Business valuation is never easy for any business. For startups with little or no income or earnings and uncertain futures, the job of assigning a valuation is particularly complicated. For mature publicly traded companies with stable earnings and earnings, it is typically a matter of valuing them as a multiple of their earnings before interest, taxes, depreciation and amortization (EBITDA) or based on other industry-specific multiples. But it is much more difficult to value a new company that is not public and that can take years to sell.
- If you are trying to raise capital for your new business, or are considering investing money in one, it is important to determine the value of the business.
- Startups often turn to angel investors to raise much-needed capital to get their business off the ground, but how do you value a startup?
- Startups are notoriously difficult to value accurately, as they don’t have operating income yet or maybe not even a salable product yet, and they will spend money to make things work.
- While some approaches, such as discounted cash flows, can be used to value both startups and established companies, other metrics such as cost to duplicate and staged valuation are unique to startups.
How startups are valued
As the name implies, this approach involves calculating how much it would cost to build another equal company from scratch. The idea is that a smart investor would not pay more than it would cost to double. This approach will often consider physical assets to determine their fair market value.
The cost of duplicating a software business, for example, could be calculated as the total cost of programming time that has gone into designing your software. For a high-tech start-up, it could be the up-to-date costs of research and development, patent protection, and prototype development. The cost-to-duplicate approach is often considered a starting point for valuing startups, as it is quite objective. After all, it’s based on verifiable historical expense records.
The big problem with this approach, and the founders of the company will certainly agree here, is that it does not reflect the future of the company. potential to generate sales, profits and return on investment. Also, the cost-to-duplicate approach does not capture intangible assets, such as brand equity, that the company might possess even at an early stage of development. Because it generally underestimates the value of the business, it is often used as a “low” estimate of the value of the business. The physical infrastructure and equipment of the business can be only a small component of the actual net worth when relationships and intellectual capital form the foundation of the business.
Venture investors like this approach as it gives them a good indication of what the market is willing to pay for a company. Basically, the multi-market approach values the company against recent acquisitions of similar companies in the market.
Let’s say mobile application software companies sell for five times their sales. Knowing what real investors are willing to pay for mobile software, you could use a multiple of five as a basis for valuing your mobile app business while adjusting the multiple up or down to factor in different characteristics. If your mobile software company, for example, were at an earlier stage of development than other comparable companies, you would probably get a lower multiple of five, since investors are taking more risks.
To value a business in the early stages, extensive forecasts must be determined to assess what the company’s sales or profits will be once it is in the mature stages of operation. Providers of capital often provide funds to companies when they believe in the company’s product and business model, even before it turns a profit. While many established corporations are valued based on earnings, the value of new businesses must often be determined based on multiples of income.
Arguably, the multi-market approach offers value estimates that are closer to what investors are willing to pay. Unfortunately, there is a problem: comparable market transactions can be very difficult to find. It’s not always easy to find companies that compare closely, especially in the startup market. The terms of transactions are often kept secret by early-stage unlisted companies, which are likely to represent the closest comparisons.
Discounted cash flow (DCF)
For most startups, especially those that have not yet started to turn a profit, most of the value is based on future potential. Discounted cash flow analysis represents an important valuation approach. DCF involves forecasting how much cash flow the business will produce in the future and then, using an expected rate of return on investment, calculating how much that cash flow is worth. Typically, a higher discount rate is applied to startups as there is a high risk that the business will inevitably not generate sustainable cash flows.
The problem with the DCF is that the quality of the DCF depends on the analyst’s ability to forecast future market conditions and make good assumptions about long-term growth rates. In many cases, projecting sales and profits beyond a few years becomes a guessing game. Furthermore, the value generated by DCF models is highly sensitive to the expected rate of return used to discount cash flows. Therefore, the DCF must be used with great care.
Assessment by stage
Finally, there is the development stage valuation approach, which is often used by angel investors and venture capital firms to quickly obtain a rough range of company value. These “rule of thumb” values are typically set by investors, depending on the business development stage of the company. The further the company has advanced on the path of development, the lower the risk to the company and the higher its value. A valuation model by stage might look like this:
|Estimated value of the company||Development stage|
|$ 250,000 – $ 500,000||You have an exciting business idea or business plan.|
|$ 500,000 – $ 1 million||It has a strong management team to execute the plan.|
|$ 1 million – $ 2 million||Has a final product or technology prototype|
|$ 2 million – $ 5 million||You have strategic alliances or partners, or signs of a customer base.|
|$ 5 million and more||It has clear signs of revenue growth and a clear path to profitability.|
Again, particular value ranges will vary by company and, of course, the investor. But in all likelihood, startups that have no more than one business plan will likely score the lowest of all investors. As the company achieves development milestones, investors will be willing to assign a higher value.
Many private equity firms will use an approach whereby they provide additional financing when the firm reaches a certain milestone. For example, the initial round of funding may be aimed at providing salaries to employees to develop a product. Once the product is proven to be successful, a subsequent round of funding is provided to mass produce and commercialize the invention.
The bottom line
It is extremely difficult to determine the exact value of a company while it is in its early stages, as its success or failure remains uncertain. There is a saying that startup valuation is more of an art than a science. There is a lot of truth in that. However, the approaches we’ve seen help make the art a bit more scientific.