One may have an idea but not the necessary funds or capital to execute this unique idea. For this the promoter of the idea has to gather funds from people called-investors. But why would these investors offer you funds for an idea that can fail? The promoter here offers an x% of return of all that is earned from the execution of this idea to the investors.
In order to determine this x%, one needs to know the value of the startup. Business valuations, especially of startups that have no or little revenue is an art. This involves a deep study of the idea, the cost involved to execute this idea and other factors required to put this idea into action. This is particularly important because investors need to know the value of their investment into this idea. Not only important from investor side but is essential from the entrepreneur to know the value of his startup or in other words of his unique idea.
Numerous factors influence the value of a startup. Some of these factors are:
- Uniqueness of the idea: The more feasible and viable an idea is, the more it will be able to attract the VCs. The idea should be unique and not ambiguous to attract funds.
- Potential for growth: The underlying factor of a startup is the prospect of growth. The growth path has to be determined carefully so as to make the startup a success.
- Team: Although the entrepreneur is the core member, however, she/he cannot work alone to accomplish goals. Right people are required to take the plan to heights.
- The Plan: Apart from the core idea, the plan involves other aspects such as targets, operations, short term goals, etc. The core idea would be successful only when other aspects are carefully taken care off.
- Technology: The startup may be outsourcing the technology or may develop its own technology. The more advance and effective technology employed, the more value the startup gains.
Other factors which influence the value of a startup are its assets and liabilities, state of the economy, costs involved, future plans, how other similar businesses are being valued and other such variables.
After considering these factors, the next step is determining the value of the startup. Valuation of a startup is a tedious and complex task. However, number of methods and techniques are available for such valuation. Some of them are discussed as follows:
1. Startup Valuation with The Berkus Method:
Developed by Dave Berkus, in mid 1990s, the method was established to solve the problem of valuing startup companies, especially, technology startups. Berkus method states that the investors should believe that the startup in a span of 5 years of operation would achieve revenue of $20Million or more. Then, the investor applies a rating of upto $500,000 to each of the following components:
- Sound idea (Basic Value, product risk)
- Prototype(Reducing Technology Risk)
- Quality Management Team (Reducing Execution Risk)
- Strategic Relationship (Reducing Market Risk)
- Product Rollout or Sales (Reducing Product Risk)
The maximum valuation that the startup can earn here is $2.5M (considering post roll out) and $2M in case of a pre-revenue startup. The perfect score here would be $2.5M implying that the startup scores $500,000 on each parameter. This scoring would give the rough estimation of the value of the startup.
One of the key advantage is that it points out the weak or the risk parameter and suggests the area of improvement. The drawback of the method is that it is not applicable when startups start generating revenues. Once the business has revenues, it will use actual revenues to project value.
2. Startup Valuation with Risk Factor Summation Method
Another pre-money method to value a pre-revenue company is the Risk Factor Summation Method (RFS method). The Berkus doesn’t consider a wide range of criteria to arrive at the pre-money valuation of a pre-revenue company. The RFS method takes into account a broader range of criteria including some exogenous factors.
In this method an initial value of the startup is determined by assessing similar startups and then risk factors are factored in this value as multiples of $250K. These multiples range from $500k: a low risk to -$550k: high risk.
The initial value is adjusted for different types of risks. Different risks that this method considers are:
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
The drawback is that it is cumbersome and difficult to find a similar business as to that of the startup.
3. Startup Valuation with Comparable Transaction Method
Comparable transaction or precedent transaction method is utilized in case of both pre-revenue and post-revenue companies valuation. This method involves determining similar M&A transactions in recent past and in same industry as to that of the subject company business. After selecting the relevant comparable transactions, the next step is to calculate key metrics by analyzing the peer group transactions. EV/EBITDA and EV/Sales are the most common used metrics. One has to find the financial data related to comparable transactions selected. Such information is available from databases such as S&P Capital IQ, Bloomberg, Google finance, etc.
After extracting the financial information, a range of multiples is determined which is used in determination of valuation of subject company. Also, a median or an average is calculated of the selected multiples.
When after the above mentioned steps are completed the value of the subject company is established by using suitable financial metric calculated from comparable transaction and financials of the subject company.
4. Startup Valuation with Liquidation Value Method
As the name suggests, it is the value of the company when it is going out of business. Assessor determines the fair value of an asset when the company gets liquidated or if the asset is no more usable. The method considers only tangible assets like plant and machinery, fixtures, inventory, etc., the intangibles are not considered in this method irrespective of the value they hold.
One needs to determine the Net liquidation Value which is calculated by deducting the value of liabilities from the total liquidation value of all assets. This value may be negative indicating that company has more of debt as compared to assets. In other words it has less assets to pay off its liabilities.
5. Startup Valuation with Book Value Method
Book value of an asset means the cost at which the asset is recorded in the balance sheet less its accumulated depreciation. Book value is calculated by deducting Intangible assets and liabilities from the value of total tangible assets. This method is generally not considered for startup valuation as it takes into account only tangible assets, whereas startups are more focused towards intangibles like patents, copyrights, etc.
The basic difference between book value and liquidation value is that book value indicates the cost at which the assets are carried on a Balance Sheet net of depreciation and Liquidation value is the value the asset would fetch assuming the company goes out of business. Liquidation value reflects what the shareholders will receive once the company goes out of business and book value indicates their investment into the business.
6. Startup Valuation with Discounted Cash Flow Method (DCF)
Once the startup begins to generate cash flows and there is certainty of cash flows in future, the DCF method could be used for valuation purposes. The first step in this method is estimation of future free cash flows and discounting them to present value. The method determines the attractiveness of the investment/project. If the value derived from this greater than the cost of the investment, the opportunity is a positive one.
Once the business starts growing at a steady pace and it is believed that the business will generate cash for an indefinite perio, Terminal Value (TV) is calculated as:
7. Startup Valuation with The Venture Capital Method
One of the practiced methods of valuing a pre-revenue company is The Venture Capital Method (VC Method). The method was first outlined by Professor Bill Sahlman in 1987 at Harvard Business School and has been revisited since then. The method is seen from the viewpoint of the investors.
Understanding this with an example: Suppose the investor expects a Return on Investment (ROI) of 25x. Also, the investor believes that after a span of 5 years the startup could be sold for $200Million. Based on ROI and expected sale value, the investor can determine the maximum price she/he is willing to pay for investing in the startup, after adjusting for dilution.
= $200M/25x =$8M
= $8M-$2M =$6M
= $6M(1-0.3) =$4.2M
$2M = Post Money Valuation
$0.5M = Amount Invested
$1.5M = Pre-money valuation before adjusting for dilution
0.3/30% = Anticipated Dilution
$4.2M =Pre-Money valuation after adjusting for dilution
Which method to opt?
Valuations are just estimates made using a formal procedure. With the availability of ample number of methods there is no hard and fast rule to select any one. Only one single approach should not be used as a standalone for valuation purposes, rather a combination of various can be used so as to get an accurate valuation. Valuations don’t truly show the true value of the company. They basically give the idea of the amount you can receive for investment from the investor and the worth of your startup. Henceforth there is no best method to value. Factors such as industry, the idea, competition, geographical location, etc. should be considered while valuing a startup.