VALUING START-UPS: ART OR SCIENCE?

Valuing start-up companies can be tricky. PATRICK DEBATTISTA shares some ways on how best to value start-ups.

As at 2016, there were around 300 million persons worldwide trying to start 150 million businesses in the countries covered by think-tank Global Entrepreneurship Monito 1 . Assuming one-third of these operations were formally launched (a conservative assumption), this translates to 137,000 new businesses per day.

Unfortunately, much of what we learn in finance and economics is based on the premise that companies are mature and stable. This means that the realities of at least 150 million businesses worldwide (per annum!) are being largely ignored by our textbooks.

In this article, we will try and bridge this gap by understanding how start-ups differ from other businesses in terms of their valuation.

The concept behind a start-up

Most start-ups share a set of common characteristics: they are innovative, they are formed on a (usually) ground-breaking idea, and there is no prior track record precisely because they are brand new. All of this makes their valuation more challenging than traditional, more mature companies.

One of the first concepts that a start-up valuer must understand is that the company’s key assets are likely to be intangible. Back in 1994, Jeff Bezos (pictured) started Amazon in his own small garage with nothing but a computer, a desk and some million-dollar ideas (i.e. intangible assets). The company is now worth almost $800 billion and, as a result, Bezos is the world’s richest man.

1 This is according to Dr Paul Reynolds, Director of the GlobalEntrepreneurship Centre’s Research Institute.

2 Zoox is currently valued at $3.2 billion in some quarters.Source: Bloomberg.

These intangible assets could be disruptive ideas, perhaps supported by a technological platform. Equally, they could be their entrepreneur’s creativity, their capacity to endure the difficulties of initiating a business, and the continual development of ideas. Several now-mature businesses once shared all these characteristics back in their start-up days. Google, Facebook, Apple and Microsoft are the most obvious examples of this.

The valuation of start-up ventures usually varies with competition for capital and the business cycle. For instance, some sectors have more capital chasing deals than others, while investors are less inclined to provide equity if the economy is in recession or if a slowdown is on the horizon. An abundance of capital would drive valuations upwards, while a recession or potential slowdown would lower them.

Valuation multiples (market or firmspecific multiples)

One method to value start-up companies involves applying a multiple to one of the firm’s operating metrics, e.g. sales, earnings or cash flows. This multiple could be based on what publicly-listed comparable firms are trading at in the stock market. However, the difficulty here lies when there are no listed comparables to our start-up operation. For example, how would one have valued Facebook back when it decided to go public? How would one value Zoox, a self-driving taxi company 2 ?

Another approach used is to capture a firm’s specific “story”: the more credible and attractive its story, the higher the multiple that investors would be willing to pay for it. Some typical questions that are asked by venture capital investors when evaluating start-up companies to finance include:

1. Is the product/service catering for a unique need in the market?

2. Is the opportunity disruptive enough to attract future investments from other early stage investors?

3. What is the potential competition in the market? Is there a “Blue Ocean” opportunity (i.e. limited to zero competition)?

4. Does the company have a specific competitive advantage? Is there a special technology, an accepted patent, a team of experts or a network of contacts?

5. Is the business model driven by higher margins or mass volumes?

6. Is the revenue composition more onetime or recurring in nature?

7. Does the team have a deep understanding for metrics driving company valuation, such as Average Revenue Per User (ARPU), Contribution Margin, Retention rate, and so on?

As you might understand, the final multiple obtained is often based on negotiations rather than any particular, “scientific” approach.

Discounted Cash Flow (DCF) technique

For most start-ups – especially those that have yet to start generating cash flows – the bulk of value rests on future potential. The DCF approach involves forecasting how much “free cash flow” the company will produce in the future (the “return” measure) and, using an expected cost of capital (the “risk” measure), calculating how much those future free cash flows are worth today. A higher cost of capital is typically applied to start-ups (thereby lowering their valuation), as there is an added risk that they would fail to generate sustainable cash flows. →

Jeff Bezos — founder, chairman, CEO, and president of Amazon.

The trouble with DCF is that the quality of the valuation obtained depends on the analyst's ability to forecast future market conditions and generate accurate assumptions about long-term growth rates. For many start-ups, projecting sales and earnings beyond even one or two years becomes especially challenging. Moreover, the value that DCF models generate is often highly sensitive to the expected rate of return and growth rates used for discounting cash flows. Therefore, DCF should ideally be used in conjunction with another method.

START-UP COMPANIES ARE LIKE FINE ART: THEIR VALUATION CAN VARY SUBSTANTIALLY FROM PERSON TO PERSON

One potential approach to applying a DCF valuation would be as follows:

1. Estimating the total market value for the start-up’s product or services and its expected growth.

2. Projecting market share acquisition over a timeline.

3. Forecasting cash flows by identifying the start-up’s potential free cash flow generation.

4. Determining: (a) an exit value if the founders envisage exiting their position after a number of years; or (b) a terminal value based on reasonable assumptions on cash flow growth to perpetuity.

5. Discounting all these cash flows at today’s cost of capital, bearing in mind the elevated risk borne by start-ups, and preferably considering comparative analysis with mature firms within the same sector.

There are several other valuation methods for start-ups which seem to be gaining traction by industry practitioners. However, these methods are often variations of the multiples and DCF techniques.

Conclusion

Start-up companies are like fine art: their valuation can vary substantially from person to person. This poses significant challenges for the independent valuer. However, the use of a combination of methodologies instead of a single one, as well as applying a valuation “range” as opposed to one fixed value, can help mitigate some of the risks inherent in valuation. M

Patrick has worked in the financial sector for 10 years. His job as private equity associate includes evaluating new investment opportunities and optimising portfolio performance. Patrick holds a CPA warrant and is a CFA charterholder.