Fundraising Analysis

Concepts and Methods of Startup Valuation

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Valuation or determining the value of a company’s stock is one of the most challenging issues that most investors and startup founders face in the process of fund raising is. In the following article, we intend to examine this concept and elaborate on the appropriate and common methods of startup valuation.

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  1. Your startup has crossed Death Valley, and it has had at least 2 funding rounds? Discounted Cash Flows​ (DCF)
  2. Your startup has had at least one funding round, you are advised to use Multiples method for valuation.
  3. Your startup is at pre-seed and seed funding rounds, you are advised to use the Score Cards Method, Risk Factors Summation method to value your startup.

What is the purpose of startup valuation?

Startup valuation can be done for various reasons, the most important of which are: 

  • Capital Increase : As you know, startups are constantly developing their products and markets at different stages of their lifespans; therefore, they have a negative cash flow for most of their lives. Fund raising is one way to compensate the negative cash flow of start-ups. In such a case, both the startup founders and the venture capitalists – in other words, both parties to the negotiation – need to know that the required capital of the business is equal to what percentage of the company’s shares, this evaluation is done through the startup valuation.
  • Employee Stock Ownership Plan (ESOP): There is no doubt that good ideas will not succeed in large markets unless a professional and motivated team focus on them. Finding the right people for the various key positions of a startup is not possible only with high salary offers and it may not motivate the managers. This is why most businesses always have a percentage of their stock to hand over to their C-levels to form a long-term relationship accordingly. In such a case, it is necessary for the founders to know the stock value of the company, design a proposal for their managers and staff, and this can only be done by startup valuation.
  • A Shareholder’s Exit : Startup shareholders may, for a variety of reasons, decide to exit the company and sell their stocks. Sometimes, the partnership between the shareholder who sells his equity and other business shareholders may be deadlocked, sometimes the venture capital fund may have expired and the shareholder may be forced to sell its assets,. or any other reason may make him to do so. In such a case, startup valuation is important and it is necessary that these calculations are done and the value of the company’s equity is calculated accurately. It should be noted, however, that in general, the value of a equity calculated in a startup valuation is different from the value on which the company’s stocks are sold.
  • Merger and Acquisition (M&A): mergers and acquisitions (M&A) is one of the windows for exiting the cap-table of a startup. In any model of agreement, i.e. full acquisition of a startup by another business or merger of both brands in the form of stock exchange or cash exchange etc., the startup must be valued and the stock value of one or both companies should be calculated and the merger and acquisition agreement should be designed and finalized accordingly.
  • Initial Public Offering (IPO): The most important exit window that startups have been looking at, is IPO. In such a case, obviously, it is necessary that the business is valued and the value of each share of the company is accurately calculated and based on the initial public offering of shares takes place accordingly.

In short, it can be stated that startup valuation plays a key role in all financial events a business encounters, and it is necessary to calculate the value of the company’s equity accurately.

What kind of value is calculated in startup valuation process?

Before examining the common methods of startup valuation, it is necessary to consider what kind of value will be ultimately calculated in the valuation process. In financial analysis, different types of “value” are calculated, the most important of which are:

What is calculated in the startup valuation process is the intrinsic value of the business, which may not be equal to its market value or market fair value. Calculating the intrinsic value of businesses can be done in different ways, some of which will be introduced below.

  • Intrinsic Value which is obtained from fundamental analyses of the business and is the value of all tangible and intangible assets.
  • Economy Value which is obtained from the normal amounts of economic size and is the maximum price for which the investor is willing to pay.
  • Market Value which is obtained from the conventional values ​​of the market and is the price that is determined in the market based on the amount of supply and demand.
  • Market Fair Value which is obtained from conventional values ​​and the results of market research and is a fair price from the perspective of market activists that is agreed upon by the seller and the buyer.

What are the different methods of startup valuation?

Startup valuation requires financial experience and knowledge, and according to the available data, business maturity stage and many other parameters valuation method should be selected and valuation process should be initiated.

In general, startup valuation methods can be divided into three categories: qualitative startup valuation methods, relative and market-based methods and methods based on business financial data.

Qualitative methods of startup valuation: These methods are often used in the early stages of startup maturity. As mentioned earlier, in the early stages, startups often lack historical financial data and sales KPI and are busy with product market fit process. In the other hand, startups are not mature enough to estimate their value by comparison with other startups. Therefore, startup valuation in the early stages is often done qualitatively by quantifying some quality indicators in order to estimate the approximate value of the business with an acceptable accuracy. Some of the most important qualitative methods of startup valuation are:

Startup valuation using Score Cards Method:

Startup valuation using Dave Berkus method: Dave Berkus proposed this innovative startup valuation method for the first time in Winning Angels and used a combination of several key business performance indicators. Berkus valuation method is based on the principle that the valuer has accepted that the income or business under his control will reach about $ 20 million over the next five years. In this case, the pre-money value to the start will be at best $ 2.5 million. This figure comes from five key business performance indicators, each of which is equivalent to $ 500,000. In other words, if the startup under review, has not realized none of these key performance indicators, its corresponding value is zero and if it has achieved all five cases, the limit value, i.e. two and a half million dollars will be assigned .These indicators include:

  • Innovative and scalable ideas
  • Ready MVP or the minimum viable product
  • Full-time entrepreneurial team focused on product development
  • Existence of strategic partners for rapid business development
  • Identification of sales channels and receiving initial feedback from current customers      

It is clear that the financial forecasts of future business conditions, the financial ratios of similar startups are not considered in Berkus method of startup valuation. In fact, this is a rapid and approximate way of valuation. The valuer’s experience is really highlighted here, and the likelihood of being erroneous will be, of course, high. It is recommended that Berkus Method be applied accompanied with other valuation methods.

Startup Valuation by Risk Factor Summation Method

But in general, the most important risk sources and factors for startups can be divided into 12 categories:

1: Is it possible that the current business management team will impose a high risk on the business in the future?

To examine the managerial risks, one should pay more attention to the personality and morale of the startup founder as well as those of the business management team. The more relevant work experience, consulting spirit, team empathy, technical capability in the team, the lower the management risk and the startup will earn more scores in this sectio

2: Is the business at the initial stage of the maturity cycle that is inherently risky and likely to fail to a great extent?

The earlier a startup is in its maturity cycle, the more likely it is to fail, and naturally investing in it will bring about more risk to the investor.

3: Can unfavorable legislation and political conditions lead to business failure?

Various legislation and political factors such as labor and trade laws, tax policies, changes in tariffs, regulations related to business licenses, etc. can affect the success or failure of a business. It is a valuer’s art to examine the status of a startup, considering the target market, legislation and political risks of the business, and to correctly consider the high or low risk for that part in the startup valuation process quantitatively.

4: Is it possible for the business to have trouble producing and failing altogether due to limited raw materials?

Making a product by the startup team requires the assurance of all parts of the supply chain of the product, and high supply risk of a supply chain part can jeopardize the entire production process.

5: How much may your business be affected by sales and marketing problems?

The more the offered product or service matches the customers’ needs, the risk of selling and marketing the product is reduced and the startup will earn more points in this area. In addition, the following can be considered in minimizing the risk of sales and marketing and rating the startup: accurate and comprehensive market research, attractive market size for the investor, coherent marketing plan, selection of correct marketing and sales channels and strong business partners.

6: Given your awareness of the ecosystem, how likely is it that the business will have trouble raising capital in subsequent rounds?

Another consideration for a venture capitalist is the risks associated with raising capital at a later stage. Are there other investors in the next stages who will invest in this project and help the business grow exponentially? Is business growth exponential and scalable? Does a startup have the potential for a profitable exit? Does investing in this project bring about the desired return for the venture capitalist?

7: Given your awareness of the market, how intense do you assess the competitive environment the business will face?

To examine competitive risk, as its name implies, it is necessary to investigate these points: the intensity of the competitiveness of the business environment; how many direct and indirect competitors does the startup have in its target market, what is the market share of competitors, how likely is it for the project to create a new market or gain a share of its competitors in the same market, how likely it is that competitors will enter the field in the future and make things difficult for this team.

8.To what extent can the emergence of new technologies in the future jeopardize the existence of the business?

Investigating technology risks requires ensuring that the necessary infrastructure for the technology is available. The following points are considered: the extent to which the use of aforementioned technology is consistent with the behavior of customers in the target market, the extent to which the hardware infrastructure in the target market allows customers to use the technology, and of course, how the emergence of newer technologies in the future can cause a complete business failure.

9: How likely is it that the business under investigation goes through litigation crises and fails?

In assessing the litigation risk of a startup, the valuer should consider that due to the startup’s nature, how likely is it to stop its activities or be involved in a legal case because of a complaint from a natural or juridical person despite having the necessary licenses.

10: To what extent can unfavorable international conditions and interactions with other countries put the business at risk?

Sometimes, international factors can increase or decrease a business risk; factors such as international sanctions, exchange rate fluctuations and good relations between countries leading to the entry of foreign investors. The better the international relations of the country in which the startup operates, the more stable the startup market, and naturally the possibility of business development increases; consequently, the probability of failure decreases.

11: To what extent can the business under investigation be exposed to the crisis caused by brand reputation?

Although reputation is always a positive issue related to a business, it should be noted that it also encompasses some risks. Increasing the reputation and awareness of a startup brand will cause the behavior of business managers, employees and everything related to that startup to be magnified, and a small mistake will inflict irreparable harm to the brand’s reputation.

12: How likely is it for the potential lucrative of the business under investigation to be in trouble in the future, and the company will not be able to make a good profit margin for its products and services?

Taking a glance at the startup’s target market, the technical, legal and technological infrastructures, and of course the business idea, can help the valuer to estimate how profitable the business idea is potentially. In this way, reviewing successful foreign instances (if any) of product, compatibility with customer needs, etc. can help the valuer to assess potential profitability risk.

Similar to Score Cards and Dave Berkus methods, Risk Factor Summation Method is carried out based on the comparison and experience. That’s why this method is applied to value pre-revenue startups that are in the early stages.

The main advantage of Risk Factor Summation Method is taking into account the critical risks of business in determining the value of a startup. For this reason, it is always recommended to the investor to apply this method at early stages. However, it should be noted that the dependence of this method on the perception of valuation team would decrease its accuracy.

Relative and market-based methods of startup valuation

Another category of startup valuation methods is the valuation of startups based on the conventional market values ​​and financial ratios. In fact, these methods assume that businesses in similar markets behave similarly, and if they have reached a relative maturity, their financial ratios can be considered similar, too. Some of the most important of these methods are:

Startup valuation using Market Fair Value Method

Suppose you decide to buy a house in one of the areas of your city. What do you do to find out about prices in that area? You will probably go to online and offline advertisements and take a look at the prices of advertised housings in that area. If you have more contacts, you will ask the residents of that neighborhood about the price of different houses and you will get the price range of the neighborhood. If you want to get more “real” prices, you should go to the real estate agencies and find out about the latest “real” property deals in the area.

The fact is that the Market Fair Value Method works in the same way. If the buyer of the property is assumed as an investor and the house as a startup, of course, when an investor wants to invest in a startup in a specific industry with a specific target market, it is similar to the situation where someone wants to buy a house. Just as in such cases, the buyer of the property (house) does not run the calculations, and he does not calculate the fine value of the materials used in the property; similarly, the investor avoids these issues and only assumes an approximate price for the startup in X field, in Y round, and if he wants to be a little more flexible, he sets a price range. For example, based on the results of this valuation method, the investor will conclude that startups in the field of financial technologies (Fintech) in the first round of fund raising are traded and valued 10-15 million dollars if they are active in country A and their target market is the same country A.

In fact, it can be said that the market fair value method tries to provide a certain value for the startup under consideration at different rounds of fundraising, considering its business field, market size and, of course, real deals made between similar startups and venture capitalists. However, this can only be done easily when the startup ecosystem is so mature and developed that sufficient disclosed valuation data and fundraising deals between the startup and the investor are available.

Startup valuation by Analytical Bench-Marking Method

Analytical Bench-Marking Method is a relative method of startup valuation that can be considered similar to the Market Fair Value method or even the Comparative Method. In this valuation method, without having the values of revenues and costs of the startup under study, valuation is done with the help of economic, political or technological adjustment ratios only by looking at the valuations made on similar domestic or foreign startups. Although this valuation method is as challenging as other relative methods, the positive point is that it can be used at all stages of business life cycle and can assess the value of similar startups operating in the ecosystem when we face data constraint.

If we tried to find a startup similar to the startup under consideration in our business ecosystem and estimate the value of the startup using its disclosed valuation data in market fair value method, there is no need to find a startup in our own startup ecosystem in Analytical Bench-Marking Method. In this case, first, we find successful startups whose business model is similar to the startup business model under consideration, collect key information such as target market size, startup value, amount of raised fund, business life, etc. and enter the valuation process. Second, it is enough to extract the same information for the startup under investigation from reliable sources and, as the Comparative Method, to estimate the value of the startup with the help of a series of ratios

Some of these key parameters are:

  • Target market size
  • GDP per capita (PPP)
  • Internet penetration rate
  • Online shopping rates
  • population
  • Global Innovation Index
  • And other factors

Once each of these key parameters has been calculated for the target markets of the origin and destination countries, depending on the scope of the startup under evaluation, it is sufficient to divide the parameter of the country of origin into the corresponding parameter in destination country; In this case, you have calculated the adjustment ratio for that parameter. Now it’s time to weigh each of these parameters. It should be noted that, for example, in valuing an online taxi startup, the weight of the adjustment ratio related to the size of the target market should be considered more than the weight of the adjustment coefficient related to the global innovation index.

In Analytical Bench-Marking Method, if it is possible to find a startup similar to the original startup, an estimation of the startup value can be quickly achieved by multiplying some ratios. Therefore, this method is less troublesome and it is a fast way to value startup in the middle and final stages. However, it should be noted that the finding a similar startup whose valuation information are available is difficult.  On the other hand, as we increase the number of adjustment ratios, it is not possible to adjust all the conditions and aspects of the original and benchmark startup. Consequently, Analytical Bench-Marking Method is commonly used to assess the accuracy of the results obtained from other startup valuation methods.

Startup Valuation Methods: A Comparative Method

Startup valuation, due to their nature and computational basis, is always a challenge not only between startups and investors, but also between different valuers. Comparative valuation method, as one of the relative methods of startup valuation, exacerbates this challenge because of its view of startup valuation. The computational basis of this method is to assume that we decide to value a startup in a completely estimative way, without wanting to enter into valuation calculations such as Discounted Cash Flow. We know the startup competitors in the same field and target market, and we happen to know that according to the leaked news, what the value of the competing startup was and the number of some KPIs. In this case, it is enough to use a simple ratio: how much do we value with this number of users and this volume of sales if they have traded so much with this number of users and this volume of sales?!

In fact, it can be summarized that in comparative startup valuation, we have one or more startups similar to the startup under study in the same field and target market, where valuation information and some KPIs have been disclosed. In this case, it is enough to calculate the value of the startup using a simple ratio. Thus, the value divided by the index for the benchmark startup is equal to the value divided by the index for the valued startup. It should be noted, however, that although the comparative valuation method is a relatively simple method and does not have the complexities of a method such as Discounted Cash Flow; if a poor performance index is used, or a benchmarked startup is significantly different from the startup under review in terms of target market, maturity, or other issues, the results provided by this method will undoubtedly be significantly different from the reality of the business.

Comparative valuation can be applied for both early stages of a startup, when it has not yet reached revenue generation, and intermediate and final stages, when it has reached revenues generation. Due to the fact that a comparison of two similar startups’ index is the basis of this method, it is similar to Analytical Bench-Marking Method. The difference between the two methods is the use of international startups and applying adjustment ratios in Analytical Bench-Marking Method. If information about the value of investments and the index of the start of a startup similar to Analytical Bench-Marking Method. If the information related to valuation is available, comparative valuation is a quick way to estimate startup valuation.

It should be noted that due to the fact that the value of comparative valuation method may not be accurate, and it is just used as an index for startup value. It is likely that the benchmarked startup differs from the startup under investigation in terms of business model risk, income model and other factors. For this reason, it is recommended to not to consider only one startup and index and add several adjustment factors related to a number of startups (similar to Analytical Bench-Marking Method) to increase the valuation accuracy. In general, it can be said that the accuracy of the Comparative Method is low and it is suggested that this method be used in conjunction with other methods of startup valuation.

Startup Valuation by Multiples Method

Valuation methods based on financial data

As mentioned earlier, as a startup becomes more mature and more established in the market, its associated risks will be less and its financial forecasts will be less uncertain. That is why in most middle and late stage valuations, one of the quantitative and financial based methods is used for startup valuation. The most important of these methods are:

Valuation of startups by Discounted Cash Flow Method (DCF)

Startup valuation through venture capital method

Venture capital method is one of the startup valuation methods that is often used by venture capitalists to quickly estimate the value of a startup. This method of startup valuation is often used in the early stages when the startup does not have a lot of financial data and in valley of death, when it is busy adapting its product to the market and trying to move towards its vision. The startup’s vision plays a key role in startup valuation through venture capital method. In this way, the venture capitalist looks at the future of the startup and the closest businesses that have succeeded in approaching the exit window and predicts the value of the startup under consideration when it will reach its exit window in the distant future. In other words, what a venture capitalist seeks in startup valuation through venture capital method is the Terminal Value of the startup. To find the terminal value of a startup, one can use the information of stock exchange companies, mergers and acquisition of similar companies, or the recent initial public offering of similar startups.

Venture capital method is not based on a complex mathematical relationship, the only basic equation in this valuation method is that the terminal value of the startup at the exit time, divided by the current value of the startup equals to the investment growth. Of course, it should be noted that this growth in investment does not mean the percentage of growth, it means a multiplication of investment.

But it is worth noting that the valuer seeks to estimate the current value of start-ups under consideration through venture capital method. For this, it is sufficient to rewrite the equation of venture capital in the form of the terminal value divided by the growth expected by the investor. The expected return of the investor is determined based on the investment horizon, economic conditions of each country and the investor’s expectations.

Venture capital valuation method is used for middle and late stages of startups that are on the verge of monetization or have not been profitable for a long time, because we need to estimate the exit value of the startup in this method. Compared to other startup valuation methods, venture capital method is a simple and fast way to determine the value of the startup. However, it should be noted that startup valuation with the help of venture capitalist method requires reliance on startup revenue and future growth forecasts. Given the risks involved in startups, it is difficult and erroneous to predict their financial performance in the future.  Moreover, determining the expected return of investors is a qualitative matter and there is no quantitative way to calculate it. These two factors make the venture capital valuation method not be an accurate way to calculate the value of a startup.

How to choose the right method for business valuation?

Several criteria can contribute to choosing the right method for startup valuation such as business maturity level, available financial data, startup growth potential, field of activity, market size, market share, etc. These factors can help the valuer to choose the best way for startup valuation. As shown in the figure below, in various stages of businesses’ maturity cycle, different calculating methods can have various precision. In the early stages of the maturation cycle of any business, that is the seed stage, the startup valuation methods tend towards qualitative methods and accordingly, as the business becomes more mature and developed valuation methods are inclined toward quantitative and financial data-based methods.

Conclusion

Various methods and approaches have been proposed to calculate the intrinsic value of businesses, the most important of which are discussed in this article; the point, however, requiring special attention is that in startup valuation, achieving a certain number as a result of the valuation is not sufficient; as a result, a valuer should be able to evaluate the effect of various parameters on the valuation result.

Retiba software provides you with this feature so that while conducting a sensitivity analysis, you could be aware of the value of conventional parameters in your own ecosystem. For example, if you do not know the average valuation of startups similar to yours or what value to consider as the discount rate, Retiba recommends you a range of conventional values, and in the end, it informs you how far the calculated value of your business is from normal values of the ecosystem and whether valuation has been done optimistically or pessimistically.

To use Retiba’s business analysis tools, it is sufficient to go to the registration page and join Retiba’s large community of clients.

2 Comments. Leave new

  • Jim Bednash Jim Bednash
    March 7, 2021 11:47 am

    How can you perform a DCF valuation on a company with negative cash flows?

    Reply
    • It is better to use different method for valuation in these sitations. As you know, in DCF method you calculatig present value of future positive cash flows, then if your business doesn’t have any profit in future, it would be meaningless to use discounted cash flows method.

      I can’t propose any alternative method for your business without analyzing any data from your side; however it might be usefull if you use Revenue Multiples Method too.

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