Valuation of start-ups is not a cakewalk, especially for those at the very early stage of business. In case of public companies, the easy availability of financial information like earnings, sales, year on year growth, share prices et cetera make valuation relatively much easier. A simple calculation of price to earnings, can show how highly or poorly is the company is perceived. That is in the market with respect to its earnings. On the contrary, the lack of financial information makes valuation of private sector firms extremely difficult and uncertain. And, especially for the ones with innovative ideas that not many ventures work towards.
So, what’s the need to ascertain the value of the start-up in the first place? Valuation is important to different parties for different reasons. For a founder, its vital to have an idea of where the company stands at present. Before fundraising rounds, valuation is needed to give a clear picture to the investors. Although VCs would be valuing the company from their end. But, it’s the basic information that will be sought by the investors. From an investor’s perspective, an accurate valuation helps them understand their potential stake in the company. And, compare it with other deals they have received and so on. Some of the VCs even mention the value range that they will be willing to invest in. Instead of the stage of the company or the fundraising round.
Valuation Basics – Approach
Having considered the difficulty but also the need for valuation, let’s see what methods can be applied here. In general, three approaches are used for valuation. Cost approach, Market approach and Discounted Cash Flow(DCF) approach. Cost approach is easy, wherein all costs including capital invested to bring the start-up up until that stage is calculated. This is essential to get an idea of cost to set up similar business from scratch. The derived cost that may include all software, licenses, other physical assets represents firm’s value. The main idea is that an investor would not invest higher than the cost to replicate that business. Coming to the market multiples approach, one of the ways is to use price to earnings. In case of publicly listed companies, price represents market capitalization. Whereas for private firms approach is by finding comparable start-ups that recently exited from the market by way of sell-off.
The price at which the company is sold is used instead of market capitalization as ‘price’. And the derived multiple gives an idea of how much investors are willing to pay for such companies. For example: 4 times the earnings or 8, or anything else. However, the challenge is to find companies that are so closely related or similar to each other. As mentioned above, it’s even more difficult to find such similar companies in case of highly innovative early-stage ventures. Thus, the general idea is to find the selling price to earnings multiple of the relatively similar exiting venture. And to adjust the derived multiple depending gauging carefully on the difference between the two companies. The final valuation would be based on the adjusted multiple for the start-up under valuation.
Discounted Cash Flow Method
The most complicated method of valuation is perhaps the Discounted Cash Flow method. The basics of DCF method is to compute the potential cash flows. The business will generate over the years and convert it to the present value using the discounting rate. The current valuation would thus be simply based on the potential of start-up to generate future inflows. The catch is to forecast the future cash flows accurately in order to come to the most appropriate valuation. The significant cash flows assigned as the terminal cash flows are especially the trickiest ones. As there is no way to figure out the terminal cash flows the business may generate in future. Thus, in case of start up valuation this method would ideally take a backseat to market multiple and cost approach.
Meta, Facebook & WhatsApp
Valuation of start-ups is very complex thing. Even if as a founder one hires an agent to do it , for instance there are companies like Pitchbook who helps in valuations, it does not mean that it’s the perfect valuation or around what investors would be willing to buy it for in case of exit. For instance, the conventional market multiples used for valuation is price to earnings, price to sales, and price to book ratios. However, when WhatsApp was purchased by ‘Facebook’ now ‘Meta’, the conventional multiples nowhere give the measure of whopping US$19 billion which Meta purchased it for. In case of most of the social networking companies, a comparatively modern metrics called per user acquisition multiple is used for valuation. When the agreed price is divided by the number of users of the application, the per user cost is derived.
The substantial user base of WhatsApp is considered to be one of the major reasons behind the extremely expensive acquisition. This created a stir in the market back in 2014. In light of everything, the main idea is to find and absorb as much market information as possible while valuing your start-up. Also, the use of more than one approach can be attempted to compare the results. Valuation is not a one-way fixed thing and the estimate differs even for public companies between one analyst or company to the other. Prudence and a healthy skepticism should be cautiously exercised while valuing start-ups.