Understanding Business Valuation and Multiples for Startups
We cannot just randomly assign numbers on how much a business is valued at, or how much an owner’s interest in a business is worth. There has to be a valid basis behind the estimate of the economic value of a business. In the same vein, there is a set of procedures on how these estimates are arrived at. This is called business valuation.
In this article, you will learn 1) about the basics of business valuation and why it’s important to know, 2) business valuation methods, and 3) factors affecting your business valuation of your startup.
BUSINESS VALUATION AND ITS IMPORTANCE
In general terms, the process of determining the price that a business will be sold, or bought, for is referred to as business valuation. You are literally putting a specific value on a business, or certain parts of it, so you can sell it.
In order to understand the importance of business valuation, we first have to know when it is used or needed. Usually, the subject of business valuation becomes more rampant in conjunction with a possible takeover offer or any other form of business combination, whether it’s a merger, straight acquisition or consolidation. Businesses also tend to focus a lot of valuation when they are seeking financing for a major project or venture.
However, more than just about knowing how much a business is worth at the point of buying or selling, business valuation has a bigger role to play.
- As an internal performance indicator. Valuing the business will tell a lot about its overall performance, and the direction that it is currently going. The business already has a mission and vision, to begin with, and it has clear-cut goals that it strives to achieve. Knowing how much the business is worth will give management and other stakeholders an idea whether the business is on track towards achieving those business goals.
- As a basis for allocation of resources. Say, for example, that a business is working with a limited pool of funds. One way to determine where to put a specific portion of those funds is to see which aspects of the business needs it most. Naturally, the areas of the business that show high growth and, therefore, corresponding economic value, will get the most attention and the bigger slice of the pie.
- As a gauge of assessing the life cycle of the industry, and the position of the business in the market. As much as we would like it, industries do not remain at their peak positions forever. There will be downtimes and, sometimes, industries can even wane and fade into oblivion to make way for newer, stronger ones. Business valuation can help the business to assess whether the industry it belongs to will still be around longer, and if it will thrive just as well as it currently is. It is also a good way to assess whether the business will still be able to maintain its market share or position in the industry in case the latter expands.
- As a decision-making tool. We have already established that the value of a business will demonstrate how well it is performing (or otherwise) and how healthy it is as a going concern. These will become valid bases for management to make key decisions on where to take the business from a certain point. It becomes a very useful tool for strategic decision-making. For example, if it has been noted that the industry is in decline, management can accordingly map out an exit plan that would still be beneficial to the company and its stakeholders. On the other hand, if the market or industry demonstrates growth, management could find ways to keep up with that growth.
BUSINESS VALUATION OF STARTUPS
In the earlier discussion, we focused on business valuation in terms of already existing and thriving businesses. There is a bit of a twist when it comes to business valuation with respect to startups.
A startup is basically a company or a business that is in its very first stages of operations, prior to earning revenue. Valuation becomes tricky when it comes to startups, and this is where budding entrepreneurs and owners of these startups have their first hurdle: how to convince angel investors and venture capitalists that they are worth investing in.
Businesses that are already in operation have a slightly easier time convincing potential investors to put their money in them, since they are already showing earning power and a steady revenue stream. They already have results of operations to show.
Startups do not. They are not even earning revenues yet, so how can they put a value to how much their company is worth? In the past, valuation used to be based on the amount of assets of the startup. Today, however, investors no longer accept that as a standard for determining a startup’s economic value.
Valuation of a startup has one major purpose: to obtain financing or funding. Early on, you can already tell that there is a conflict of interest here. Startup owners and entrepreneurs would want to put a high value on their business in order for them to get more funding. Investors, on the other hand, would want to own more than a reasonable portion of the business that they invest in, so they would prefer that the business have a lower value. After all, even if they invest a low amount, this would mean they would still have a sizeable interest or ownership in the startup.
BUSINESS VALUATION METHODS
There are many valuation tools and methodologies that businesses can now readily use in order to determine their economic worth. Among these methodologies, we can shorten the list to those that would apply best to startups.
1. Cost-to-Duplicate Method
Also often called as the Cost-to-Recreate method, this approach takes that “what if” stance. What if you are to build another similar company from scratch? How much would it cost you to do so? That is the cost to duplicate. The general rule is that investors will not pay an amount that is higher than the cost required to recreate or duplicate the business.
This method focuses on the fair market valuation of the physical assets of the startup to determine the cost to duplicate. Other amounts that figure into the cost, especially in the case of startups, include costs that have already been incurred, such as research development costs, patent costs and cost to build a product prototype.
What this method fails to take into consideration, however, is the cost of intangible assets, especially if the startup has those. Therefore, it does not fully capture the value of the company, especially in the future, when it is already generating revenues and earning returns on investment.
2. Market Multiples
This methodology is using multiples based on revenue, cash flow, earnings before interest and taxes (EBIT), EBITDA and net income. There are several other industry specific multiples that are used, but the ones mentioned are the most commonly used.
The strength of this approach is that it makes use of market indicators that are truly reflective of market conditions. After all, investors take into account the various market forces at play when evaluating their investment options, especially when it comes to startups.
These multiples are most commonly used in forecasting, which means they are also useful in predicting the future performance of the startup. The only limitation is the availability of these market indicators and statistics. There is also a degree of difficulty in identifying transactions that are comparable, in order to establish trends and patterns that can be used in forecasting.
3. Discounted Cash Flow Method
This involves conducting a discounted cash flow analysis and, as the name implies, places strong emphasis on the amount of cash flow that is expected in the future and how much that cash flow is worth today.
This valuation method makes use of an expected rate of return on investment, which is both a good thing and a bad thing for startups. It is a good thing because it is possibly one of the closest estimation of the future cash flows of the company. However, it is also bad because startups are often assigned with very high expected rates of investment return, considering that they are considered to be more high-risk than business that are already in operation and earning revenue.
4. Venture Capital Method
In calculating the pre-money valuation of a startup, this method takes into account the expected rates of return on investment when the company makes its exit from the industry. It follows the following formula:
Anticipated ROI = Terminal (or Harvest) Value / Post-Money Valuation
Pre-Money Valuation = Post-Money Valuation – Investment
Terminal Value, also known as investor harvest value, is the anticipated selling price for the company at a certain point in time – often several years – after the investment has been made. This is arrived at by computing the estimated revenues of the company on the year of sale (the harvest year) and the estimated revenue multiple based on industry statistics.
Post-Money Valuation is the value of the company after it has received outside financing or funding from investors. It is different from Pre-Money Valuation in that the latter excludes these injections of capital or financing.
Company A plans to exit the cloud computing industry in year 2025.
|Estimated revenues in 2025||$ 30.0 million|
|Estimated after-tax earnings in 2025||$ 4.5 million|
|Required investment||$ 1.25 million|
|Price-Earnings Ratio in 2025 based on industry standards||10x|
Terminal Value = 10 x $ 4.5 million = $ 45 million
Post-Money Valuation = $ 45 million / 20 = $ 2.25 million
Pre-Money Valuation = $ 2.25 million – $ 1.25 million = $ 1 million
FACTORS AFFECTING BUSINESS VALUATION
Consider this: in a large industry, you cannot expect your startup to be the only one of its kind. You will have competitors or rivals, and the investors will not be looking solely at you. There is more than 99% chance that the investors will be looking at more than two or three similar startups at the same time, and they are simply making comparisons on which one is the best bet. There is also more than 99% chance that the valuation of these two or three similar startups will be different, even if they belong to the same industry. These differences arise due to various reasons and influencing factors.
We can categorize the factors into three: financial, strategic and investment ecosystem reasons.
This is pretty straightforward, as most investment decisions are spurred by financial motivations. Some of the financial aspects that potential investors pay attention to when looking at a startup’s valuation include:
- Size of the market being targeted. If the market is huge, there is a tendency for the startup to have a higher valuation.
- Growth rate of market share. If there is high potential of the startup enjoying a fast growth in its market share, it will be valued higher.
- Growth rate of sales. Sales is one of the key determinants on whether a startup has a chance to succeed or not. Investors tend to be willing to pay a higher amount for startups that have a potential to have high sales growth.
- Future profits. Forecasting the future results of operations or performance of a startup is one of the key methods adapted by investors in determining what the startup is worth. Business valuation will definitely be higher if the computations and estimates show the company earning exceedingly high profits in the future.
Investors do not just focus on the numbers. They also have strategies that, at first, may not be quantifiable but, in the long run, become one of the financial reasons. Some examples are:
- If the startup owns, or is in possession of, a technology or any other intellectual property that gives it strategic advantage in the market and over its competitors;
- If the startup has exclusive rights or ownership over key people/talent, that gives it an edge over the competition.
- If the startup already has customer access or a distribution channel for its products or services.
Investment Ecosystem Reasons
Most investors readily claim that the investment ecosystem is the biggest determinant of the value of a startup. We are basically referring to the market forces of the industry and the specific sector within that industry that the startup aims to belong to. They call this factor as the “hotness of the industry”. In short, investors ask, “How hot is the industry where the startup will operate in?”
The investors would be especially concerned about the following:
- The size of generally available capital to be invested into startups. The fluctuating nature of the availability of capital is seen in the balance and imbalance between the demand and supply of money that the investors have purposefully for funding startups.
- The size and frequency of recent exits from the industry. If there is a sudden stream of business making an exit out of that industry, it could be an indicator a decline is impending, and this will influence how investors will value startups.
- The willingness of investors to pay premium. There are investors that are not hesitant to pay more, especially if they are sure that they are getting an excellent deal out of it. If investors have no qualms about paying such premium, this could also affect the business valuation of a startup.
There are other factors that have an effect on the valuation of a startup.
- The reputation of the entrepreneur or startup owner or founder. This may not be the first startup of the entrepreneur. If this is the case, investors will also look into the reputation of the person behind the startup. There are entrepreneurs who have established stellar reputations that, no matter what their next startup is, they are bound to get high valuation for it. In contrast, a startup idea may be brilliant and shows a lot of promise, but if the person who came up with it and is pushing for it does not have a good reputation, valuation may be low.
- Stock Options for employees. A startup that is able to set up an option pool for future employees gives off the impression that the startup will be able to attract talent. The amount set aside for the option pool will be deducted from the valuation, since it is value set aside for future employees, meaning you still do not have these talents in your startup.
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