Valuation start-ups

For any company, business valuation has never been smooth sailing. For start-ups with little or no revenue or profits and uncertain futures, the job of assigning valuations is particularly tricky. For mature publicly listed companies with stable income and earnings, they are usually valued as multiples of earnings before interest, taxes, depreciation and amortization (EBITDA) or multiples based on other specific industries. However, it is much more difficult to value new companies that are not publicly listed and that may take years to achieve sales.

Key points

  • If you are trying to raise funds for your startup, or you are considering investing money in it, it is important to determine the value of the company.
  • Start-ups usually expect angel investors to raise much-needed funds to start their business-but how to evaluate a brand new company?
  • As we all know, it is difficult for startups to accurately value their valuations because they do not yet have operating income, may not even have saleable products, and will spend money to keep things going.
  • Although some methods such as discounted cash flow can be used to value start-ups and established companies, other indicators (such as copy cost and stage valuation) are unique to new companies.

How to value startups

Copy cost

As the name suggests, this method involves calculating the cost of establishing another company from scratch. The idea is that a smart investor will not pay more than the cost of copying. This method usually looks at physical assets to determine their fair market value.

For example, the cost of copying a software business can be calculated as the total cost of programming time for designing the software. For a high-tech start-up company, it may be the cost of R&D, patent protection and prototype development so far. Copy costing is often regarded as the starting point for evaluating startups because it is fairly objective. After all, it is based on verifiable historical expense records.

The big problem with this approach-the founder of the company would definitely agree here-is that it does not reflect the future of the company Potential Used to generate sales, profits and return on investment. More importantly, the method of copying costs does not capture the intangible assets that companies may have even in the early stages of development, such as brand value. Because it usually underestimates the value of venture capital, it is often used as a “low-key” estimate of the company’s value. When relationships and intellectual capital form the foundation of a company, the company’s physical infrastructure and equipment may only be a small part of its actual net worth.

Market multiple

Venture capital investors like this method because it can give a good indication of how much the market is willing to pay for a company. Basically, the valuation of a company by multiple methods of the market is compared with the recent acquisition of similar companies in the market.

Suppose that the sales of the mobile application software company are five times the sales. To understand how much real investors are willing to pay for mobile software, you can use a multiple of five times as the basis for assessing the risk of mobile applications, and adjust the multiple according to different characteristics. For example, if your mobile software company is at an earlier stage of development than other comparable companies, its price-to-earnings ratio may be lower than 5.

In order to value the company at an early stage, a broad forecast must be determined to evaluate the sales or earnings of the business after it enters the mature operation stage. When capital providers believe in a company’s products and business model, they usually provide funds to the company even before it generates revenue. Although the valuation of many established companies is based on earnings, the value of start-up companies must usually be determined based on multiples of revenue.

It can be said that the value estimate provided by the market’s multiple methods is closest to the price that investors are willing to pay. Unfortunately, there is an obstacle: it is difficult to find comparable market transactions. It is not always easy to find a company that is close, especially in the startup market. Transaction terms are usually kept secret by early unlisted companies-these companies may represent the closest comparison.

Discounted cash flow (DCF)

For most startups—especially those that have not yet begun to generate revenue—most value depends on future potential. Discounted cash flow analysis represents an important valuation method. DCF involves predicting how much cash flow a company will generate in the future, and then using the expected return on investment to calculate the value of that cash flow. A higher discount rate is usually applied to start-up companies, because the company inevitably has a high risk of not being able to generate sustainable cash flow.

The problem with DCF is that the quality of DCF depends on the analyst’s ability to predict future market conditions and make correct assumptions about long-term growth rates. In many cases, predicting sales and earnings in a few years has become a guessing game. In addition, the value generated by the DCF model is highly sensitive to the expected rate of return used to discount cash flows. Therefore, DCF needs to be used very carefully.

Valuation by stage

Finally, there is the development stage valuation method, angel investors and venture capital companies often use this method to quickly get a rough range of company value. This “rule of thumb” value is usually set by investors and depends on the stage of commercial development of venture capital. The deeper the company is on the road of development, the lower the company’s risk and the higher its value. The staged valuation model may look like this:

Estimated company value development stage
USD 250,000-USD 500,000 Have an exciting business idea or business plan
US$500,000-US$1 million Have a strong management team to execute the plan
US$1 million-US$2 million Have the final product or technical prototype
US$2 million-US$5 million There are strategic alliances or partners, or signs of customer base
USD 5 million and above There are obvious signs of revenue growth and obvious ways to make profits

Likewise, the specific value range will vary from company to company, and of course investors. But it is very likely that a startup company with only a business plan may get the lowest valuation from all investors. As the company successfully achieves development milestones, investors will be willing to give higher value.

Many private equity firms will adopt a method of providing additional funding when the company reaches a certain milestone. For example, the goal of the first round of financing may be to provide wages for employees to develop products. Once the product is proven to be successful, the next round of funding will be provided to mass-produce and sell the invention.

Bottom line

Since the company’s success or failure is still uncertain, it is difficult to determine its exact value when the company is in its infancy. There is a saying that the valuation of startups is not so much a science as it is an art. There are many reasons for this. However, the methods we have seen help to make art more scientific.


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