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The valuation of any company, whether it is an established company, or a start-up new venture, requires forecasts and predictions about the future. Hence, in this regard, business valuation is commonly referred to as a “Prophecy to the Future”, in technical literature.
A company’s value is based on its ability to produce economic benefits, in the form of future cash flows, profits and other returns, to its owners and investors. Hence, this is why fair market value is commonly defined as the amount at which property would change hands between a willing buyer and a willing seller, when neither party is under any compulsion to buy or sell, and both parties have reasonable knowledge of relevant facts.
A company with a history of revenues and profits enables a business valuation analyst to predict future financial performance based on better objective assumptions and greater confidence. A venture start up firm, that lacks a history of revenues and financial performance, presents unique challenges for valuation. However, this does not mean that such a start-up venture firm does not have a value. What this means is the valuation of a start-up firm is more difficult to perform due to information constraints and potentially the use of more subjective assumptions during the valuation process. Nonetheless, the fundamental principles of valuation are applicable to the valuation of a start-up firm.
Fundamentally, the valuation of a start-up firm should be based and supported on the present value of future expected cash flows from its operations. The valuation of a start up firm generally requires a shift in focus, which means that a valuation analysis of a startup firm requires the valuation analyst to focus on valuing the startup firm for what it wants to be in the future, and yet apply fundamental principles of valuation.
Estimating the Level of Risk
Generally speaking, buyers and investors will view the prospects of a startup firm for ultimately achieving projected revenues and earnings with greater risk, and to compensate for higher risks, investors and buyers will demand greater rates of returns, which translates into lower values. Given the fact that the probability of failure for a startup firm may be high in the first year, it is of paramount importance to assess risk based on reasonable assumptions. This requires business valuation analysts to examine a number of factors to project a startup’s future performance and to estimate the level of risk involved. Such factors may include, but are not limited to, the quality and reputation of the company’s management team, and the demand, uniqueness and differentiation of the product or service to be provided. Additionally, the business plan and financial projections constitute critical factors for valuation of startup firms.
Although the valuation analyst may need to discount internal projections or forecasts to reflect management’s natural optimism, no one knows the company’s products and services better than the business’s founders and senior executives. The valuation analyst will ultimately use management’s projections, and may extend such projections further into the future, based on realistic and reasonable assumptions. Additionally, valuation analysts review the experience and value of comparable companies, industry, and market statistics, as well as the value of intellectual property or other assets that may give the company sustainable competitive advantages.
Other Critical Valuation Factors
Another critical factor in valuation of startup firms is time. Generally speaking, the shorter the time frame for the startup firm to be profitable, the more valuable the company. This is because the lesser the time to achieve profitability, the lower the risk for the startup firm, and the buyer or investor does not need to wait a long time to achieve an exit value.
Another related critical factor is liquidity. Since a startup does not generate profits immediately, it must have sufficient working capital and liquid assets to fund current operations and absorb short term losses.
Still another related critical factor is the startup stage of development. A startup that is in its earliest stages, with little more than an idea, will be less valuable, than a startup with will developed products and services and financing from venture capitalists and investors.
Valuation Approaches:
Discounted Cash Flow Analysis
As previously mentioned, the fundamental principles of business valuation apply when valuing startup firms. This means that the value of a startup firm should be based on its capacity to generate future cash flows from its operations. Hence, the discounted cash flow method (DCF) that is commonly used to value established firms can also be applied to value a startup firm. Like for established firms, the framework for valuation analysis of a startup firm shall involve an assessment of the business environment and industry in which the startup will operate, as well as an assessment as to where the startup stands in relation to potential competitors. This will include a critical evaluation as to whether the startup has sustainable competitive advantages that will enable it to generate revenues and cash flows in the future.
Another step in the process of the application of the DCF method is to estimate revenue growth to project revenues into the future. Because a startup firm does not have a history of revenues and earnings to make revenue projections, critical factors to determine a revenue growth rate shall include, but are not limited to, determining the projected growth rate of the industry in which the startup operates, the sustainable competitive advantages of the startup, and estimations of market share to be captured by the startup firm. Additionally, the application of the DCF method will also require estimation of sustainable operating margins for the startup. The ultimate goal in the application of the DCF method to value a startup firm, is to develop adequate revenue projections into the future to arrive at free cash flows to the firm, and discount those cash flows to arrive at the present value of the startup firm. This present value may be adjusted for the estimated probability of survival of the firm, and a discount for illiquidity, to arrive at a final estimate of value.
Relative Valuation
The use of relative valuation methods constitute a very valuable approach to value startup firms, and can be used in combination with a discounted cash flow analysis. Relative valuation is a market approach to valuation that estimates the value of the firm, based on how much the market values similar firms.
Relative valuation involves the use of public company multiples to value private companies; and the use of relative valuation constitutes a useful good practice to value startup firms. Fundamentally, the process involves the use of forecasted revenues and earnings, the compilation of relevant public company multiples, and the application of such multiples to a forecasted metric (e.g. revenues, EBITDA) to arrive at an expected value, to then discount the expected value at the estimated discount rate for the firm, to arrive at the present value of the expected value. A discount for illiquidity may be adjusted to the expected value to arrive at a final estimate of value under relative valuation.
Predicting the Future with Facts
As evidenced by this information, it is easy to see how valuation of start-ups require a business valuation analyst who understands the nuances of this particular type of valuation. Regardless of the reason for needing a valuation, it is preferable to work with a team that has the experience to provide the most accurate information available. The Ahuja & Clark team has this experience and can support your business valuation needs, start-up or otherwise. Contact us to learn more about how your organization would benefit from a professional business valuation analyst. Also, consider signing up for our newsletter to receive professional tips and information regarding your organization’s financial opportunities.
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