Understanding the Unique Value Drivers of an Early Stage Company
Why Startup Valuation Is Different?
It is often said that valuation of a company involves mixing science with art. The science being the implementation of sound valuation methodologies and best practices and the reliance on objective or independent data. The art is the degree of judgment reserved to the valuation professional in making assumptions. Good valuations have the appropriate balance between the two.
Early-stage businesses are often very difficult to value based on the traditional methodologies due often to fact that startups have little to no past financials to account for to predict the longer term outcome. Therefore there is typically a much greater use of “art” than “science” in determining the right value of a startup. The valuer is required to rely more on judgement and specific industry knowledge, than mathematical models and valuation techniques.
How to Value a Startup?
First: Adjust General Valuation Approaches
The income approach, the market approach and the cost approach are the three main methods for valuing a business. These are the starting point of any startup valuation and one must look to see if these methods are applicable.
In the case of a startup that has started generating consistent stream of revenues and is experiencing high growth rates, it is feasible to use the income approach using a DCF (Discounted Cash Flow). It is advisable to use a three-stage free cash flow discount model to account for different growth periods and rates and to reduce reliance on terminal value being linked to a high growth rate that is not sustainable in the long run. Since the capital structure of startups is typically debt free, taxes are low due to NOLs, and convertible instruments are assumed to convert into equity, this is simplifying income valuation methods.
The market approach should be adjusted for an early stage company, and instead of looking at trading comparable of mature businesses as valuation benchmarks, a valuation performed under the market multiples approach should look more closely into recent VC financing valuation as a guide to the subject company’s valuation at such early stage. While there can be problems with extrapolating the value of a company from a VC investment due to lack of information on how these valuations were determined, these valuations still represent an important market information as they are based on the premise that sophisticated financial investors conducted comprehensive due diligence and conducted rational negotiations which inherently make those valuations at fair market value.
This valuation method is typically not considered appropriate for startup valuation as startups assets are more intangible in nature like patents, copyrights etc. and less rely on tangible assets. this in turns means that the value of intangible assets is not considered and the valuation of the start up company is significantly depreciated.
Next: Apply Startup-Specific Valuation Methodologies
Assuming the traditional valuation methods on the left are not coming in very helpful, there are other methods for valuating startups companies that are currently at a pre-revenue stage. Here are the three we consider to be widely used:
The VC method is used by investors to calculate the present pre-money value of the firm by projecting the value of the company at exit, and discounting this value at a high rate (typically 50%-70%). The exit value is estimated using certain assumptions such as the annual earing or EBITDA at the end of the projection period (typically 5-7 years), and applying an exit multiple to this metric. It ignores any intermediate cash flows. Here are the basic steps of this method:
- Estimate exit value.
- Discount exit value to present by using investors’ rate of return as the discount rate.
- Calculate the post-money valuation.
- Calculate the pre-money valuation.
- Finally, calculate the equity percentage owned by the investors.
Please see our sample VC method model here.
This method is using a benchmark valuation for your business as a starting point (typically obtained from gathering information on comparable valuations for other pre-revenue companies in your sector within your geographic region). The method has three steps:
- Step 1: Gathering valuation from used recent relevant VC financings as a guide to the subject company’s valuation
- Step 2: Calculating the average of those valuations.
- Step 3: Comparing your company to similar deals done using factor weighting of the following criteria:
|Value Driver||Weight*||Your Venture’s Score*||Factor|
|Strength of the Management Team||30%||150%||0.45|
|Size of the Opportunity||25%||125%||0.31|
|Need for Additional Investment||5%||100%||0.05|
|PRE-MONEY VALUATION||$ 3,338,125|
Notes: this example assume a base average obtained from comparable deals of $2,725,000 and applying a 1.23 factor to arrive at a company valuation of $3,338,125.
* Weights and venture score are adjustable by the user.
The Berkus Method was developed by renowned Silicon Valley angel investor Dave Berkus who treats a startup as a closed box and uses a simple two step assessment process that he applied for pre-revenue and early stage companies:
First step: does it seem feasible for the company to reach 20M in revenue within 5 years ? Only if the answer is positive we move on to the next step.
Second step: Assessing the box against 5 key criteria with potential value range for each key criteria between $0-$500,000, such that the maximum value for a company receiving a “perfect” $500,000 score against each criteria cannot exceed $2,500,000.