It is undeniable that start-ups attract a high interest thanks to many factors, such as their growth and wealth generation potential, the novelty of their products or services, their approach to amazing new technologies, and the impact they can make on relevant sectors, such as health, education, food, information, or trade.
Nevertheless, most start-ups do not succeed. Most studies reveal that more than 90% of start-ups fail at some point between the first and the tenth year. The reasons why this happens are varied. Many startups try to enter into emerging markets for which there is no sufficient historic information for reliable financial projections, while the short age of the technologies leaves big space for uncertainty.
Consequently, we could say that valuing start-ups is somehow like trying to grasp the air with your fingers: how are you supposed to calculate, in a certain moment of time, the value of a thing whose purpose is to constantly increase its own value with countless elements to manage beyond its control? How can you value something so changeable and volatile?
“Valuing start-ups is somehow like trying to grasp the air with your fingers”
10 important aspects to value a start-up
But we must not desist. Many startups need investors and fair valuations are essential to close investment deals.
First of all, we must assume that it is not possible to have fully reliable, stable and complete information when talking about startupsTherefore, let’s lower our expectations andtry first a qualitative approach.
At Strata, we look at 10 aspects when valuing a start-up:
- The Team: The people and especially the leaders (or the management team) must sum up the skills, professional backgrounds and experience to carry out the project forming a consistent, motivated, goal-oriented and cohesive group.
- Conflicts of interest: There should be no internal obstacles that impede the project to progress or question it in terms of conflict of interest regarding authorities, competitors, suppliers, stakeholders, specific target groups, etc. The project must be ready to freely compete relying on its own strengths and assets.
- Legal aspects: Things must be clear with regard to the legal requirements, employees, competitors, intellectual property rights, assets, stakeholders, accounts, etc.
- Value proposal: What customers are going to get must be valuable, according to realistic needs, the target users must have been identified, and the market size dimensioned to a certain extent.
- Business Model: It must be clear and well understood from all its aspects assuring that it is coherent and plausible, especially referring to the generation of cash flows and the identification of costs.
- Monetization: The company must be able to generate some incomes on the basis of its value proposal and business model.
- Localisation: It must be adequate to carry out the activity, to assure the employees’ well-being and workforce stability, the company branding, distribution costs and operations strategy.
- Treasury: The company’s treasury must assure that, even if cash is still not generated, it is sufficient for the start-up’s continuity until it begins to make sales and clients pay.
- Unit economics: The price level must be harmonized with what customers can pay and must provide sufficient margin to pay back the investment.
- Marketing: Marketing costs actually pay back at least in terms of client generation and leads.
If in all these points the analysis is favourable, then our start-up is more likely to have value, which means that we can proceed with the valuation.
We hereby briefly describe four start-ups valuation methods very commonly used:
Cost Value or book value
It consists of valuing all the investment made along the start-up’s life. It actually provides a reference for the seller’s best negotiation alternative to a non-agreement (BATNA), and shows the accumulation of work, time and the company’s assets. The amount of resources invested could relate to the companies’ value although this is not always the case. Unfortunately, it provides no information about the start-ups future wealth generating potential, which is much more relevant to the eyes of investors.
Comparable Multiple Valuation
When valuing a start-up, we should have enough information about the profits generated, turnover,figures, the number of users or the number of visits on a website. This valuation method consists of comparing the start-up’s parameters (comparable multiple,like the ones previously-mentioned), with the ones of other start-ups from the same sector and business activity, of which we actually do have values obtained from real transactions, and therefore, set values applying the parameter multiple to these values. Specialised companies provide these real transactions data for specific activities and sectors.
Free Cash Flows with scenarios
This method establishes the company value on the basis of an estimation of the cash flow that is expected to generate like any other financial investment. It first puts the entrepreneur who wants to know at what price he should sell his start-up in the buyer’s standing point. It calculates how much investors would have to invest today toallow, at present market interest rates, to obtain the cash flows actually expected by the entrepreneur. The entrepreneur should understand that, depending on the perceived risk level for start-ups, the WACC (Weight Average Cost of Capital) used is normally high (from 30% to 50%) given the high risk of startup investments.
To calculate the cash flows expected in a more precise way, the entrepreneur can establish scenarios (normal, optimistic and pessimistic) assigning a certain estimated weight to each one according to their feasibility and thus obtaining the most feasible cash flow. For more precision regarding the scenarios, decision trees can also be introduced for generating new scenarios depending on the chances of certain events to actually happen. For example, a pharmaceutical start-up can generate a new scenario depending on whether a specific test has been successful before a certain date, which means that it is positioned ahead of the competition.
Venture Capital Method
This method is thought to value the participation of investors in start-ups. It begins by obtaining an estimation of the company value after the investors round:
Start-up Value after the financing round = Final Start-up Value / Aimed Profitability
Then we determine the value of the entrepreneur’s initial investment:
Entrepreneur’s Initial Investment Value = Start-up Value after the financing round -Funding obtained the first round
Let’s see it in the following example:
An entrepreneur thinks he can increase the value of a start-up founded one year ago by 7 (x7) and requires 500,000 € for new equipment and for developing an aggressive marketing plan. Up to now, the entrepreneur has invested 1,000,000 € in working hours, materials, consultancy, equipment, travelling and others.
What is the company value after the investment round? What is the final start-up value? How much is the share of the entrepreneur?
Start-up Value after the financing round = Entrepreneur’s Initial Investment Value + Funding obtained the first round
1,500,000 € = 1,000,000 € + 500,000 €
Final Start-up Value = Start-up Value after the financing round x Aimed Profitability
10,500,000 € = 1,500,000 € x 7
The total Start-up Value after the financing round is 1,500,000 € and the investor’s participation is 500,000 €. The entrepreneur’s share has been reduced from 100 % to 30%:
100 x (500,000 € /1,500,000 € ) = 30%
This valuation method is usually carried out by investors from a different perspective. In this same case, the investor is looking at a x7 ROI for a 500,000 € investment. The investor calculates his exit valuation – usually according to other similar operations – and goes backwards to perform the current valuation.
For early-stage companies, often pre-revenue and with limited financial KPIs to monitor, other methods such as the scorecard method, the Merkus method, or the risk factor summation method are also used.
Obviously, a negotiation process between the investor and the startup will finally need to reach an agreement. The final valuation will depend on many other factors and on the negotiating power of the startup and investor; and these powers are very much affected by their corresponding deal flows. This is why it is critical for both, the investor and startup, to actively work with several deals in parallel to increase their BATNA.
“The final valuation will depend on many other factors and on the negotiating power of the startup and investor; and these powers are very much affected by their corresponding deal flows”
Apart from numeric models, building a strong deal flow of investors would become critical in the final transaction value! When valueing a startup, it is not all about numbers.
