A start-up is a company or a venture in the early stages of operation. The young company focuses on a particular product or service to establish itself. Since most startups begin with high costs and low earnings, founders seek capital from different sources, such as family, friends, loans, venture capitalists, and crowdfunding.
The 3 Stages of a Tech Start-up
Pre-seed. This conceptual stage of starting a business entails the initial effort to raise funds. Founders may raise funds from within their circle of family and friends or, in some cases, angel investors.
Seed. The founders invest the funds received at this stage into market research and product development. Potential investors at this stage include founders, family, friends, incubators, venture capitalists, etc. The business can identify the user base after completing the product development phase.
Series. The series stage of a start-up business has three sub-stages:
- Series A. The founders initiate this stage, usually within 18 to 24 months of business launch, only after identifying the user base and see consistency in revenue. During the Series A stage, “the company must complete a complex transition: from a company with a great offering that could scale to a company with a great offering that is rapidly and predictably scaling.“ Investors, usually traditional venture capitalists, look for great ideas and effective strategies in this stage.
- Series B. In this stage, the startup focuses on expanding its market reach. This stage is all about taking the business to the next level, with investment funding often depending on the company has “shown some strong achievements after its Series A round.” Venture capital companies invest at this stage to achieve more significant profits.
- Series C. At this later-stage investment level, investment funding “generally occurs to make the startup appealing for acquisition or to support a public offering.” The mature business introduces new products, establishes itself fully, and is more likely to acquire new business.
Throughout these stages, a startup business needs funds from investors. To attract investors, it needs a business valuation. The business valuation process involves determining the company’s worth and the future benefits to potential investors.
Valuation is essential for both the potential investors and the startup founders because investors provide funds in exchange for partial equity in the company. Therefore, founders need to determine the correct percentage of equity they should offer.
If the startup is valued at a lower rate and later earns higher returns, it gives the investors a more significant portion of the equity. However, if the company is valued at a higher rate and makes lower returns, the investors incur losses. For startup companies, business valuation can change the game by reducing the investors’ risk.
However, the business valuation of a startup involves many limitations.
Constraints in the Valuation of Startups
A new company lacks historical information or has only limited information about the factors responsible for valuation. This information includes:
Traction. Traction determines how much present and prospective customers like the product and whether the business will develop and survive in the market for the long term.
Reputation. Investors take an interest in companies that have founders with good reputations in the market. Founders must maintain their reputation.
Prototype. Without a visual model of an idea, no one believes in it. Founders need a prototype to enhance their chances of getting funds from potential investors.
Pre-valuation revenues. The company’s revenue just after the product hits the market is essential in attracting investors who seek future benefits, especially if that revenue is sustained or shows an increase.
Industry. Industry type also impacts funding for startups. If the company enters a rapidly growing sector, investors are more likely to provide funds.
The valuation of start-ups depends on estimates regarding these factors, which are challenging to compute. Also, most start-ups have no significant investments in fixed assets and derive most of their value from intangible assets. Therefore, analysts use negative earnings and intangible assets to develop new ways to justify investing in start-ups.
Methods Used to Value Startups
Book Value Method
The book value method depends on the values of tangible assets that the start-up owns to calculate its business value. After depreciation, the book value is calculated as the total cost of tangible assets in the balance sheet minus total liabilities and intangible assets.
However, start-ups tend to build intangible assets (e.g., product ideas, research, development, copyrights, patents) rather than tangible assets like real estate and equipment. Because of this lack of substantial assets, the book value method is seldom used to valuation start-ups.
This valuation method calculates the cost to build an identical company from scratch, assuming an investor will not pay more than it would cost to start a new, similar company. The method determines the fair market value of physical assets.
For example, the cost to duplicate a software business may be calculated as the total cost of the programming time spent designing its software. In a high-tech start-up, the cost to duplicate could factor all the costs involved in research, prototype development, purchase and protection of patents, etc.
The cost-to-duplicate method is relatively objective and based on verifiable, historic expense records, and it is often viewed as a starting point for valuing startups.
However, the problem with this method is that it does not consider the company’s future sales, profits, and return on investment. Nor does it consider its intangible assets, like brand value, that the business might possess even at an early stage of development.
Physical assets may only form a small component of the company’s physical net worth, whereas relationships and intellectual capital might be the basis of the business. The cost-to-duplicate method bases business valuation entirely on the costs incurred and not on the future benefits (which interest investors), making it incomplete.
Discounted Cash Flow Method
The value for most start-ups, especially ones that have not yet started earning, lies mainly in their future potential. The discounted cash flow method (DCF) focuses on projecting the future cash flow movements of the start-up, representing a vital valuation approach.
It forecasts how much future cash flow the business will produce and uses an expected rate of investment return to calculate the worth of that cash flow. Typically, a higher discount rate is applied to cover the high risk associated with start-ups. Primarily, the increased risk relates to the high probability of the start-up failing to generate sustainable and increasing cash flows.
This method depends on the analyst’s ability to forecast long-term growth rates and future market conditions accurately. Projecting sales and earnings beyond a few years get tricky. Also, the value generated from that DCF method is susceptible to the expected rate of return used for discounting cash flows. So, use the DCF method with utmost care.
Projection risk is often associated with start-ups or when a company forecasts unprecedented growth compared to historical performance while also forecasting higher profitability (EBITDA margins). A relatively new business exhibiting rapid growth fits somewhere in between. Consider the high degree of projection risk strongly in the development of the discount rate.
The guidelines (referenced above) list different ranges of rates of return based on the stage of development.
Startup valuation does not involve a single approach. It requires the expertise and experience of best-in-business analysts and advisors to combine different methods to calculate an accurate valuation.