organising fundraising efforts to ensure that their project gets through. Each startup faces its own sets of challenges, but those three are common and vital to most of them. To overcome these problems Founders should seek for good mentors: entrepreneurs or ex-entrepreneurs that have been through the process before, that are independent, and can provide a detached opinion, and advice on how to overcome obstacles.

How are VCs hindering startups in the current economic model?
Let me start by saying that VCs play an essential and positive role in funding many businesses from startups to early and late-stage companies. For that, we should be grateful to them. However, that doesn’t mean that the model is perfect and it cannot be improved. For every company that gets funding for their ideas, there is another company that doesn’t. The screening process for funding companies is far from perfect. I believe that with better screening and valuation methods, VCs and crowdfunding companies will be able to fund more well-qualified companies that nowadays are left behind.
What problems does your research solve?
The main problem it solves is that of valuation of startup companies. Instead of using rudimentary pricing methods, we can now move to a peer-reviewed scientific method. In section 2 of the manuscript, we explain how the study sets to solves a long-standing issue in the corpus of finance theory.

Who could use your research to gain a better understanding of how the current model works?
Other scholars can follow on my research. In the manuscript, I suggest some future areas of development. The discount rate is sector and industry dependent. I suggest avenues of research in consideration of more sectors and subsectors as each has its characteristics. The three parameters that I use in the model, each vary by sector. Also, in other findings that I have not published yet, I discovered that the discount rate varies by country.

For instance, the probability of survival of a startup in the UK is higher than in the US. The corollary of this fact is that the discount rate for UK startups should be lower than for those from the US. In other words, two companies, one from the US and the other from the UK, both facing the same cash flow forecast, our model shows that the UK company should get a higher valuation. Understanding how the model works helps to provide new insights to investors and founders.
What does your evaluation model examine?
First of all, my evaluation model looks at the company’s cash flow forecast. This is the most time consuming and critical part of the evaluation process; the forecast should be credible for the level of company’s available resources, that is, team’s skills, size of the serviceable obtainable market, and funds. Then, the model looks at the company’s industry to find the value of the four parameters for the discount rate formula: C, alpha, lambda and F. With that information, the model has all the inputs to evaluate a startup company.
How do you think the STO market benefits startups?
The STO market is a new source of funds for startups. As mentioned before, there is a group of well-qualified companies that don’t get the funds they need, STOs are an alternative way of financing their business. The product offered by VCs is different than STO, both are sources of funds, but they differ in the services they offer and price. There are cases where the bundle of services that the VC offers is more convenient for some firms. In other cases, STOs are a more economical and direct alternative to raise funds. If a company were to use an STO as a means of fundraising it would also mean that there are fewer intermediaries, making the process more cost-efficient and in turn saving the business money.
Based on your vast experience, where do you see how STOs benefit over paper shares?
Equity token offerings are digital representations of company shares, and same as for paper shares, their holders are collectively the owners of the company. One primary benefit of equity tokens is that they live in a blockchain and enjoy all its benefits like transparency, immutability, trustless transactions, security, no central authority overseeing transactions, and resistance to collusion. These are essential benefits that in time will become more evident to the public.
What other research projects do you have coming up?
I am working on the idea that company incubators with the right coaching methods can increase the probability of survival of startup companies. Moreover, as I have established in my previous work, this would decrease the discount rate and increase company valuation. This future study will hopefully describe new ways on which startups should organize in their early-life. The study will also focus on methods incubators can devise to increase the probability of survival of startups, and, thus, valuation.


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Source: Venture Capital Valuation of Startups is Broken

Amine is an internet entrepreneur and the founder of Crypto Radar. Amine operates several internet businesses and has been passionate about cryptos for many years. He occasionally shares his insight on this blog.

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