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HOW TO VALUE A START-UP

Wondering what a young company is worth and why? Apply the most accepted and sound ways to find out. (For already established companies, see HOW TO VALUE A GOING BUSINESS.)

First, at Their Core, All Valuations Are the Same

Whether explicitly or not, all valuation techniques — including those used to value Start-ups — try to boil down the stream of a company’s future free cash flows by adding them up to a single number. The cash flows come from company operations (draws, distributions, dividends — so-called “organic” returns) and liquidity events (M&A, IPOs, loans).

Even rules of thumb commonly used in some industries are, at the end of the day, guesses at future cash flows. Two examples: In the bottled water delivery business, $200/cooler. For medical practices, 1.5x gross annual revenue. (See the Business Reference Guide for hundreds of examples.)

In fact, if you find that a rule of thumb disagrees with a valuation based directly on future cash flows, go with the cash flow.

But Valuing a Start-Up Has a Special Twist

They don’t have positive cash flow. They don’t even have sales or operating expenses. So as a first step you’ve got to find a way to convert things that might generate sales into assumed sales. From there you estimate expenses. Then you fuss around a bit on how you’re going to exit the investment. Finally, you have annual cash flows that you can add together.

The next thing you’ve got to do is discount the cash flow for risk and for how long it takes for you to get the money. Upon discounting, the cash flow stream becomes the company’s present value or PV. You discount by subtracting a certain percentage from each successive year’s cash flow — the discount rate. When valuing a Start-up, the discount rate is quite high, maybe 50% per year. That’s because the failure rate is so high.

A Simple Plan

Here’s an example. You think Felicia’s brand-new software business may generate a cash flow of $50K in Year 1 and the right discount rate is 40%. The PV of Year 1’s cash flow is $50K x 60% = $30K.

Net present value (NPV) is how much you make after subtracting the costs you paid to buy the PV. On January 1 of Year 1 you bought 50% of Felicia’s business for $75K. Later you two split 50/50 that year’s cash flow of $50K. You got $25K in cash that therefore had a PV of $15K ($25K x 60%).

So far, you’re in the hole $60K. That’s -$75K+(60% x $25K). But wait, there’s more!

At the end of the following year, Year 2, you and Felicia sell the business to a competitor for 5x cash flow. During Year 2 the company had cranked out $200K in cash so you and Felicia split a sales price of $1M. The PV of $1M at end of Year 2 is $1M x 60% x 60% = $360K. You own half of that PV or $180K.

Add to that $180K the PV of $15K you got at end of Year 1. Your NPV is now $180K + $15K – $75K = $120K. Capiche?

Congratulations for hitting it out of the park. In two years your $75K investment appreciated 1.6x or 27% per year.           

The Three Devils in These Details

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

Set a Realistic Discount Rate

With Start-ups, the greatest contributor to the discount rate isn’t how much you’re sacrificing by not investing your money elsewhere or not having it handy. It’s the risk that the business runs off the rails and down a ravine. According to a recent HBS article Why Start-ups Fail, two-thirds of them never generate a positive return for their investors. And that’s after the Launch or Start-up company survived an investor selection process where only one out of about 100 get third-party funding.

Make an Accurate Guess at Multiples on Exit

That’s multiples of cash flow, EBITDA, sales, employee headcount, etc. that you’ll earn at exit and when you expect that to happen. For company owners, exits typically generate as much as 85% of the total value they’ll earn. The example above is average. (The exception is real estate where owners can get distributions of cash from bank loans to the company as their property appreciates.) Most VCs and PE groups think of exits in terms of 5 years or less.

You estimate what multiples might apply to your company by looking at the multiples of similar companies as set either by their publicly-traded shares or in M&A transactions. That’s called a comparables analysis. The practical difficulty of comparables analyses comes in getting the multiples data you need and in adjusting for the differences between the companies and your target.

Adjust Again for Specific Buyer or Seller Pairs

All the above is well and good for setting rough expectations. But when you come face-to-face with a certain buyer-seller pair, you want to know precisely what synergies might be in play — scale, IP, management talent, etc. In other words, what’s the deal’s rationale? All your comparables analyses only pump out average or median multiples.  

Deals only close when buyers and sellers agree that a target company becomes more valuable the moment that a buyer owns more of its equity. How much more valuable and who gets what share of that? Welcome to “the art of the deal” a place where investment bankers play.

Why Care About Value Before You Go to Market?

After all, why not let the market tell you? Well, buyers need to have a sense of what they can afford to buy and whether the price of a certain deal is worth paying. Conversely, sellers need to know whether they’re likely to see a compelling offer from anybody and then whether dealing with a specific buyer – which is a demanding, expensive exercise – is likely to be worthwhile. Without NPVs both of them risk wasting time and in the final analysis “leaving money on the table.”

Some Non-Financial Signals for Start-Ups

Valuation techniques match the industry and lifecycle stage of the company in question– Start-up, Growth, Maturity or Decline. As mentioned, to value a Start-up you must rely nearly exclusively on non-financial signals because there’s hardly any relevant financial data available.

Try valuing a company with no sales by how much it spent on a Foosball table. (For one thing, all Start-ups — winners and losers alike — seem to buy Foosball tables.)

Here are some examples of non-financial signals that can positively impact Start-up value:

  • Size of addressable market;
  • Degree of competition;
  • Degree of product substitution (thank you, Prof. Michael Porter);
  • Management team quality (very important and includes industry track record)
  • Regulatory constraints;
  • Litigation exposure;
  • Proxies for revenue (like “eyeballs”);
  • “Blocking” intellectual property (key patents, trade secrets, know-how);
  • Key milestones reached (further described below);
  • How clean the bathrooms are (no kidding);
  • And any other characteristics revealed by exercising commonsense.

For quick ways that an entrepreneur can create positive non-financial signals shortly before or even after entering the market, see our HOW TO INCREASE YOU COMPANY’S VALUE: A CURB APPEAL CHECKLIST.

On the Wings of Angels: Valuing the Launch

Given the Start-up’s perilous journey, how do investors quantify value in the absence of quantified data? 

Step 1: Go/No Go

The first investors on the scene typically rummage through items like the list above. Those items fall into the two broad signal categories associated with successful Start-ups:

  • Market research that demonstrates large-scale “blue ocean” demand for a high-margin prototype with weak or no competition, plus;
  • Team quality where quality consists of two things: First, a team comprised of individuals with complementary and relevant skill-sets (example, charismatic, driven CEO and experienced R&D specialist). Second, a proven track record with connections in the industry at hand.

For more detail on the traits associated with early-stage entrepreneurs who win, see our article, CHARACTERISTICS OF A SUCCESSFUL ENTREPRENEUR.

Angels drop companies that fail one or both of these two non-financial signal groups. Of course, friends and family may plow ahead out of loyalty regardless.

Step 2: Priceless Investing

Given the dearth of predictive signals for zero revenue companies, some angels don’t bother trying to value Launch or Start-up ventures. They kick that can down the road by investing in an instrument that prices the shares they buy based on the value that later investors say those shares have.

This instrument is called a SAFE or Simple Agreement for Future Equity.

The pricing investor that comes along later is typically a VC who has presumably benefitted from having more data about the company than the angel did. VCs generally have more early stage investing experience, even in specific industries, as well. Of course, if nobody ever invests a priced round in the company, the angel’s investment never values. C’est la vie.

Alternatively, an angel or early-stage VC might invest with a loan that later converts to equity when the investor believes it’s become more valuable than the note. You could even create a note that converts according to some subsequent SAFE equity pricing provision.

Step 3: Converting Milestones to Money

Investors who think the time is right to price the Start-up’s shares take the bull by the horns and quantify the value of specific stages or milestones that are, again, associated with winning Start-ups. One such approach is the Berkus Method which attaches a fixed dollar value to each successive milestone that management completes.

Step 4: Follow the Leader

More detailed and probably more accurate techniques have you finding companies similar to the one you want to value and that recently sold priced equity. Those companies either raised capital or sold shares in M&A transactions.

Knowing a company’s value, you then divide it by relevant metrics like employee headcount, monthly recurring revenue, number of clients, etc. — whatever you can meaningly divide into value.

Now say you find that the average value per employee for companies like yours is $500,000 and you have 10 employees. Your company’s worth $5 million!

But before breaking out the champagne you realize that the companies you’ve compared to have certain advantages that your company doesn’t, like established sales channels and a complete management team.

So you discount the $5 million by percentages associated with each missing stage or resource and reach a net value of $3 million. For descriptions of valuation techniques like these – e.g., the Scorecard Method, the Risk Factor Method and other types of Start-up comparables analyses – see a handy list at the Brex website.

These comparables-driven valuation techniques can be quite powerful but they have two Achilles’ heels:

  • Finding relevant multiples denominators — like the number of employees at the time of a comparable company’s priced transaction — is hard and expensive. Worse, what limited data you’ll find will be scattered across multiple proprietary databases.
  • For companies in the earliest stages, beware cases where the blind lead the blind until all the lemmings go over the cliff together.

In Sum

Valuing companies without any or only a little revenue is obviously for those who tolerate high risk. You can slice uncertainty into ever-tinier pieces but at some point it becomes doubtful that calculus is your answer.

Yet just as obviously, some angels and early-stage VC’s have made hundreds of millions from embryonic companies. Some fewer of them have even done so repeatedly.

They have the ability to recognize — and luck to encounter in their deal stream — outstanding management teams with an idea that matches an exquisitely-timed market opportunity.

© 2023 Kuhn Capital, Inc. All Rights Reserved

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Ryan Kuhn

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07/08/23

“Ryan Kuhn is the founder of Kuhn Capital (bio). This article is not the product of AI. AI is a product of this article.