How to Value a Business: Methods for Startups and Established Companies

By Ryan Kuhn, founder of Kuhn Capital, an M&A advisor to mid-market technology companies.

This article explains the various tools investors use to estimate your company’s value. To understand why one type of investor may offer more than another, or propose a different purchase structure, read this site’s article, Your Best Acquirer. It describes which buyer type may best fit you and your company.

Introduction

Investors (VCs, PEs, family offices, strategics, etc.) estimate a company’s value beyond the sum of its parts by projecting future cash flows—when they will arrive, from what sources, and in what quantities. They can do that with some precision for established companies. But for very young ones with little or no revenue, they must make educated guesses. Put another way, investors use valuation techniques that match the maturity of their target.

Valuing the Startup

The value of “launches” (the earliest stage of startups, also called “zero-stage” businesses) lies in three broad categories: an idea, secondary research, and the founding team.

Technique #1: Go/No-Go

• So, the first investors on the scene look for:
  A unique product or service idea with low production costs.
• Secondary research supporting a large “blue ocean” market, with weak or no competition.
• Strong management quality: That’s 1) a team comprised of individuals with complementary and relevant skill sets (for example, a charismatic, driven CEO and an experienced R&D specialist); 2) a track record with connections in the industry at hand.

Most angels pass on companies that don’t show these non-financial signals. Of course, friends and family may proceed regardless.

Technique #2: Forget About Value for Now

Assume a startup survives the Go/No-Go exam, but its value remains unclear. In that case, angels may simply kick the can down the road and pass it on to the next round of investors. They’ll presumably have more actual market performance data to weigh.

Angels do so with an instrument called the SAFE or Simple Agreement for Future Equity. It prices equity at whatever later investors are willing to pay. Of course, if there is never a next priced round, the angel’s SAFE investment never realizes an arm’s-length valuation unless the company or its assets are sold.

Technique #3: Convert Achievements and Circumstances into Dollars

Investors who believe the time is right to price the startup might do so by quantifying the value of specific stages, milestones, and other factors associated with the activities and circumstances of winning startups.

One such approach is the Berkus Method, which assigns a fixed dollar value to each of five risk-reducing milestones. Example: the company has a working prototype that customers like. Berkus values that at up to $500K. Add the values of all milestones achieved so far to estimate the company’s worth, up to a $2 million ceiling before revenue.

A more nuanced approach focuses less on what the company has done and more on its circumstances. Say you know how early-stage companies in a given industry score across factors such as team strength (0% – 30%) and competitive environment (0% – 20%), with zero competition being 20%. At the same time, you also know the price of those other companies’ first-round shares.

After adding up the percentages of all your startup’s factors, you get 140%. So, your startup’s first-round value is 1.4 times the average first-round valuation for companies in its industry.

Other examples of this approach include the “Scorecard Method” and the “Risk Factor Method.” For a detailed walk-through of the Scorecard approach by the investor who developed it, see the Angel Capital Association. Some common examples of the non-financial signals they use:

• Size of addressable market;
• Degree of competition
• Vulnerability to product substitution (thank you, HBS Prof. Michael Porter)
• Again, management team quality (See more details on the traits and circumstances of the successful founder at 12 Characteristics of Successful Entrepreneurs).
• Regulatory constraints
• Litigation exposure
• Substitutes for revenue (like “eyeballs” or even measures of prospects’ intention to buy)
• So-called “blocking” IP (like key patents that are hard to circumvent)
• Expected expenses based on comparables analysis
• Milestones reached (further described below)
• And any other characteristics evident from common sense.

Valuing the Established Business

Technique #1: Thumbs-Up

Rules of thumb use a fixed multiple of a financial or operating metric. Two examples: 1) In the heating and air conditioning business, 0.5x revenue, or 2) for medical practices, 1.5x revenue. (See Business Reference Guide for hundreds more examples.)

Among rule-of-thumb methods, the most popular metric that’s multiplied is EBITDA, as in “5x EBITDA.” (This despite the fact that EBITDA, earnings before interest, taxes, depreciation, and amortization, overstates cash and “cash is king.”)

You rarely know what evidence supports a rule’s particular multiple. And even when the evidence is sound, a single multiple can’t explain the sometimes large differences between two companies serving the same market with the same product, like sales growth rate.

Technique #2: Net Present Value

Two more accurate but complex approaches are used when complete financial data is available, and they’re typically used in tandem. The first is the present value method. It requires you to estimate the amount of cash the target will generate over the years you own equity in it. The cash comes from company operations (so-called “organic” returns) and from “liquidity events” (such as M&A, IPOs, loans, etc.).

After you estimate the after-tax cash generated each year, the present value approach asks you to reduce those payments (or “discount” them) to account for risk and time. Then you add these annual discounted payments to arrive at a single number: present value.

Last, when you subtract what you invested from the present value, what’s left is the net present value (or NPV). A positive net present value indicates that what you’re putting into the business may generate a positive return on investment (ROI).

A Simple NPV Calculation

For a concrete example of how to calculate NPV, see below. (In it, we’ll use “K” to indicate thousands of dollars):

• At the beginning of 2021, you decide to buy half of Felicia’s fledgling GPS software company, “Softwhere,” for $75K. You valued Softwhere at $150K by applying a 50% discount rate to a few years of estimated future cash flows. A 50% annual discount rate is brutal, but it actually understates the risk of failure for early-stage companies. By the end of 2021, Softwhere generated $50K, and you two split the cash 50/50. So, you got back $25K in cash with a PV of $12.5K ($25K x 50%).
• At the end of 2022, Softwhere pumped out more cash, this time $150K. Your slice was $75K. Even though that was three times what you received in 2021, the risk that you could have received nothing reduced the present value of your $75K to $18.75K ($75K x 50% x 50%).
• In 2023, you and Felicia got an offer you couldn’t refuse. You sold the company to a competitor for 5x 2022 cash flow. That’s $750K. Your 50% share, $375K, has a PV of $46.9K ($375K x 50% x 50% x 50%).
• So, what’s your NPV? Three years of discounted cash flows generated a PV of $78.2K. (That’s $12.5K in Year 1 + $18.8K in Year 2 + $46.9K in Year 3.) After subtracting your $75K investment, you squeaked into positive NPV territory: $3.2K.

Your investment barely paid off. But if you hadn’t used PV, you would have been mightily impressed by your $400K net return ($475K minus your $75K investment). Still, don’t forget the risks and the time you’ve invested in earning that $400K. They were substantial. And your return doesn’t include taxes.

While the math above is simple, it’s tedious. Reduce it by using a handheld or online calculator.

The Three Devils in NPV Calculations

Notice how the example above requires that you press carefully on three sensitive levers to make a value estimate:

1. The level of risk
2. How much you get back
3. When.

So, First Thing, Set a Realistic Discount (or Risk) Rate

With startups, the biggest contributor to the discount rate isn’t how much you’re sacrificing by not investing your money elsewhere or by not having it handy. It’s the strong chance that the business will run off the rails.

According to research by Harvard Business School professor Shikhar Ghosh, about 75% of venture-backed startups fail to return cash to investors. Startups without VC backing have even higher failure rates.

Then the Most Difficult NPV Step: Estimating Exit Multiple and Timing

What should you use as a multiplier when trying to figure out what your business might sell for five years out (something called “terminal value”)? Any number of things — cash flow, EBITDA, sales, employee headcount, etc. You find multipliers from the financials and M&A transactions of comparable companies.

Technique #3: Comparables Analysis

The second of the two most widely used techniques, “comparables analysis,” involves compiling data from companies you believe share commonalities with the business you’re valuing. Ideally, you find their cash flow multiples, either from M&A transactions or from the prices the public pays for their shares. You want cash flow multiples because you’re trying to predict cash returns.

After you identify a set of comparable companies, you then adjust your estimate by noting how they may differ from the company you’re valuing. Examples: working capital, growth, extraordinary expenditures, etc. Today, AI plays an increasingly significant role in these complex calculations.

All this work estimating timing and exit multiples from a comparables analysis is worth the effort because the multiple you earn by exiting often accounts for as much as 85% of your total present value. One reason is that the intervening years generate comparatively little cash, and discounting rapidly erodes even those amounts. (In the NPV example above, note that Softwhere’s terminal value accounted for 60% of the total NPV return.) Regarding timing, most VCs and PE investors aim to exit within 5-6 years.

Bringing It All Together

M&A advisors typically compare the results of both techniques—net present value and comparables analysis—to estimate a value range. Ideally, the two sets of numbers agree.

Adjust Again for Specific Buyers and Bidding Competition

All the above is well and good for setting general expectations, general in the sense that you may not have a clear idea of who the likely buyers are.

But as you go to market and meet a specific buyer, you’ll also want to know more precisely what strategic synergies may be in play. Examples: economies of scale, IP valuable to the buyer, and effective management. In other words, why is that specific buyer interested in purchasing your company? Last, as the seller entertains letters of intent, its alert M&A advisor will further adjust valuation expectations by assessing competition among bidders.

Caveat Venditor

Buyers only buy when they think the target company is more valuable than the price they’re paying. The question is: how much more valuable is it, and does the buyer receive all that value? Welcome to “the art of the deal,” a place where sell-side M&A advisors live.

Should Sellers Estimate Value Before Going to Market?

Of course. Without a firm understanding of value, both buyers and sellers risk wasting time on dead-end negotiations and leaving money on the table. For the specific measures that technology company acquirers consider when estimating value, see this site’s article, Metrics That Sell a Digital Tech Company.