Determining the value of a startup can be a challenge.
Entrepreneurs need to establish how much to give away in return for investment, and investors need to evaluate their next venture.
Typically, the valuation of any new economic asset is based on expected future cash flow, discounted at a rate that reflects the inherent risk facing the business. Getting it right, however, requires a complex combination of science and art.
Science: the cash flow dilemma
Most startup entities share the same characteristics: they are innovative; they are based on an idea, (which is likely to create disruption in the market); and they are grounded in cutting edge technology. Additionally, there is a substantial reliance on the entrepreneur, who strives to make their big idea a reality. Relentless energy and agility is required in order to keep up with dynamic changes in the market.
This combination of innovation and entrepreneurialism presents significant uncertainties in determining the cash flow of the business.
The challenge of valuing a startup company
All these variables make the process of a startup valuation very challenging. Not only due to the lack of historical financial data, but also the difficulty in assessing a product or service that implies a new way of doing things. In addition, the business is likely to be running at a loss in early phases.
Usually, the determinants of discount rates are based on market data. Even when valuations are made based on comparable transactions or multiples, the concept of a cash return to investors in the business is implicit.
This is not to say that the valuation of a start-up company should be disconnected from basic or traditional economics. However, a start-up valuator must understand that the key assets of the company are likely to be intangibles. These intangibles could be disruptive ideas, normally supported by a technological platform. Equally, they could be the creativity of the entrepreneur, their capacity to endure the difficulties of initiating a business, and the continual development of ideas.
Traditional valuations methods need a shake up
In an innovative and forward-thinking business environment, traditional valuation tools (such as discounted cash flow or multiples) may not be the right way to fully understand the value of a startup. Should an alternative, more artistic valuation approach therefore be applied? Both investor (buyer) and entrepreneur (seller) can consider qualitative information to help evaluate the business, although much subjective judgement is involved:
- entrepreneur’s ability to implement the idea
- entrepreneur’s market profile
- compatibility of the relationship between buyer and seller
- the entrepreneur’s capacity to build on the product - and capture the market opportunities (current and future)
- stage of business maturity
- the risks of technology
- likelihood of a lucrative exit.
In this context, a parallel could be drawn with the art market. When buying a piece of art, even though the market is mature, the price paid is inherently based on the subjective view of the buyer. It is not focussed on immediate cash flow generation from the asset, but rather the perception of the potential price increase. This perception depends on the uniqueness and aesthetic appeal of the asset, as well as the creativity of the artist.
Balancing science and art: What are the options?
Today, along with the traditional methods of discounted cash flow and multiples, there are different methodologies to evaluate a start-up. Two commonly used are:
Berkus methodology - a simple rule of thumb that bases its valuation on qualitative aspects of the business.
Risk summation methodology– which compares 12 characteristics of the start-up company, from the business stage until potential lucrative exit.
How do I know if one of these methods is right for my business?
There isn’t a pre-made valuation methodology that applies to all kinds of start-up businesses. Nevertheless, there are some adjustments to the conventional financial approach that should always be taken into account. A sound valuation should be based on a model that combines conventional financial approaches with a more qualitative risk based methodology that suits the market and lifecycle stage of the business.
Due to the characteristics of emerging businesses and the uncertainties associated with them, start-ups should be valued systematically. For this to be achieved it is necessary to consider each identifiable variable. These should be adapted for the special characteristics of the company being valued.
In any analysis, the main variables to review and adapt are:
The profits and cash flow forecast, in particular with a bottom-up or top-down critical approach concerning the company’s market potential.
The exit value and, if a terminal value is to be used, reasonable assumptions about cash flows growing in perpetuity.
The discount rate in a discounted cash flow analysis, ideally avoiding the use of arbitrary ‘target rates’ to allow for uncertainty, preferably considering comparative analysis with mature firms within the same sector.
Startup companies, like fine art, pose a challenge for accurate valuations. However, using a combination of methodologies can result in a more accurate value.