Startup Valuation: How to calculate what your startup is really worth?
“A startup is a company that is in the first stage of its operations. These companies are often initially bankrolled by their entrepreneurial founders as they attempt to capitalize on developing a product or service for which they believe there is a demand. Due to limited revenue or high costs, most of these small-scale operations are not sustainable in the long term without additional funding from venture capitalists” - Investopedia
As the definition from Investopedia suggests that every startup seeks for funding from either venture capital, angel investors or crowd funding, the startup valuation is a primary requirement for the funding firms. Venture capital is a type of funding for startups or growing business. It usually comes from venture capital firms that specialize in building high risk financial portfolios. Venture capital firm gives funding to the startup company in exchange for equity in the startup. An angel investor is a wealthy individual who provides funding for a startup, often in exchange for an ownership stake in the company. Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business venture. Crowdfunding makes use of the easy accessibility of vast networks of people through social media and crowdfunding websites to bring investors and entrepreneurs together to raise the funding for a startup.
For any startup to grow and get the funding, they need to prove their value (in terms of innovative technology used in their product or service, future demand of their product or service and/or financial value) to the investors. There are many standard valuation methods that can be adopted by investors to invest in a startup.
1. The Berkus Method
“Pre-revenue, I do not trust projections, even discounted projections.” — Dave Berkus.
This method, which is used and defined by active angel investor David Berkus, involves a lot of estimation. First, Berkus says that investors should believe the company has a potential to hit $20 million or more in revenues by the 5th year of operation. Then, he applies a scale to five components of a startup, rating each at up to $500,000. The components are:
These numbers are maximums that can be “earned” to form a valuation, allowing for a pre-revenue valuation of up to $2 million (or a post rollout value of up to $2.5 million), but certainly also allowing the investor to put much lower values into each test, resulting in valuations well below that amount.
2. Risk Factor Summation Method
This Method brings further risk management and governance consideration based on specific risk factors.
The Ohio TechAngels describe the method as follows:
“Reflecting the premise that the higher the number of risk factors, then the higher the overall risk, this method forces investors to think about the various types of risks which a particular venture must manage in order to achieve a lucrative exit. Of course, the largest is always ‘Management Risk’ which demands the most consideration and investors feel is the most overarching risk in any venture. While this method certainly considers the level of management risk it also prompts the user to assess other risk types,” including:
2. Stage of the business
3. Legislation/Political risk
4. Manufacturing risk
5. Sales and marketing risk
6. Funding/capital raising risk
7. Competition risk
8. Technology risk
9. Litigation risk
10. International risk
11. Reputation risk
12. Potential lucrative exit
Instead of assigning percentage weights and multiples, we assign the following ratings to each risk factor and do an adjustment to the average pre-money valuation per each rating:
3. Scorecard Valuation Method
This method compares the target company to angel-funded startup ventures and adjusts the average valuation of recently funded companies in the region to establish a pre-money valuation of the target. Such comparisons can only be made for companies at the same stage of development.
Individual accredited investors in typical angel deals put personal capital at risk for an equity share of growth-oriented, start-up companies. These angel investors generally invest $25,000 to $100,000 in a round totalling $250,000 to $1,000,000. In 2011, the valuation of pre-revenue, start-up companies is typically in the range of $1–$2 million and is established by negotiations between the entrepreneur and the angel investors. For this round of investment, the angels collectively purchase 20-40% of the equity of the company and are seeking a return on investment of 20-30X in a period of five to eight years.
I. Determine the average premoney valuation of pre-revenue companies in the region and business sector of the target company.
Pre-money valuation varies with the economy and with the competitive environment for startup ventures within a region. In most regions, the pre-money valuation does not vary significantly from one business sector to another.
II. Evaluate the start up on the following 7 critical factors and their weightage accordingly.
The investor then assigns a rating usually in the range of say 0.5 to 1.5 with 1 as a base for the normal requirement and arrives at the weighted average rating of the start-up.
Suppose the investor assigns the following ratings to the start-up.
III. Multiply the rating factor with the average valuation
In this case: 1.15*1.25 = 1.4
Hence, the pre-money valuation of the start-up will be $1.4 million.
4. Comparable Transactions Method
Comparable transactions is one of the conventional methods to value a company for sale. The main approach of the method is to look at similar or comparable transactions where the acquisition target has a similar business model and similar client base to the company being evaluated.
Steps to perform precedent transaction analysis:
I. Search for relevant transactions
The process begins by looking for other transactions that have happened in (ideally) recent history and are in the same industry.
The screening process requires setting criteria such as:
· Industry classification
· Type of company (public, private, etc.)
· Financial metrics (revenue, EBITDA, net income)
· Geography (headquarters, revenue mix, customer mix, employees)
· Company size (revenue, employees, locations)
· Product mix (the more similar to the company in question the better)
· Type of buyer (private equity, strategic / competitor, public/private)
· Deal size (value)
· Valuation (multiple paid i.e. EV/Revenue, EV/EBITDA etc.)
II. Analyze and refine the available transactions
Once the initial screen has been performed and the data is transferred into Excel then it’s time to start filtering out the transactions that don’t fit the current situation. In order to sort and filter the transactions, an Analyst has to careful “scrub” the transactions by carefully reading the business descriptions of the companies on the list and removing any that aren’t a close enough fit. Many of the transactions will have missing and limited information if the deal terms were not publicly disclosed. The Analyst will search high and low for a press release, equity research report, or another source that contains deal metrics.
III. Determine a range of valuation multiples
When a short list is prepared (following steps 1 and 2) the average (or selected range) of valuation multiples can be calculated.
The most common multiples for precedent transaction analysis are EV/EBITDA and EV/Revenue.
An Analyst may exclude any extreme outliers such as transactions that had EV/EBITDA multiples much lower or much higher than the average (assuming there is a good justification for doing so).
IV. Apply the valuation multiples to the company in question
After a range of valuation multiples from past transaction has been determined, those ratios can be applied to the financial metrics of the company in question.
For example, if the valuation range was:
· 5x EV/EBITDA (low)
· 0x EV/EBITDA (high)
And the company in question has EBITDA of $150 million,
The valuation ranges for the business would be:
· $675 million (low)
· $900 million (high)
V. Graph the results (with other methods) Once a valuation range has been determined for the business that’s being valued it’s important to graph the results so they can be easily understood and compared to other methods.
5. Book Value
Book value, a multiple of book value, or a premium to book value is also a method used to value manufacturing or distribution companies. Book value is total assets minus total liabilities and is commonly known as net worth.
This form of valuation is based on the books of a business, where owners' equity total assets minus total liabilities is used to set a price. There are a couple of problems with this simplified approach. First step is to audit the business’ books of the company. Secondly, the value of some assets, such as buildings, equipment and furniture/fixtures, may be overstated on the books, and may not reflect the maintenance and/or replacement costs for older assets.
Using the Tangible Book Value, intangible or soft assets are deducted from the total assets.
6. Liquidation Value
Liquidation value is the total worth of a company's physical assets when it goes out of business or if it were to go out of business. Liquidation value is determined by assets such as real estate, fixtures, equipment and inventory. Intangible assets are not included in a company's liquidation value.
Liquidation value does not include intangible assets. Intangible assets include a business's intellectual property, goodwill and brand recognition. However, if a company is sold rather than liquidated, both liquidation value and intangible assets are considered to determine the company's going concern value. Value investors look at the difference between a company's market capitalization and its going-concern value to determine whether the company's stock is currently a good buy.
For an investor, the liquidation value is useful as a parameter to evaluate the risk of the investment: a higher potential liquidation value means a lower risk. For example, all other things equal, it is preferable to invest in a company that owns its equipment compared to one that leases it. If everything goes wrong and you go out of business, at least you can get some money selling the equipment, whereas nothing if you lease it.
So, what is the difference between book value and liquidation value? If a startup really had to sell its assets in the case of a bankruptcy, the value it would get from the sale would likely be below its book value, due to the adverse conditions of the sales.
So liquidation value < book value. Although they both account for tangible assets, the context in which those assets are valued differs. As Ben Graham points out, the liquidation value measures what the stockholders could get out of the business, while the book value measures what they have put into the business.
7. Discounted cash flow
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis finds the present value of expected future cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered.
DCF is calculated as follows:
I. Cash Flow (CF):
It is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of CF, with various important uses for running a business and performing financial analysis.
Types of cash flow include:
· Cash from Operating Activities – Cash that is generated by a company’s core business activities – does not include cash flow from investing. This is found on the company’s Statement of Cash Flows (the first section).
· Free Cash Flow to Equity (FCFE) – FCFE represents the cash that’s available after reinvestment back into the business (capital expenditures). Read more about FCFE.
· Free Cash Flow to the Firm (FCFF) – This is a measure that assumes a company has no leverage (debt). It is used in financial modelling and valuation. Read more about FCFF.
· Net Change in Cash – The change in the amount of cash flow from one accounting period to the next. This is found at the bottom of the Cash Flow Statement.
II. Discount Rate (r):
The discount rate is typically a firm’s Weighted Average Cost of Capital (WACC). Investors use WACC because it represents the required rate of return that investors expect from investing in the company. For a bond, the discount rate would be equal to the interest rate on the security.
The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.
8. First Chicago Method
The First Chicago Method is a situation specific business valuation approach used by venture capital and private equity investors for early stage companies. This model combines elements of market oriented and fundamental analytical methods. It is mainly used in the valuation of dynamic growth companies. Let´s go through this method step by step.
I. Define different future scenarios for the Company
Usually you create three scenarios for an enterprise:
First you have to set up a financial forecast (including revenues, earnings, cash flows, exit-horizon etc.) for each case. A detailed qualitative analysis of the market trends and the company are necessary in order to estimate these scenarios. In general, the mid-case scenario is the expectation of an Analyst after the Due Diligence (DD).
Hence, in many businesses, which are mainly driven by the scalability factor (e.g. the market is in a “winner takes it all” situation), it is reasonable to set the worst-case equivalent to the event of total loss of the invested capital. Then again there are businesses where the market determines a natural maximum cap of the financial outcome.
Still, step 1 is not easy to master and needs an extensive analytical research of the circumstances. You might even have the freedom to consider strategy-shifts in your financial forecast depending on the assumptions of each case.
II. Estimate divestment price for each scenario using multiples
After setting up your financial-forecast, you need to determine the Terminal Value (TV) at the time of the exit (divestment price). At this point we apply a market oriented valuation concept, Multiples. The idea is to estimate a valuation by comparing the investment to other transaction within the same peer group. Peer groups in the venture industry are characterized by:
· Enterprise industry
· Enterprise stage
· Enterprise region
There are various forms of Multiples each suitable for different asset classes. Professionals in the venture industry will use Multiples based on KPIs like EBIT, Revenues etc. The critical factor in this market oriented approach is the transaction data of the peer group. Data about M&A activity in the venture industry are rare, nevertheless there are data provider on the market specializing on the venture industry.
III. Determine required return and calculate valuation for each scenario
Many VCs determine the required return internally. They do not trust concepts like WACC (Weighted Average Cost of Capital) and CAPM (Capital Asset Pricing Model) due to of the incompleteness of the private equity market (you can´t replicate the payoff of an investment with a portfolio of assets). However, we will give a brief introduction into WACC concept which is adjustable to the venture market. Furthermore, we will assume the absence of debt capital in the financial forecasts, which reduces the WACC to the cost of equity (not a strong assumption approaching valuation of early stage companies).
IV. Estimate probabilities of scenarios and calculate weighted sum
For this last step you have to allocate a probability to each scenario. This probabilities are naturally correlated to your definition of the scenarios and the number of them. Of course it is impossible to estimate precise probabilities for every scenario. The idea is take extreme outcomes into your valuation process.
At the end calculate the weighted sum of the valuations depending on each scenario.
All above mentioned eight startup valuation techniques are helpful for valuation and gives the clear picture to an investor before putting their money at risk in any startup. Not all the techniques must be applied before investing in any startup as they depend on the situation of the startup (whether it is in a prototype stage, in a product stage or just an idea). The first Chicago method and Discounted Cash Flow (DCF) method gives a clear mathematical picture of the start-up’s present as well as future monetary value perspective. The Comparable Transaction method and Risk Factor Summation method gives an idea to the investor about the risk involved and how good is the start up from the other competitors in same field.