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Over 650,000 start-ups are formed in the UK every year. This is often one of the most exciting times for a company, where the potential for growth and opportunities has no bounds.
However, with so many rapidly moving parts and unknowns, how would you go about calculating the value of a start-up company?
To answer this question, it’s first important to understand why start-ups might require a valuation.
There are several reasons why start-ups need a valuation, the most important would be to secure funding to grow. Given that start-ups are unlikely to be generating cash or have substantial assets in the early stages, a debt provider is unlikely to loan the funds needed for growth as there are no trade or assets on which debt can be secured. Therefore, often the only option available for start-ups to obtain funding is through sources such as angel investors and venture capital funds.
These sources will give the funds required in exchange for equity. Thus, a valuation is required to know much equity they will be given in exchange for the cash invested.
The starting point of a typical valuation would be to review the company’s historical track record on its revenue, profits and performance and use this information to forecast its future growth and form the basis of a valuation.
But what if a company doesn’t have this information? As mentioned previously, it is typical for start-ups to not be generating any revenue but have the potential to achieve high future growth. This is a common dilemma that we are often asked, ‘how do I value my start-up with limited or no historical financial data?’. In this article, we will break down the usual methodologies that are used to help value a start-up. The methodologies have broadly been split into two different approaches: pre-revenue, and traditional.
It’s important to note that even with the best approach and methodology, the valuation of a start-up will still be a broad estimate. However, when done correctly, the valuation should reflect the growth potential and support fundraising opportunities that a business owner may wish to pursue.
Startup valuation methods
Pre-revenue approaches are usually reserved for very early-stage startups, when a company has yet to generate revenue. At this stage, all investors will really be looking for is a proof of concept, that the business idea is viable, and there is traction in what a company is trying to accomplish. As there is no financial information to go on, instead, the company will be broken down into various key components and a value will be placed on each component. The total valuation will then be all the component’s values added together. The most common methods used for pre-revenue stage companies are set out below.
The Berkus approach, named after venture capitalist and angel investor Dave Berkus, looks at five key qualitative factors for a start-up:
- Idea - starting with the basic value, which would be simply how much is the business worth in its raw state.
- Prototype – assessment of the technology that is used by the company.
- Management team – the experience and qualifications of key personnel.
- Strategic relationships – how the company will adapt to market risks.
- Production and consequent sales - whether the company has any traction to date.
The Berkus approach suggests that a maximum of £500,000 is allocated to each of the 5 components, the sum of all these components will give the final valuation. Therefore, under this method, the maximum value will be £2.5m.
The Scorecard approach is a technique that is commonly used by angel investors. The idea of the scorecard method is to first identify an average valuation for a generic angel-funded start-up (the “Benchmark Valuation”). This information can be found on various public databases and typically would range between £100k to £2m for seed and early-stage companies, depending on their industry sector and location. Once a suitable Benchmark Valuation is identified, a multiplier will be applied based on specific factors of your own company.
The factors are shown in the table, and we have allocated start-up values simply to demonstrate how the multiplier works.
|Strength of team||30%||125%||0.375|
|Size of opportunity||25%||150%||0.375|
|Need for additional funding||5%||100%||0.050|
The range represents the relative weighting applied to each factor, with a heavier weighting towards factors considered more important. The range is not fixed and will be up to the valuer to assess the overall importance of each factor to the start-up company. The start-up value column is then used to assign value for each of these factors. A guideline for this is that 100% would be the average, anything that is a key strength for the company should be above 100% whereas areas of risk should be below 100%. The resulting summed multiplier of all the factors is then multiplied against the Benchmark Valuation to obtain your overall valuation.
The risk summation method is almost a combination of the two previous methods mentioned; it takes a Benchmark Valuation and adjusts based on the key risk factors, which are summarised below:
- Stage of the business
- Legislation/Political risk
- Manufacturing risk
- Sales and marketing risk
- Funding/capital raising risk
- Competition risk
- Technology risk
- Litigation risk
- International risk
- Reputation risk
- Potential lucrative exit
Each risk (above) is assessed, as follows:
- +2 extremely positive
- +1 positive
- 0 neutral
- -1 negative
- -2 extremely negative
The Benchmark Valuation is then adjusted positively by £250k for each +1 and negatively by £250k for each -1.
If a start-up is at a stage where it has started generating revenue and has some historical financial data, a traditional valuation approach may be more suitable. Discussed below are two key traditional approaches used. However, there are other methods which might be more suitable depending on the status of the company.
The income approach, or the discounted cash flow (“DCF”) model, involves building a forecast model to forecast the future cash flows of the company and then discounting those amounts back to present-day value. This is broken down into three components:
- Free cash flow
Free cash flow (“FCF”) refers to how much money a business has left over after it has paid for everything it needs to continue operating, including capital expenditure and taxes. This amount is considered ‘free’ cash that a company can use as they see fit. To calculate the FCF, detailed forecasts for the next three to five years are usually prepared based on management’s best assumptions and knowledge, with the aid of advisers. The forecast model would then show the level of free cash available at the end of each period.
The weighted average cost of capital ("WACC") is the calculation of a company’s cost of capital, weighted proportionately against the level of equity and long term debt that is used to fund the company. This WACC will be used to discount the FCFs to arrive at the present-day value and reflects the expected return of the investment. To reflect the present-day value and expected return it considers variables such as, opportunity cost, being the return of comparable markets, additional risks based on the status of the company, and the risk profile of the industry. For a start-up we normally see a premium being added due to the elevated risk of business failure.
The rate is calculated using a specific formula, capturing the considerations mentioned above.
As forecasts that are prepared are finite and will stop after a certain period, to account for performance beyond the forecasts, a terminal value is calculated. This value is calculated by taking the FCF of the final year prepared in the forecasts multiplied by a growth rate and then divided by the WACC minus the growth rate, which is the assumed rate that the FCF’s will continue to grow into perpetuity, or over a significant length of time. This terminal value is then added to the discounted FCF’s to arrive at an overall valuation.
The market approach is split into two key components:
In its simplest terms, the market approach valuation is calculated by multiplying a financial metric with a multiple to arrive at a valuation.
So, what financial metrics are used? There are several different metrics that are often used, such as profit before tax, however, the most commonly used is Earnings Before Interest, Tax, Depreciation, and Amortisation (“EBITDA”). This is because it is a better measure of the true underlying earnings of a business as the impact of leverage (debt finance), unique taxation features, and depreciation and amortisation - being large non-cash items - are excluded.
However, given that a start-up may not yet be generating any profits or earnings at its early stages, this metric may not be entirely appropriate. Another option would be to look at the revenue-only metric. This approach ignores the fact that the company may be incurring losses but instead focuses on revenue growth and the potential it possesses. We see this quite often when looking at Software as a Service (“SaaS”) companies that are able to rapidly scale up and generate annual recurring revenues.
Once the metric is decided, the next step will be to find a suitable multiple. Multiples may be derived from publicly listed companies or private companies where recent transactions have occurred.
It will often be difficult to identify any publicly listed companies that would be considered similar to start-up companies given the differences in size and diversity of operations. Similarly, multiples information on private companies are usually very limited and specifics on the deal may not be made available to the general public. Therefore, careful consideration is required when selecting an appropriate multiple that will fit the profile of the company.
How can Gerald Edelman help
The methods above are highly subjective and require substantial industry experience. Our team has a wealth of experience, preparing numerous valuations each year across companies at various stages of the business life cycle. Four of our transaction services team are members of the ICAEW valuations community, and as a firm of 16 partners and more than 140 staff, we can call upon industry experts if needed.
We also help businesses in creating business plans and work with clients to obtain fundraising opportunities through our extensive network. Should you require further assistance and advice in financial due diligence assistance for purchasing or selling a business, or other transaction advice, then please contact Carl Lundberg or a member of our transaction services team.
What is a business valuation?
A business valuation is a calculation of the current or potential value of a company using data-backed, objective models. Valuations are useful to business owners, potential buyers, and investors for various reasons.
How do you calculate the valuation of a business?
There are several methods for calculating the value of a business, depending on the stage and type of business in question. Startups or early-stage businesses may require alternative, pre-revenue valuation methods, whereas established companies can be valued through traditional approaches based on financial metrics.
How long does a business valuation take?
Depending on the size and complexity of a business, plus the availability and accuracy of company information, it can take anywhere between a few days and a few weeks to complete a business valuation.
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