Business Valuation For Start-Ups
By Him Shun Yu
Q1 Why Do I Need To Know About Business Valuation?
Investment is extremely important to every start-up. Thus, it is imperative that your business is attractive to investors to gain funding.
The “fair” market value of a business is generally agreed to be the economic value of a business from the viewpoint of a completely rational investor with full knowledge of the all the relevant facts and is given the choice to complete the transaction or not. It’s the age-old question of “What is it [the company] really worth?” Simply put, business valuation is the methods used to determine the true value, or a value closer to the true value, of a business.
Of course, multiple methods of doing this exist, depending on the complexity (based on time and data available on the investor’s end), and the type of business being investigated (primarily looking at the maturity of the company, leadership team, and market dominance, etc.)
If you are a start-up or an early-stage company then some of the above listed methods would not help analysts value your company much because there wasn’t enough data available to draw a reliable conclusion. Instead, more intangible assets are reviewed to see which start-ups are promising investments.
Q4 What Other Additional Factors Should I Be Aware Of?
To do a business valuation, there are several definitions that we need to understand:
Revenue – The amount of money that a business has made from its products and services, before deductions.
Income/Profit – What are the revenue and expenses of the business? This is the amount of money earnt after all deductions: taxes, paying off debts, etc.
Assets – These are the parts of the business that are not accounted for in cash, usually tangible possessions that can be sold such as property or goods. But can also be intangible, such as patents and technology. A business may have many assets yet little liquidity (ability to raise cash).
Cash Flow – The total amount of money coming in and out of a business. The difference between this and revenue is that revenue is solely how much the business makes from selling its services and products, and cannot be lower than zero, while cash flow can be negative.
Q2 What Basic Terminology Should I Know?
Q3 Can You Give Me A Brief Overview Of The Different Valuation Methods?
Traditionally, the following methods are some of those used to value a business:
Discounted Cash Flow (DCF) uses the projection of future cash flows usually based on past statements, accounting for the time value of money. This analyses method will give you the present value of estimated future cash flows. The discount rate is usually the weighted average cost of capital, but will vary depending on the project.
DCF = E Cash Flow per year / (1 + discount rate)*
So, for example: if the discount rate was 5% and the initial investment was $5 million
Year 1 Cash Flow: $1,000,000 (All values forecasted)
Year 2 Cash Flow: $2,000,000
Year 3 Cash Flow: $2,000,000
Year 4 Cash Flow: $3,000,000
The DCF will be thus:
(1M/(1+0.05) + (2M/(1+0.05)2* + (2M/(1+0.05)3* + (3M/(1+0.05)4*) = $6,962,222
So the net present value, how much profit your investment will bring, is worth would be the total DCF minus the initial investment, which would be $1.962M. However, note this method relies on predictions, and thus, can be unreliable if these estimates are wrong.
The Times-Revenue method is primarily used to investigate how much money a buyer is willing to purchase the company for with its current revenue model. Here, the past year’s revenue is multiplied by a coefficient based on what companies in similar industries have been brought out for.
For high-growth sectors or rapidly expanding companies, this coefficient will be higher, resulting in a greater estimated value.
However, this is not suitable as some companies have high revenue but negative profit, and this method does not account for that.
Example: A similar company in a high growth sector was brought out for 8 times its revenue. Your company has a past revenue of $1.6M.
Thus, the times-revenue value of your business would be thus:
$1.6M*8 = $12.8M
A similar but more accurate method uses the profits of a company. This is the Earning Multiplier method. Here, future profits are adjusted against projected discounted cash flows and interest rates. This essentially calculates the earnings per share of stock.
This compares the price per share (market cap/number of shares) by the earnings per share (profit/number of shares) for any point in time. This way, you can measure how a stock’s value has been changed relative to itself and other companies.
So for example, if your company’s PPS was $10 and EPS was $5 a year, then it would take 2 years to make back the stock price.
However, if 5 years ago, the PPS was $40 and the EPS was $10, it would take 4 years. This means the stock is cheaper now than 5 years ago.
Of these, the DCF method is most commonly used, though this is not an absolute rule. There are also methods that unique to start-ups:
Cost-to-Duplicate is an approach that calculates how much an investor would have to spend to duplicate completely, a company like the one being valued. To calculate this, all assets, such as property, research costs, and patents are accounted for.
However, this does not reflect future potential for profits and return on investment. It also doesn’t account for things that didn’t spend money, such as brand value and worker experience.
Valuation by stage is when investors look at the stage where the business is at. This is split from least valued to most according to development:
Business plans written.
Strong management team with the above.
Final product or technology prototype with the above.
Has partners and research indicating a customer base with the above.
Revenue growing and profitability is predicted with the above.
Start-ups are notoriously hard to valuate from an analyst’s point of view as they are seen as high-risk investments with very little data to drive decisions. However, there are several things that start-ups can have which make them relatively more attractive to investors.
Company Differentiation
How is your product or service different from your competitors? Why is it more likely to succeed? Investors aren’t only investing in your product or service, but also your company and team. Can you capitalise on the difference between you and your competitors? Can you do things more efficiently and overtake them?
Leadership Team
In general, when looking at a company with little institutional history, investors instead look towards the leadership team that the new company has declared. The longer the record of achievements your leadership team has, the higher the value of your company as a more experienced leadership team is more likely to be able to avoid the typical pitfalls and provide a return on investment.
Growth Potential
Your plans must be both realistic and ambitious because investors want to see the greatest return with the lowest possible risk. You can mitigate their fears by having the right people with experience on your team, having a detailed business plan covering as many facets as you can, and thinking about how you can scale your business while maintaining a good profit margin.
Sustainability
This covers two facets: environmental and social sustainability, and business sustainability. The first is regarding your business in an increasingly more environmentally aware world. Your business must produce as little waste as possible. In addition, being sustainable means more support from the community and often, government schemes. The second is whether your business model can survive beyond the short term. Does you business rely on any trends that might not exist in the future?