In an era of rapidly evolving technology, the success of a company is less and less determined by its assets in the sense of fixed assets, but more and more by its intangible assets such as know-how, owned patents or industrial designs. The dynamics of change within a company, maintaining contact with stakeholders or adapting smoothly to changes in the market are also increasingly important. Changing conditions determining the success and competitive environment of a business have led to the emergence of the start-up model. When do we talk about a startup and how do we value it?
When can we actually talk about a startup?
The concept of a start-up does not have a legal definition in current legislation. Nor is it just another organisational and legal form alongside JDG, commercial partnerships or civil partnerships. What then is a start-up?
It is assumed to mean a business model that is distinguished by the following characteristics:
- no fixed customer portfolio – startups address their services to multiple customer segments, depending on the current target and market conditions;
- a lack of financial security – many startups operate at or even below breakeven in the first period, hoping to attract customer attention and stand out from the competition with a unique solution. Many startups also rely on external funding;
- scalability and innovation – the lack of a rigid business framework means that the scale of operations can be easily changed to suit market conditions, and innovative technologies allowing the company to maintain a distributed structure also make this possible;
- the history of the business generally does not exceed 5-10 years and is at an early stage of development;
- lack of in-depth testing of products or services – in most startups, new ideas are developed quickly and tested directly on the market, which allows for a rapid rotation of the portfolio and a smooth improvement of the offer.
It is usually said that startups operate in a high-risk environment. However, if they are successful, the rate of return on investment is usually far beyond that expected from a traditional business.
For what purpose are startups valued?
Startups are primarily valued to determine the expected return on investment. Without such an estimate, investors will be reluctant to invest their capital as they cannot determine whether such an action will pay off. Determining the value of a startup can also be important from the point of view of a potential M&A transaction, and from the perspective of both the buyer and seller.
The process of valuing a startup is unfortunately quite complicated, as these companies are rarely based on owned assets, much more often on intangible assets. They also do not have a long enough history that one can simply assess the amount of revenue over the last few years. In practice, it therefore appears that asset-based valuation methods, at least at the initial stage, will not be a suitable solution.
Start-ups are often created on the initiative of a few people who have the proper knowledge. However, does the fact that a project exists only in the form of general assumptions and the founders have no assets mean that it has no value? Nothing could be further from the truth! However, it becomes necessary to select an appropriate valuation method correlated to the phase the startup is currently in.
What factors should be taken into account when valuing a start-up?
So what factors should a start-up valuation take into account? First and foremost will be the ability to build competitive advantages and optimise business processes. It should also be borne in mind that the valuation of a startup must take into account slightly different risk factors than for classic businesses, such as:
- the innovativeness of the product or service;
- the incidentality of transactions and the lack of a permanent counterparty base;
- the fluctuation of revenues, as well as their deficit in relation to needs;
- the higher-than-average level of business risk.
When choosing a valuation method, it is also important to take into account the startup’s development phase. The later it is and the more mature the business is, the more data the valuator has at his disposal and the better he can reflect the specifics of the business, and thus investors receive more reliable information. The doctrine distinguishes between several stages in the development of a startup:
- pre-seed stage;
- early growth stage;
- growth stage;
- expansion stage
- exit stage.
It is worth noting that there is no single, good answer to the question of how long the different phases of a start-up last. Much depends on the commitment of the founders, the business and competitive environment of the company, but also the current economic climate. Which valuation methods will be appropriate depending on the stage the business is at?
Start-up life cycle – the pre-seed phase
At this stage, usually the startup has not yet been founded and the founding group is just testing the market. The product itself functions at the idea stage, has not yet been produced, and even less so, has not yet gone on sale. At this stage, a market analysis is carried out, which results in finding a suitable niche for the startup to operate in. Typical valuation methods include Scorecard Valuation and the so-called Berkus method.
Scorecard Valuation is based on a comparison of entities with a similar profile taking into account parameters such as:
- intangible assets;
- stage of development;
- qualification of the staff
- business area and market size;
- activity of competitors.
The Scorecard Valuation method is based on adjustments applied to a company operating in the seed stage. Individual evaluation criteria are assigned specific values, which can be modified depending on the specifics of the company.
An alternative solution is the Dave Berkus method. The main premise of this method is to assign specific values to individual project components. Criteria adopted for evaluation include:
- management team (contributes to reducing project execution risk);
- interesting, innovative idea (core value of the startup);
- product prototype (results in lower technological risk);
- strategic alliances ( result in reduced market risk);
- product implementation or sales (reduces production risk).
Practice shows that startups valued according to the Berkus method often perform poorly due to, among other things, the lack of a prototype, its insufficiently advanced stage or the disruption of the communication flow between the different founders. To avoid this problem, it is recommended that founders implement coaching. This will result in significantly higher evaluation results right from the start. This is important from the point of view of business angels or Venture Capital funds, who usually fund innovative ideas.
Startup life cycle – early growth phase
In the early growth phase, the collaboration between founders and the target user group intensifies. It becomes important to develop the concept of an MVP (Minimum Viable Product), i.e. a product good enough to meet the users’ baseline expectations. Usually, the MVP does not yet reflect the final shape of the offering, but is a kind of visualisation of the startup’s intentions. At this stage, in addition to the Scorecard Valuation technique, the Real Option and Venture Capital methods are used for valuation.
The real options method is based on the assumption that the startup is treated as a project valued on the basis of net present value (NPV) and real option value. The technique assumes high market volatility, but also that the entrepreneur can react dynamically to changes. Founders are therefore allowed to change their management decisions on an ongoing basis as their idea or the competitive environment evolves. In other words, they can take into account (or disregard) assets that, although not yet profitable, have the potential to do so, such as a patent. It is widely believed that the real options method should only be used complementarily.
The Venture Capital business valuation method, on the other hand, is a combination of the commonly used DCF (cash flow discounting) and the multiplier method (otherwise known as the comparative method). The value of a startup is determined on the basis of three criteria:
- the residual value, i.e. the expected value of the income generated by the business after the free cash flow estimation period;
- the expected return on investment (ROI);
- the amount of funds to be invested.
It is worth noting that in this method, both the expected return on investment and the amount of funds to be invested depend on the investor, so different valuation results can be obtained.
Start-up life cycle – the growth phase
The growth phase, also referred to as the scaling phase, is when the founders have already determined the final shape of the product, but it becomes crucial to increase the revenue of the business, which has so far been in the background, as quickly as possible. The money flowing into the start-up becomes even more important than the costs associated with running the business. Very often in the scaling phase, external financing starts to play a fundamental role, which quickly provides the necessary funds to allow a smooth adjustment to market expectations. In addition to the Venture Capital method, the comparative method and the so-called First Chicago Method are most commonly used here.
The comparative method consists of comparing companies at a similar level of development with each other. The valuation base may look different, but usually the profit volume, book value or sales volume plays this role. To the value calculated in this way, the value of the whole company or equity is compared (in the case of start-ups, it will usually be the former). Multipliers for comparable companies are then calculated. Premiums or discounts are applied to the result, increasing or decreasing the valuation accordingly.
In the comparative method, the matching of companies plays a very important role. They should not only operate in the same industry, but if possible also in a specialisation (e.g. IT sector and cloud technologies). The more entities can be located that can serve as a benchmark, the greater the value of the valuation will ultimately be. Business turnover and the practice of M&A transactions show that the most frequently chosen ratios for multiples valuation are:
- share price to earnings per share (P/E);
- share price to book value of the company per share (P/BV);
- the share price to earnings per share ratio.
In practice, basic accounting parameters such as EBITDA value are also usually used. Unfortunately, the disadvantage of such a method is the risk that the value of the startup is severely undervalued or overvalued, which in turn is reflected in the absence of the expected profit and the failure of the startup.
The First Chicago method is based on a cash flow valuation, but approaches the valuation of a startup as if it were a scenario. It assumes that the company may encounter:
- a base model;
- an optimistic model;
- a pessimistic model.
A set of guidelines and assumptions is constructed for each scenario and then a weighted average is derived based on all three.
Start-up lifecycle – expansion phase
The expansion phase involves the startup entering the market aggressively. Not only is its funding at an increasing amount, but the company itself is becoming bolder in the business environment. This phase is usually marked by the acquisition of other companies, the purchase of patents, investment in new technologies or the recruitment of a large number of new employees, including specialists bringing in know-how. The expansion phase is also referred to when a startup reaches a break even point. This is the point at which the cost of production equals revenue. One more step forward and the startup’s profits increase dramatically.
At this stage, one of three valuation methods is usually used – First Chicago, real options or comparative.
Startup lifecycle – maturity phase
In the maturity phase, the startup is essentially approaching a standard business model. Typically, the company is already widely recognised, with stabilised revenues, market history and a clarified product or service portfolio. Many of the companies at this stage are already considering going public in order to gain funding from independent investors rather than Venture Capital or business angels. Due to the high stage of development in the maturity phase, the classic DCF method is primarily used.
The basis for the DCF calculation is the expected net sales revenue of the asset. Typically, the detailed forecast period is between three and six years. The method assumes the loss of the value of money over time. The implementation of DCF requires a thorough analysis of the company’s financial situation, in particular its accounts.
An important advantage of cash flow is the ability to calculate the risks associated with the investment, as well as the amount of expected benefits, elements that are either missing in the previously mentioned methods or are treated negligently. At the same time, however, it is a difficult technique to apply because of its complexity. It is easy to make mistakes in the calculations and, as a result, the result obtained will be unreliable.
Other valuation methods
Of course, the above-mentioned valuation methods are not the only ones used in the valuation of companies, including those operating in the start-up model. Among the less common ones we can mention e.g:
- The multi-stage method, which carves out the various stages in the life of a company and the chance of success or risk of failure to take the project to the next stage. This method also identifies the inputs required for a particular phase of the business. The calculations are adjusted for the risk of cash outflow at each phase of the investment;
- Risk Factor Summation is a technique that is based on the assessment of 12 criteria related to the operation of the business (including legal, competitive, litigation or technological risks). Each factor can be given a value from +2 to -2. The final value of the business is calculated by summing all the values together.
In addition to the various types of base methods, mixed and non-standard approaches are used, as well as variations of the individual base methods. The situation is not made any easier by the fact that each valuation technique will give a different result, so it is worth considering several different calculation methodologies to obtain a reliable result.
Can founders value a startup on their own?
The huge number of valuation methods available makes it practically impossible to calculate the value of a project on one’s own, which is, after all, dynamically evolving. This is because it requires in-depth knowledge of law, accounting, finance, but also the ability to determine the stage at which the startup is.
Legal services for start-ups – Linke Kulicki law firm
As a rule, the valuation of a startup is outsourced to professionals, such as law firms specialising in legal services for startups. Founders are most often focused on developing an optimal product that will allow the business to survive and, at a later stage, prosper.