Before raising capital, the first question most entrepreneurs ask is: What is the company worth?
Notably, the only certainty in any business startup is uncertainty, hence determining the valuation worth of the business before it has revenues is pretty difficult. The valuation of pre-revenue often is a bone of contention between angels and entrepreneurs. Thus, it’s important to determine how much is the business’s worth.
Why Are Valuation Methods Important?
According to Forbes Magazine, at early stages, investors are trying to decide whether they should invest in a start-up. Considerably, they base their valuation on the possible exit size for any particular startup in any specific industry. If business owners have used methods to ascertain the value of the firm, they have higher probability of getting high stake investments. Additionally, different startup valuation methods should be used to get the most accurate appraisal possible. Also, using these frameworks is important since start-up companies do not have reliable past performance and predictable future.
Factors to consider when choosing a startup valuation method
Geographical location and knowledge of other businesses in an industry and what they are valued at is very crucial in figuring out the value business. No single method is used all time; thus, a business owner should not stop with just one approach. Using multiple facet approach helps determine an average valuation which may represent the actual picture of the start-up company. The most popular assessment methods include
Venture capital method
Venture capital method is used for showing the pre-money valuation of pre-revenue companies. It deploys the following formula in the evaluation process:
Return on investment (ROI) is arrived at by dividing the Terminal value by post money valuation thus:
Terminal value/ Post-Money valuation= ROI
On the other hand, Post-Money valuation is arrived at by dividing the Terminal value against the anticipated return on investment, hence:
Terminal Value/ Anticipated ROI= Post money valuation
Harvest (or Terminal) value is the startups anticipate selling price moving into the future estimated by using a reasonable expectation of revenues in the year of sale and estimate earnings.
The problem with this method, dubbed by Damodaran “The Dark Side of Valuation”, is that it encourages a too simplistic estimation. In other words, by focusing on revenues and earning, it excludes considerations on the intermediate items in the income statement (likely misrepresentation of operating costs) and of the relationship between investments required to sustain growth and their impact on cash flows. This leads to a projected value that is more a result of a bargaining process (the entrepreneur will push for higher forecasted earnings and the VC to lower ones) than of the likely evolution of the business.
Moreover, the use of high discount rates as a vehicle for all uncertainty has the greatest impact on valuation. Indeed, the actual returns that have been historically recorded by VCs are much lower than those used for discounting the terminal value in the VC method. This difference represents VCs’ perceptions on the probability of failure and illiquidity of the investments.
Finally, this valuation approach does not take into account the impact of dilution generated by the later rounds, the IPO or stock option issues. If it is necessary to consider these factors, steps 4 and 5 above will have to be repeated for each investment assuming a different IRR for each round (typically decreasing).
Cost to duplicate method
The method involves looking at the hard assets of a startup and calculating how much it will cost to replicate the same business in a different location. The idea is: an investor should never invest more than it will cost to duplicate a business in a different location. The demerit of using this method, however, is that it does not include the future potential of the startup like intangible assets in the market; thus, it’s known as a low-ball estimate of a company value.
Discounted cash flow
The method involves predicting the value of cash flow a company will produce and then calculating the value that cash will is against at an expected rate of investment return. A higher discount rate is then applied to show the risk a company will fail at as its sprouts out. The trouble with this method of evaluation depends on the ability to forecast future market price conditions.
Market multiple approaches
Most venture capitalist like this approach. It provides an excellent condition of what the market is willing to pay for the company. This method values a company against the recent acquisition of similar enterprises in the market. An extended forecast must be determined to achieve desirable results. Notably, the approach delivers value estimates that most investors are willing to pay. However, getting comparable market transactions are hard to get.
First Chicago method
Named after the First Chicago Bank, the approach factors in the possibility of startups taking off, or doing badly in the market. It, therefore, presents a business owner with three different valuations:
- Standard case scenario.
- Best case scenario.
- Worst case scenario.
We will see more in the next episodes…
As you can see Valuation Methods are many and they are the product of detailed planning and data gathering.
You should focus on Valuing your company only after you developed your proof of concept, have a growing user base and are working on your business plan.
In the next episodes we will take a closer look at the tools you need to get in front of investors.
Stay Tuned !!!