How to value a startup?
By James Martin
December 2nd, 2019
How does one calculate the value of a startup that has just launched? What is an investor looking when valuing a startup?
We regularly hear about the debate between: 'valuation' AND 'funding'. How do founders figure out the valuation of their company? What is the value of a startup?
Valuing a company is often more art than science.
The value of a startup is used to determine the share of the company that an investor will get in return for a certain amount of money.
Take a case in point: you start a startup, and need funds to start. You will meet investors who will buy a share of your company in exchange for their money. Here's how to calculate the value of your startup at early stage.
The final value of your startup depends on two things: how are startups similar to your startup evaluated, and how can you convince your investor of the high value of your project?
How to determine the value of a startup?
It is quite difficult to estimate the value of a young startup, since it has not yet proven itself. You can first check the following 2 top criterias:
How much each one is experienced to solve the problem?
The career, the past experience of the team and how they are qualified for your startup will have a great impact on the value of your startup.
The number of users / customers you are able to attract in the first 6-8 months has a great impact on the value of your startup.
In fact, it's traction that makes the most of the value: if you get to show that people have an interest in your product or service, it will not be difficult to convince an investor of your potential.
Even if they are less involved in a B-to-C startup than in a B-to-B startup, the revenue from a startup helps to evaluate its value. In fact, having revenue as a B-to-C startup can even lower the appraised value in the first round: if you charge your users, it makes sense to say that your growth will be slower.
Having to carry out this exercise for a new company is all the more challenging because many concepts acquired in corporate finance and proven methodologies do not apply to it.
We must then "reinvent" and, as often, from what we know to venture into an unknown area but revealing a lot of wealth.
Some methodological approaches to value a startup
We have prepared this infographic about the Berkus method:
- EBITDA multiple - “net financial debt” method. This method is based on the observation that all assets, which produce value with a certain return (the "return on assets"), are financed by equity and debt. Shareholders are entitled to the net result produced by the company after it has paid its creditors what it owes. We will therefore take into consideration only debts that "cost", namely financial debts (bank credit, bonds, ...), and we will not take into account the "free" debts (debts to suppliers, social and tax debts). By adding the company's own funds and its financial debt, we obtain what we call "the enterprise value". In the event that the company has excess cash, this cash can be subtracted from the financial debt to obtain the so-called "net" financial debt. This method consists in estimating the value enterprise as a multiple of the operating profit before depreciation (in English "Earnings Before Interest, Tax, Depreciation & Amortization" or "EBITDA"): Enterprise Value = multiple of EBITDA
- Book value method (book value of own funds):
The simplest way to make a quick assessment of the value of a company is to look at its own funds. Nevertheless, it is often necessary to make certain adjustments: on the assets side, the establishment costs are most often a non-value since they can not be used outside the company. Even if the accounting is supposed to assign to each item of the asset a value close to its real value, it often happens that, with the time and the depreciations, certain tangible fixed assets present values lower than the market price.
- Stock ratio method. This method aims to apply certain ratios observed in the valuation of listed companies to the company that we want to value. The multiples commonly used are: The multiples of the turnover, Multiples of EBITDA, The multiples of the net result (Price / Earning Ratio or "PER"). Other multiples are sometimes used for specific industries: number of passengers carried, points of sale, customers, members, users … The basic idea is to say that if the company to be valued realizes half the turnover or the profit of a reference company listed on the stock market, it is probably worth about half.
- The Discounted Cash Flow (DCF) method. The DCF is the best known and most proven method. It is based on the following characteristics: Its principle is to measure the intrinsic value attached to an asset generating future net income. It depends on the time during which these cash flows are produced, their size and their predictability. It includes an explicit horizon (around 7 to 10 years) and an implicit horizon (beyond the explicit) covered by the terminal value. This terminal value is most often calculated on the basis of a growing perpetual annuity or an exit multiple on horizon based on a core profitability aggregate, the gross operating surplus or the operating result.
- The First Chicago Method or Venture Capital Method
A variant of the discounted future cash flow method is the First Chicago method (which is a DCF with multiple scenarios). This method is named after the bank that originally used it. Let's summarize the main features that differ only slightly from the DCF method. Its principle: determine the result of three scenarios and update these scenarios at a realistic rate. Each scenario is assigned a probability of occurrence and the enterprise value is the weighted sum of these three scenarios. It is flexible (adjustment of flows and discount rates for each scenario), based on the DCF and incorporates a certain notion of optionality (through the 3 possibilities) absent from the DCF approach. However, like the future flow method, this method has its limits: the approach is particularly focused on human judgment. It is therefore necessary to designate the one that will determine the relative weights to be given to the probability of occurrence of each scenario and why.
- Historical and prospective performance Method: Valuation methods are based on the historical performance of the company (as reflected in the accounting, with some adjustments sometimes) and / or projections made for future years. Prospective methods are theoretically the most appropriate: whatever the past, what matters is the future! For example, a company (software or biotechnology) that, after years of research, develops a promising product can be valued at amounts that are incommensurate with what the historical evolution of its accounts might suggest. However, the use of prospective valuation methods requires a lot of work to determine the estimates: ideally, one should project as far as possible in the future, which can only increase the uncertainty. They are therefore subject to caution since no one can predict the future. Forward-looking methods are regularly used during important events such as the listing of a company: the external body responsible for value estimation (typically the merchant bank) will make projections based on estimates of society and confront them with their own experience of the sector. Only investors who are convinced by the result of these calculations will accept the price offered. Such a method is difficult to apply in a private sale because, besides the difficulty of making estimates on the evolution of the course of business when one is not in the company, the projections of the buyer will be systematically considered too cautious by the seller.
Other criteria you can take into account when valuing a startup:
- Distribution channels.
If you already have distribution channels for your product, you have higher potential growth, so your value increases.
- The hype of your industry. "Investors are moving in packs". If your industry is hot, you will be more likely to have a higher value. To know which are the hype industries of the moment, I advise you to take a look at the companies in your sector that recently raised early stage funding (check out Google News, Crunchbase, twitter for specific keywords).
Does the value of a startup predict a great future?
When you evaluate the value of your startup during the seed round,you can consider two different options:
- Raise the maximum against the least possible shares of your company:
You will spend a lot of money quickly, to grow very quickly. This will allow you, in the second round, to raise even more money against a small part of your startup. Since your first turn will have cost you only a few shares, if you grow a lot, you will almost have saved a spin.
- Grow slowly but surely. It's a tactic as good as the other one. Having a stable growth rate over the long term will allow you to attract investors in the second round. Of course, you will not be in the news, but it works.
The emergence of crowdfunding and the possibility of tax deductions for investments in small and medium-sized enterprises are broadening the scope of investments for individuals.
But investing in a start-up can not be improvised and, before entering into this type of investment, it is useful to be able to estimate the value of the company in which one plans to invest.