4 Ways to Value a Startup –Investopedia

Investopedia weighs in on the pros and cons of varying approaches:

Business valuation is never straightforward – for any company. For startups with little or no revenue or profits and less-than-certain futures, the job of assigning a valuation is particularly tricky. For mature, publicly listed businesses with steady revenues and earnings, normally it’s a matter of valuing them as a multiple of their earnings before interest, taxes, depreciation and amortization (EBITDA), or based on other industry specific multiples. But it’s a lot harder to value a new venture that’s not publicly-listed and may be years away from sales. 

 

TUTORIAL: Valuing Employee Stock Options

If you are trying to raise capital for your start-up company, or you’re thinking of putting money into one, it’s important to determine the company’s worth.

Cost-to-Duplicate 
As the name implies, this approach involves calculating how much it would cost to build another company just like it from scratch. The idea is that a smart investor wouldn’t pay more than it would cost to duplicate. This approach will often look at the physical assets to determine their fair market value. 

 

The cost-to-duplicate a software business, for instance, might be figured as the total cost of programming time that is gone into designing its software. For a high-technology start-up, it could be the costs to date of research and development, patent protection, prototype development. The cost-to-duplicate approach is often seen as a starting point for valuing startups, since it is fairly objective. After all, it is based on verifiable, historic expense records. 

 

The big problem with this approach – and company founders will certainly agree here – is that it doesn’t reflect the company’s future potential for generating sales, profits and return on investment. What’s more, the cost-to-duplicate approach doesn’t capture intangible assets, like brand value, that the venture might possess even at an early stage of development. Because it generally underestimates the venture’s worth, it’s often used as a “lowball” estimate of company value. The company’s physical infrastructure and equipment may only be a small component of the actual net worth when relationships and intellectual capital form the basis of the firm.

 

Market Multiple
Venture capital investors like this approach, as it gives them a pretty good indication of what the market is willing pay for a company. Basically, the market multiple approach values the company against recent acquisitions of similar companies in the market. 

Let’s say mobile application software firms are selling for five-times sales. Knowing what real investors are willing to pay for mobile software, you could use a five-times multiple as the basis for valuing your mobile apps venture, while adjusting the multiple up or down to factor for different characteristics. If your mobile software company, say, were at an earlier stage of development than other comparable businesses, it would probably fetch a lower multiple than five, given that investors are taking on more risk. 

 

In order to value a firm at the infancy stages, extensive forecasts must be determined to assess what the sales or earnings of the business will be once it is in the mature stages of operation. Providers of capital will often provide funds to businesses when they believe in the product and business model of the firm, even before it is generating earnings. While many established corporations are valued based on earnings, the value of startups often has to be determined based on revenue multiples. 

 

The market multiple approach, arguably, delivers value estimates that come closes to what investors are willing to pay. Unfortunately, there is a there is hitch: comparable market transactions can be very hard to find. It’s not always easy to find companies that are close comparisons, especially in the star-up market. Deal terms are often kept under wraps by early stage, unlisted companies – the ones that probably represent the closest comparisons. (The trouble is that while relative valuation is quick and easy to use, it can be a trap for investors. To learn more, read Relative Valuation Of Stocks Can Be A Trap.)

 

Discounted Cash Flow (DCF)
For most startups – especially those that have yet to start generating earnings – the bulk of the value rests on future potential. Discounted cash flow analysis then represents an important valuation approach. DCF involves forecasting how much cash flow the company will produce in the future, and then, using an expected rate of investment return, calculating how much that cash flow is worth. A higher discount rate is typically applied to startups, as there is a high risk that the company will inevitably fail to generate sustainable cash flows. 

The trouble with DCF is the quality of the DCF depends on the analyst’s ability to forecast future market conditions and make good assumptions about long term growth rates. In many cases, projecting sales and earnings beyond a few years becomes a guessing game. Moreover, the value that DCF models generate is highly sensitive to the expected rate of return used for discounting cash flows. So, DCF needs to be used with much care. (The DCF method can be difficult to apply to real-life valuations. Find out where it comes up short. Check out Top 3 Pitfalls Of Discounted Cash Flow Analysis.)

Valuation by Stage
Finally, there is the development stage valuation approach, often used by angel investors and venture capital firms to quickly come up with a rough-and-ready range of company value. Such “rule of thumb” values are typically set by the investors, depending on the venture’s stage of commercial development. The further the company has progressed along the development pathway, the lower the company’s risk and the higher its value. A valuation-by-stage model might look something like this:

Estimated Company ValueÂ	Stage of Development
$250,000 – $500,000	Has an exciting business idea or business planÂ
$500,000 – $1 million	Has a strong management team in place to execute on the plan
$1 million – $2 million	Has a final product or technology prototype
$2 million – $5 million	Has strategic alliances or partners, or signs of a customer base
$5 million and up	Has clear signs of revenue growth and obvious pathway to profitability