What Does Valuation Mean, and How to Value a Startup?
How to Value a Startup?
In the previous article, we briefly discussed the concept of valuation. As mentioned, the valuation may refer to different meanings. In general, “value” is defined differently in various fields of science. However, this concept has its own meanings in finance and economics. When we talk about “value” in economics, there are a few types of meanings:
- Intrinsic value means real value, taking into account the value of all tangible and intangible assets.
- Economic value is the maximum value or price that buyers are willing to pay.
- Fair value is a reasonable price agreed upon by both parties to the transaction.
- Market value is the price determined in the market based on supply and demand.
To evaluate a startup or any other company, we should say that their intrinsic value may differ from economic or fair value. However, the fair value of many assets, such as stocks, is determined by supply and demand. Valuation is the process by which the fair value of a startup is determined. In this article, after raising some introductory titles, we will discuss different methods of valuing a startup.
The Purpose of the Valuation
The primary purpose of valuation startups is to determine the current value of a company.
As mentioned, the present value of a company can be equal to its intrinsic value, economic value, market value or fair value.
Reasons for Valuing Businesses
Companies need careful valuation at different stages of their progress. Some startups need to be valued at the beginning to raise capital, and some medium and large companies should be valued at the time of merger or acquisition. Here are some of the essential reasons why startups should be evaluated:
To Find the Value of the Transaction
When a person or entity intends to buy a company, its fair value or transaction value must be determined. The value of the transaction is the price that both parties agree on. The transaction value of the company can be less or more than its intrinsic value, which can be determined with the help of accurate valuation methods.
Companies must be valued to determine the investor’s share when raising capital. In summary, the investor’s share is determined based on the ratio of capital injected to the startup value after attracting money.
For example, suppose a startup with the worth of $ 8 million before raising capital. If an investor invests $ 2 million, the startup value after attracting money will be $ 10 million. By dividing the injected capital ($ 2 million) on the startup’s value after raising money ($ 10 million), the percentage of the investor’s shares, which is equal to 20% of the total, will be obtained.
Merger and Acquisition
A merger occurs when two companies become one due to synergies in expanding activities, reducing costs, and other reasons. On the other hand, the acquisition is when a company buys most or all of another company’s stock to take control of it.
At the time of the merger and acquisition, to determine the transaction value or the share of both parties, it is necessary to determine the value of the startups.
Sometimes, the parties use the shares transfer for mergers and acquisitions instead of paying the transaction price. In this case, to calculate the exact value of each company’s share, both must be valued.
When two or more companies agree to share resources to increase synergies, valuing companies is a prerequisite for determining the parties’ share and participation degree.
Challenges in Startup Valuation
Valuation is a complex and challenging process. As mentioned, the purpose of a startup valuation is to find the intrinsic value. However, to determine it, we need a lot of information:
- Current and potential revenue streams
- Financial Statements
- Previous and forecast sales status
- Market size
- Market share
- Brand value
- Managers’ performance
- And many more
So obviously, accessing all this information is not so easy.
However, the two main challenges for business valuation are as follows:
Lack of Access to Company Information
It is challenging to access all the company’s information, even in the case of listed companies, whose financial statements are regularly made available to the public.
Lack of Consensus on the Valuation Method
There are several ways to value companies. You can use each of them depending on the type of company, it’s maturity and business conditions. On the other hand, due to numerous differences between companies, there is no consensus on the valuation methods.
These two main challenges cause analysts to seek the most accurate estimate of the business value constantly. However, we can say that the precise valuation turns capital attraction into a win-win deal for investors and founders. In the following, we will briefly review the valuation process of startups.
The founders must agree with the investor on the startup value before raising capital. Therefore, startup valuation is an essential factor in determining investor stock and a fundamental criterion in how negotiations between the parties proceed. When we use the term valuation for startups, we mean the figure on which investors and startup founders base their negotiations.
Valuing a startup is not an easy process, especially valuing startups in the early stages of operation.
For this reason, valuing a startup is more of an art than a science.
The items listed below are part of the difficulty of valuing:
- In the early stages, a startup has little or no reliable historical information about its performance.
- Compared to traditional businesses; startups have fewer physical assets.
- Startups do not have a solid business model, especially in the early stages.
- They may not have achieved sustainable revenue.
When the investor can not rely upon the existing data, valuing a startup involves assumptions and probabilities about the startup future as well as its potential for success. As a result, the startup valuation process is more complex than traditional businesses.
Startup Valuation Methods
The most important factor influencing the value of a startup is its growth potential. Value proposition, the scope of activity, market size, market share, team strength and many other factors may affect this potential.
There are many ways to value startups, some of the most important of which include the following:
Discounted Cash Flow or DCF method:
In financial knowledge, Discounted Cash Flow is one of the pricing methods. It is for estimating financial assets and examine the attractiveness of investment opportunities in corporate stocks.
To analyze Discounted Cash Flow, you should use the image of the company’s future cash flow and discount it (using the weighted average cost of capital) to reach the current value of the company’s stock.
In this valuation method you assume that similar assets have the same price.
To value a startup using the Multiples Valuation Method, The investor compares the value of a startup’s financial indicators with the same one of another company. In this way, by seeking help through available information of similar companies, one can obtain the price or the value of the desired startup.
Scorecard valuation is one of the most common methods for valuing startups in the early stages (Pre-revenue startups). Due to being “qualitative” as well as being suitable for seed stage startups, the scorecard is one of the most popular methods among angel investors. The output of this valuation method determines the pre-money valuation of the startup.
The First Chicago Method:
The most important difference between this method and other valuation methods is its flexibility. Instead of looking for an exciting future for a startup, the investor considers optimistic, realistic, and pessimistic scenarios, and in each of them, identifies a specific output for the startup.
Valuation techniques help us determine startup value to negotiate with the investor for capital.
The value of each startup can vary depending on the method used. For example, a startup may be valued at $ 10 billion in “discounted cash flows” and $ 8 billion in the “multiples method”.
Which Valuation is More Accurate
But based on the above information, which valuation is more accurate?
The answer to this question depends on the assumptions made in each method. So finally, The parties determine the value of a startup in negotiation.
In the following articles, we will discuss these methods as well as their advantages and disadvantages.