How to value Startups

Work hard and grow fast! Take your opportunity and work global. Digital technologies allow startups to address global markets. It has never been as easy to build such a scalable business. Aside from a fabulous idea, a great team and a phenomenal product, receiving enough funding is essential to succeed on a global scale. As viral growth is rather considered a myth or a so called black-swan than a standard – it is hard work and still quite capital intensive to achieve an international brand awareness for your product.

Unfortunately 90% of all startups will neither receive an Angel Round, nor a Venture Capital investment. So the question is: “Why is it so tricky to get early stage funding?” Most startups usually do not have strong enough historic financial records, which may be inserted in a “standard” business valuation framework. As a result banks and other “traditional” investment institutions, will not be able to calculate the risk of default and will therefore back off. What remains are Business Angels and Venture Capital Funds, who are specialized in high-risk investing and usually provide much more than just money – so called “smart-money”.

In order to come up with a valuation, early-stage investment professionals will take factors like competition, technology risk, capability and quality of the founder team, attractiveness of the market and scalability of a business case, into account. Hence the fact, that most of those highly scalable enterprises focus rather on traction, than on revenues and profits in early stages – they will have a quite significant burn-rate in their first years. Investors and startups will find it difficult to consider this fact regarding classic valuation concepts, and therefore need to use different valuation approaches.

Two main questions remain:

“What is the Enterprise Value of a startup?”

and,

“How do you measure this Enterprise Value?”

There is no such thing as a one and only, true value for a startup company. There is a set of valuations, which all need to be considered and paired with negotiated deal-terms – combined they may be used to set a specific price for a transaction. In order to understand the full picture it is necessary to avoid a selective analysis. The following standard valuation approaches are determined by different external and internal circumstances.

We usually differentiate between, three standard approaches for Enterprise Values (EV):

1. Fair Market value – the value of an enterprise determined by a willing buyer and a willing seller – both conscious of all relevant facts – to close a transaction.
2. Strategic value – the value the company has for a particular (strategic) investor. The positive effects like synergy, opportunistic costs and marketing-effects are considered and calculated for this valuation approach.
3. Intrinsic value – the measure of business value that reflects the entrepreneur’s in-depth understanding of the company’s economic potential.

Fair Market Value

The “Fair Market Value” implicates full knowledge of all the “relevant” facts on both sides. In other words, information symmetry between Startup and Investor – in practice this will be highly unlikely to establish. In case of a young company, without meaningful track record and often a lack of understanding of the product on Investor’s part, it is more likely to have systemic information asymmetry. Because of the nature of startups, it is tough to determine a “Fair Market Value”. Market values of startups will turn out arbitrary, as stakes of privately held companies are infrequently traded assets.

To overcome this problem investors tend to compare the transaction to other deals within a peer-group, which as a group executed a large number of transactions. This sample delivers a statistical figure, also known as a Multiple. The weak side of this method should be adequately considered, as there is a considerable incomparability of Startups. Never the less it is a benchmark.

Strategic Value

The “Strategic Value” is deeply influenced by the Investor himself. A strategic investor always carries a hidden agenda. There are synergies, opportunistic costs and potential advantages in terms of market competition, among other factors, which will lead to a certain strategic premium. This premium could eventually lead to a higher valuation of a startup he is willing to acquire.

It is difficult for startups, to get a feeling for this strategic premium an investor might be willing to pay. This premium will most likely appear if you have a very good understanding of the buy-side industry, the specific buy-side company, or if there are a view companies in competition for a transaction. On the other side strategic investors may be highly valuable partners for startups, if they have troubles to overcome difficulties, in terms of go-to-market or production scaling. Synergies with a strategic partner in this sense could be a huge asset and eventually lead to a discount of a startup valuation.

Deal parties will need to weigh out carefully who will profit the most out of a deal. A Startup and its potential investor need to evaluate how much worth support, experience, contacts and knowledge of markets have. On the other hand, they need to value the amount of savings (e.g. cheap external R&D), additional returns or the ability to hold a market position, an investor may enable due to a partnership.

The valuation is strictly correlated with potential future synergy effects, and is usually implemented through premiums or discounts to a certain Multiple or a given valuation (so called “Anchor”).

Intrinsic Value

Also known as the fundamental value it requires detailed knowledge about the company, product, market, current trends and a good feeling for probabilities in future business development. A qualitative and quantitative analysis of the business model is necessary to estimate the future impact on the market. Technological competitors, advantages and disadvantages also need to be considered as key risks.

One of the most common valuation approaches in this case is the Discounted Cash Flow method. This method has been criticized a lot. A Valuation is calculated through the sum of discounted future cash flows (so called “present value”). The discount factor is another critical factor, it determines the riskiness of the business case. The discount factor is a composition of the required rate of return (ROI), the time value of money and a risk premium, which is directly correlated with the deviation of future cash flows and other aspects of the startup. Small changes of the discount factor lead to large changes of the valuation. Hence there is no uniform Methodology (yet) to determine the risk-premium, the output of the DCF method is not satisfying for many cases.

Conclusion

We have introduced three standard valuation approaches and explained the backgrounds for potential tensions and conflicts, when it comes to negotiations and the complex question of a company valuation. Early stage startups offer great chances, but bare various risks, which are hard to calculate.

Some Business Angels and early stage Venture Funds concentrate primarily on founder teams – as they believe there is no point in calculating any models. This approach is not as trivial as it sounds. Current studies have shown that it is hard to find reliable criteria for successful teams and that statistically investors will not do very well if they only trust on their expert knowledge and life-experience. From aprofessional perspective I would call this “gambling”, which certainly does not mean that it will definitely lead to a fiasco – sometimes gamblers win too, the odds are just not good enough for us. In a professional transaction process investors and startups will build up trust, take external research into account, calculate a couple of models for negotiations and eventually find a deal structure, which takes most of the considerable likely hoods into account.

One of the most complex valuation questions may be solved easily if you define clear terms along side your investment. In practice professionals will consider external advice and research to obtain a different and unbiased point of view. They will compare valuation concepts, weigh synergies and will consider premiums and discounts. Offers will come with a Term-Sheet, which will show a valuation and a corresponding deal-structure.

We consider deal-structuring as an art! Even with drifting valuation beliefs it is easily possible to close satisfying deals for both sides – if you find the right structure. Contact us to find out more!

Co-Author: Sasan Haji-Hashemi, Senior Analyst – Venionaire Capital