Business valuations are critical to determine the current worth of a business, using objective measures, and evaluating all aspects of the business. The tools used for valuation can vary among evaluators, businesses, and industries.
Traditional methods used for valuing already established businesses are quite different to valuing startups, early-stage businesses and even SMEs.
The real issues in early-stage funding are the absence of two key variables used to come up with a valuation: cash (economics), which encompasses how much an investor pays for shares; and equity (control) or how many shares are issued to investors.
Of course, the entrepreneur’s demand curve and investor’s supply curve intersect in a zone where both can reach mutual agreement. This is the sweet spot. Yet, transactions often close based on the bargaining power of the parties concerned.
So, the best way to approach this issue is to put yourself in the shoes of an investor… and ask yourself a few questions.
Is the startup in a hot sector or do you have an experienced and proven management team? For instance, a serial entrepreneur can command a higher valuation. Do you have a functioning product (this may be more applicable to companies in the early stages)? Do you have traction? In other words, do customers see value in your product?
To arrive at a valuation, it is important to determine the typical characteristics of a business and the ultimate source of value across the various stages of a business lifecycle.
Figure 1 – Determining the basis for Business Valuation
To derive a value, a business needs to generate revenue from its current operations and become profitable over time. Revenue is usually low during the startup phase and the initial operational costs mean the business runs at a loss before breaking even. Hence, during the startup phase, the source of value will completely be reliant on future growth estimates. During the growth phase, revenue increases and so does profits.
During the Stake-out stage, revenue and operating profit grow and the business becomes comparable across other companies and now has a reasonable operating history on which to base the valuation on. The source of value can now be derived from existing assets rather than growth. Once the company reaches maturity, revenue and profits tend to drop gradually, hence the value is now derived entirely from the existing assets of the business.
Once the source of value is derived, the valuation must be done based on the investment opportunities. The investment requirement changes from high to low as the company progresses. On the other hand, the financing decision is required to ascertain if debt, equity of a combination of both are required as the company journeys across its life cycle.
Figure 2 – Financing choices for Business Valuation
At a high level, Business Valuation models play a key role in determining the ultimate valuation of a company; however, these models tend to differ based on the maturity stage of the company.
Figure 3 – Financing choices for Business Valuation
There are a few models that could be considered to value anearly-stage business and different models can be used as the business matures, but businesses shouldn’t stop at one approach. Sophisticated investors use several methods because no single method is useful every time.
(1) Cost-to-Duplicate method
As the name implies, this approach involves calculating how much it would cost to build another company just like it from scratch. The idea is that a smart investor wouldn't pay more than it would cost to duplicate. This approach will often look at the physical assets to determine their fair market value.
(2) Discounted Cash Flow (DCF)
For most early-stage businesses, the bulk of the value rests on future potential. Discounted cashflow analysis represents an important valuation approach as it involves forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth. However, it depends on the ability to accurately forecast future market conditions and long-term growth rates.
(3) Venture Capital Method The venture capital method reflects the process of investors, where they are looking for an exit within 3 to 7 years. Hence, they first estimate an expected exit price for the investment, they apply their anticipated ROI (based on time and risk) to identify what the post money valuation today should be. This valuation method emphasizes the exit or the terminal value of the startup. It is one of the most effective methods which makes it is easier to estimate a potential exit value once certain target milestones are achieved. The following formula is used, Post-money Valuation = Terminal Value ÷ Anticipated ROI in which,
Post money Valuation refers to the value of the business after including the value of the venture capitalist’s investment
Terminal Value = The value of the business beyond the forecasted period when future cash flows can be estimated. It assumes a business will grow at a set growth rate forever after the forecast period.
Anticipated ROI = This is calculated before a project kicks off and is often used to determine if that project makes sense to pursue. Anticipated ROI uses estimated costs, revenues, and other assumptions to determine the profitability of a project or business. Usually, the expected ROI rates range from 20% - 30%
(4) Scorecard method
This method uses the valuation assigned to an already angel-funded company. It begins with finding a company of a similar stage operating in the same geography and same domain. After getting the average pre-money valuation of that company, the startup is thoroughly analyzed to find its strengths and weaknesses. It is given weightage to various factors such as the size of the opportunity, technology/ product, management strength, competitive environment, marketing, funding requirement, etc.
(5) Risk factor summation method
Various types of risks associated with the investment are categorized to assign grades to each category. The major risk categories include management, stage of the business, sales and marketing risk, funding requirement, competition, technology, litigation, international, and reputation risk, and potential lucrative exit.
To summarize, business valuation of any kind is never cut and dry. Yet, using multiple methods will help in the negotiation process because an average can be determined between them, and this too depends on the stage of the business life cycle!