Startup valuation should not be performed as a rule of thumb, or with black box practices that leave space for arbitrary conclusions. Traditional valuation approaches are methodological and grounded, but they need to be adjusted to capture the value of start-ups.
The Startup Valuation guidelines encourage the use of several valuation methods as they analyse the business value from different angles and result in a more comprehensive and accurate view. One effective way to define them is through their financing story and cycle: Startup’s rely on multiple rounds of funding to grow, aiming at a high and short-term exit strategy or IPO strategy. In fact, the transaction defines the valuation methods to be used and depend on the Startup story.
The following are the Five Valuation methods for early-stage Startup companies
1. Qualitative Aspects - Scoreboard Method
2. Qualitative Aspects - Checklist Method: Valuing intangible assets
3. Future Cash Flow - DCF (discounted cash flow) with LTG (long-term growth)
4. Future Cash Flow - DCF with Multiple
5. Investors Return - VC Method
The final valuation is computed as the weighted average of the five valuation methods, applying default weights according to the company’s stage (Idea Stage, Development Stage, Startup Stage or Expansion Stage).
When valuing convertible bonds issued by early-stage technological companies, a number of factors should be considered, including:
1. The change in market and sector pricing conditions.
2. Funding risk, cash burn, and liquidity profile of the company.
3. The seniority of the bond in the capital structure of the company.
4. Recent developments in the underlying technology and innovation of the business and the industry.
5. The probability of default, loss given default, and expected volatility in the listed share price of the company (or its closest comparable).
Due to the difficulty of gauging the probability and financial impact of the success or failure of development activities of early-stage companies, one should consider that the traditional valuation techniques cannot be used in all cases. It needs the use of more complex valuation methodologies, when necessary. These may include:
1. Scenario-Based Model (or PWERM).
2. Option Pricing Models.
3. Milestone-Based Model (or adjusted price of recent investment).
4. Monte Carlo Simulation.
Traditional approaches to Standard business valuation employ financial statements, cash flow models, and comparisons to competitive companies within a similar field or industry. Although the primary purpose of Standard business valuation is preparing a company for sale, there are many purposes including the Valuation for Financial Transactions, Valuation for financial Reporting, and Compliance, Valuation for Litigation & Dispute Resolution and other internal purposes including Strategy Formulation, Business Planning and Capital Structure Repair. Here are primarily three approaches including Income Approach, Asset Approach and Market Approach.
Income Approach: determines business value based on income. This type of valuation focuses on net cash flow, discretionary cash flow, and capitalisation of earnings. Following are some of the methods under Income Approach.
1. Capitalisation of Earnings / Cash Flows Method
Assumes that all of the assets, both tangible and intangible, are indistinguishable parts of the business and does not attempt to separate their values. Assumes the critical component to the value of the business is its ability to generate future earnings / cash flows.
It is important that any income or expense items generated from non-operating assets and liabilities be removed from estimated future benefits prior to applying this method. The fair market value of net non-operating assets and liabilities is then added to the value of the business derived from the capitalisation of earnings
2. Discounted Earnings / Cash Flows Method (a.k.a. Discounted Cash Flow Method.) This is based on the theory that the total value of a business is the present method of its projected future earnings, plus the present value of the terminal value. This method requires that a terminal value assumption be made. The amounts of projected earnings and the terminal value are discounted to the present using an appropriate discount rate, rather than a capitalisation rate
3. Excess Earnings / Treasury Method
This method combines the income and asset-based approaches to arrive at the value of a business. Its premise is that the total estimated value of a business is the sum of the values of the adjusted net assets (as determined by the adjusted net assets method) and the value of the intangible assets. The determination of the value of the intangible assets of the business is made by capitalising the earnings of the business that exceed a “reasonable” return on the adjusted (identified) net assets of the business.
Asset Approach: determines business value based on assets. This type of valuation focuses on both asset accumulation (assets minus liabilities) and capitalised excess earnings. The Asset Based Approach considers a company’s tangible and intangible assets. The Approach includes
1. Book Value Method = Book value of assets – book value of liabilities. Tis method is frequently used for buy-sell agreements. And
2. Adjusted Net Assets Method = FMV of assets – FMV of liabilities. This method is often used to value of a non-operating business (e.g. holding or investment company). Used to value businesses that continue to generate losses or which is to be liquidated in the near future. Does not address the operating earnings of the business.
Market Approach: determines business value in relation to similar companies. This type of valuation focuses on the comparative transaction method and appraises competitive sales of comparable businesses to estimate economic performance looking at revenue or profits primarily. Following are some of the Market Multiple examples:
Price Earnings Ratio – Discount or Capitalisation Rate is the inverse of the PE ratio
Price/Cash Flow
Price/Revenue
Dividend/Price
Price/Book
Earnings Per Share
Financial plan and valuations provide important information about the market, strategy and financing possibilities: they do not provide a sure way to recognise investments that will fail, but they can classify the type of investments and avoid overfunding companies with little market potential. Using advanced financial techniques is therefore recommended for all start-ups.
Stay tuned for more in startup valuation in two weeks!
By Dulal Das Please contact contact@thestartupclub.net for any questions, clarifications and further help.