For any company, business valuation is is never straightforward. The challenge of assigning a valuation is especially daunting for start-ups with little to no sales or earnings and uncertain futures. For mature businesses that are publicly listed with steady sales and earnings, usually it is just a matter of carrying out the company valuation as a multiple of their earnings before interest, taxes, depreciation, and amortization or other industry-specific multiples. It can be extremely difficult to carry out a company valuation for a new venture that is not publicly-listed and is far away from sales.
As the name suggests, this technique entails estimating how much it would cost from scratch to build an equivalent company from the ground up. The theory is that a wise investor would not pay more than it would cost to duplicate the business under consideration. This technique often will use the value of physical assets to determine fair market value. To give an example, the cost-to-duplicate a software business might be calculated as the total cost of programming time that is gone into designing its software. This technique often acts as a starting point for performing company valuations for start-ups as it is fairly objective due to it being based on historic, verifiable expenses.
The main issue with this technique is that it does not take into account any future earning potential. This technique also does not capture intangible assets, such as brand value and, as such, cost-to-duplicate generally underestimates company value (basically giving a “lowball” estimate).
Market multiples are the favourite of venture capital investors due to the fact it gives them a pretty good indication of what the market is willing to pay for a given company.
Let’s use mobile application software as an example. Imagine businesses selling for five times their profits. Knowing what investors are willing or able to pay for mobile apps, while changing the multiple up or down to various characteristics, one might use a five-fold multiple as the basis for valuing your mobile app venture. If investors were considering a company at an earlier stage of development than other comparable businesses, the appropriate multiple would likely be less than five as investors are taking on more risk.
So that a company at its infancy can be valued, extensive forecasts must be carried out to determine what the revenue or profits of the business could be once a company is in the mature stages of operation.
Capital providers will also supply firms with funding because they believe in the company’s product and business model, even before it produces profits. Although certain existing firms are priced on the basis of their profits, company valuation of start-ups must be calculated on the basis of multiples of revenue.
Arguably, the market multiple approach offers pricing figures that fall close to what investors are willing to pay. There is, of course, a hitch with this approach: market transactions for comparable businesses can be extremely difficult to find. It is not always easy or straightforward to find companies that are close comparisons, particularly for start-ups, as deals tend to be kept secret by unlisted companies.
Discounted Cash Flow
For most start-ups, particularly those that have yet to turn a profit, their value rests on demonstrating future earning potential. Discounted cash flow (DCF) represents an important method of company valuation and involves predicting how much cash flow the company will produce in the future and how much this will be worth. A higher discount rate is generally applied to start-ups due to the risk that the start-up will not generate cash flows that are sustainable.
The issue with DCF is that it depends on the ability of the analyst to accurately forecast both market conditions and long-term growth rates. Estimating revenue and profits beyond several years is basically a guessing game. The value that these models generate can be influenced by the expected rate of return used for cash flow discounting.
Valuation by Stage
The final method is known as the development stage valuation approach. This is a technique often used by angel investors and venture capital firms to calculate a range of company value. This range of values is typically set by the investors and it depends on what stage of commercial development a business is in. The further along a company has progressed along the development pathway, the higher its value due to lower risk.
Unsurprisingly, start-ups that have nothing more than a business plan likely will get the lowest valuations from all investors due to high risk. After companies begin to meet developmental milestones, investors may be willing to assign a higher valuation. Some private equity firms will take the approach where additional funds are made available only after businesses reach certain milestones.
It is difficult to estimate an accurate value of a company’s worth when it is in its infancy stage. Speak with our startup business valuer today.