VALUING STARTUPS

INTRODUCTION

Valuing refers to the process of estimating the price at which a stock can be bought and sold in the current market place or the intrinsic value, i.e., the actual value of the stock based on its true value.

Accordingly, startup valuation refers to the specification of the value or price per share of equities of the newly established venture to help them with financing, management, and operation of their business. 

Valuation is both an art and a science, science in the sense that it involves researching similar companies. Valuation of startups is persuasively the most intriguing and, at the same time, the most frightful challenge. I will be studying in depth the various challenges and considerations while valuing startups.

Need for validation.

With the help of startup valuation, it becomes easier for the investors to calculate the potential return on investment and helps them in deciding whether it will be fruitful to fund the business or not. This will also help the entrepreneurs learn whether they are operating profitably or not by enabling them to compare their costs against their revenue.

CHALLENGES

1. No Historical Data: Most start-ups do not have any historical track record of operations or financials, so it is difficult to gauge their growth, profitability, or costs.
2. Minimal Tangible Assets: A start-up’s value often rests on its future investment and growth prospects rather than on a physical asset, such as plant and equipment, that it already owns.
3. No Revenues, No Earnings, or Negative Earnings: The traditional valuation parameters of earnings, P/E ratios, etc., become moot when a firm has no revenues or earnings, and often a negative EBITDA.
4. Extreme Risk: Most start-ups fail, an outcome that has to be built into the valuation.
5. Unpredictable Future: Markets can jump or swerve overnight, and the basis for a projection of future growth and market share is tenuous.
6. In the Red for a Long Time: Most start-ups do not make money until after they have been in existence for a decade or more.
7. No Comparable: The innovative start-up could hold true to its promise of reinventing the industry and have few or no comparable.
8. Continuing Valuation Rounds: There is a lot of room for difference in valuations across subsequent investment rounds, and not just because of new information but also because investor sentiment and general market conditions can affect the prices.
9. Lots of Room for Subjectivity and Bias: As the entrepreneur pitches expected growth and presents information (that is often vague or misleading) or it is analyzed and massaged (by a broker or investment banker) into a neat valuation model, the number that emerges as the value of the firm is subjective and can differ wildly depending upon the explicit and implicit assumptions made along the way.
10. Other Risks: Start-ups face other types of risks, including technical, funding, and strategic risks, which are often not captured in traditional estimates of a cost of capital or hurdle rate.
11. Low Probability Revenue Projections: Revenue projections often display a “hockey stick” pattern, with modest growth in the initial years and explosive growth in the years that follow, a pattern that actually holds true for a very small percent of start-ups.

12. Operating Leverage: As operations scale up, especially with dot-com or internet service companies, there are benefits that come from operating leverage, which is very difficult to measure, but these benefits will add to the value of the firm, often not directly captured in valuation.

Methods of Validation

i) Venture capital method (involve showing pre-money valuation of pre-revenue startups)

ii) Berkus Method (development stage—a tool that allows pre-revenue startups to assign value and compare their qualities with the others to seek opportunities)

iii) Scorecard Valuation Method: using the average valuation of the other startup similar to their business segment.

iv) Risk Factor Summation Method—comparing 12 elements of the target startup.

v) Cost to duplicate method: calculating the cost and expenses of an existing startup to find out how it would cost to replicate a similar kind of business.

vi) Discounted Cash Flow Method: predicting a company’s future growth by analyzing the market.

vi) First Chicago Method: predicts the business through different outcomes with elements of discounted cash flow and multiple-based valuation.

vii) Future Valuation Multiple Method: uses estimation of expected return on investment.

viii) Risk Factor Method: using the 12 factors affecting the return on investment and forecasting the profitability of success.

ix) Book Value Method—considers only the net worth of the company.

x) Comparable Method: looking for similar startups implies valuation.

The valuation method will depend on and differ for early-stage companies, companies in early growth and expansion stages, and companies that have reached the stage of sustainable growth.

CONCLUSION

Startup valuation is a very crucial part of the business, as accurate valuation will affect the financial outcomes and lead to startup success. 

Valuation highly matters as it will help attract investors to invest their funds, bringing in capital for the firm. 

Accurate valuation will enable the investor to gain trust in the firm’s potential, contributing to fair equity distribution among the stakeholders. 

Valuation will prepare the startup for due diligence and acquisition, providing insights into the actual progress and helping attract skilled and talented professionals to join their company.