How do we value startups

With the heightened activity in the startup scene these days, the common question of how to value a startup comes into the forefront again. Valuation of businesses have always been both a science and an art. Valuing startups poses more of a challenge as unlike conventional businesses, they do not have much of a track record to serve as a guide. Also, their business models may still be subject to change, introducing further variability to forecasts and assumptions.

Conventional approach

When it comes to valuing businesses, conventional methods like the market approach and income approach often come to mind. In coming up with the value of a company, the market approach involves analysing how companies with similar businesses are valued in the market. On the other hand, the income approach looks at the intrinsic value of the business itself instead of how the market values similar businesses. The use of Price-Earnings (P/E) multiples is popular within the market approach while discounted cash flow (DCF) analysis is commonly used within the income approach.

When it comes to valuing startups, it is important to understand the limits of applying these valuation methods and to make relevant adjustments adapting them to startups.

As an example, let’s look at the use of P/E multiples. The P/E multiple is calculated by taking the price of a share divided by earnings per share. It involves looking at similar businesses comparable to the startup that are listed on the stock exchange and the P/E multiple they are trading at. We then multiply this P/E multiple to the earnings of the startup to arrive at the value of the startup. For example, if the comparables trade at a P/E multiple of 12 times and the startup’s earnings is $10m, the value of the startup would be $120m.

We have to be aware that companies listed in the stock exchange used as comparables may be at a different stage in its life cycle. Very often such companies are at a later stage or a more stable growth stage compared to that of the startup. In such instances, we should exercise judgement in the selection process and make relevant adjustments when using the comparables.

Most startups especially early stage ones are yet to be profitable and may not have a positive earnings number to be used in the P/E multiple. In such cases, we can use forecast earnings and have it discounted back to reflect the value today. Naturally, we need to forecast how far in the future the startup becomes profitable and the appropriate projected earnings to be used in the multiple. Alternatively, instead of the P/E multiple, we can look at non-earnings based multiples like Price/Sales, Price/Active User, etc. . 

If instead of the P/E multiple, we decide to use the DCF method, we would look at the future cash flows of the company and discount them back to the present at a discount rate to arrive at the value. For startups, we usually don’t have the luxury of having past performance to guide us in predicting future performance. We will need to rely on some key assumptions when coming up with projections of future cash flows. Also, the discount rate which is a key input in the DCF method, will be very different from that used for conventional businesses. Investors in startups usually require a much higher rate of return given the higher risk involved and this should be reflected in a much higher discount rate. 

Modified approach

Because of the various challenges posed by the more common valuation approaches, investors often use a modified approach when valuing startups. This is especially the case with financial investors like venture capital firms (VC) that invest purely for financial returns. Their approach to valuation involves taking into account the future value at exit of investment, the current investment price and the required rate of return. It is the future value at exit that is the focus rather than the current value of the startup. 

One simple way of describing this approach is as follows:

·      Forecast the value of the startup at the potential exit of investment, for example in 6 to 8 years’ time. One way to do this is by using the market approach involving for example, the P/E multiple. Start with forecasting the revenue of the startup at the exit year. Analyse the value drivers and metrics behind that forecast revenue for example, number of users, customer lifetime value and user engagement. We should ask - given the current performance of the startup and its growth plans – do these metrics look achievable? Is the market big enough to accommodate this assuming the business expands successfully. Look at the current growth rate of the business and assess whether the growth needed to achieve the forecast revenue is plausible.

·      Then, by studying the startup’s current performance and future projections, assume an appropriate profit margin and multiply that against the revenue to arrive at the earnings number at exit of investment.

·      We can then use multiples from comparable companies to derive the future value of the startup. Keep in mind that as mentioned earlier, the use of multiples involves judgement calls on how similar the comparables are to the startup, the appropriate projected earnings to use, etc. 

·      We would now have worked out the future value at exit. Next, we look at the investment price and compare that to the exit value. Does the exit value exceed the investment price by multiple times? The investors will assess whether this is sufficiently attractive given the number of years they assume it takes to exit the investment. For investments in startups, VCs aim to make multiple times the money put in. As an example, some VCs may consider an exit value of 10 times the investment price after a period of 7 years to be attractive.

If the forecast return is too low, then the investor should renegotiate for a lower entry price, re-look at its forecast assumptions or walk away from the deal. 

From the above, we get an idea of the modified approach that financial investors and VCs use to value startups. Rather than focusing on pinpointing a value of the startup, we are forecasting a future value at exit. We then assess whether this is reasonable and see if the investment returns are attractive enough given the current investment price. If it is attractive, this investment price would be what the investor values the startup at for purposes of investing.