I am anirban Chakrabarty. I am managing treasury and corporate Finance in Baidyanath Group - the worlds largest manufacturer of ayurvedic medicines. Valuation of a new company is very difficult.Unlike well-established firms, most start-ups typically have little or no track record, ongoing losses, few revenues, untested products, unknown cost structures, unknown implementation timing, unknown market acceptance, unknown product demand, unknown competition, inexperienced management, an untested business model, and high development or infrastructure costs. Managers of start-up companies commonly make projections based on unrealistic expectations.
Other factors that make the valuation of new companies difficult include:
Making assumptions about the success of the venture
Determining the costs to replicate what has already been achieved
Gauging the level of investor commitment to the project
Fully understanding the competition and market dynamics
Being able to project the life and timing of future cash flows.
The valuator needs to understand the size of the markets being served, the probability of successfully entering those markets, and the time needed to achieve the projected market share. Also to be considered are the costs of product development, bringing the product to market, and making subsequent improvements to the product, service, or technology.
Evaluate management team
In many cases, only broad estimates of the above factors are available, and the valuation must be done within wide ranges of possibilities. It is important to develop a base case with which to start quantification and decision making. The best place to start is with a critical look at the management team. Management traits needed for a successful start-up venture include:
Strong focus and attention to cash flow
Willingness to admit mistakes and adjust
Adherence to a clearly defined action plan with timetables and performance benchmarks
Clearly defined responsibility and authority
Ability to communicate timely and effectively
Ability to design effective information systems and use them for decision making
Creativity and “can do” attitude
Understanding of and reliance on risk analysis
Leadership skills that provide guidance, motivate behavior, and set standards of conduct
Organizational skills that blend team skills and maintain high productivity
Clear goals and objectives, and a desire to seek new opportunities
Strong functional, interpersonal, administrative, and technical competencies
Analyze financial projections
Reasonable projections are also key to the valuation process. Any market-based approach or discounted cash flow analysis depends on the reasonableness of financial projections. Projections must be analyzed in light of the market potential, resources of the business, management team, financial characteristics of the guideline public companies, and other factors. Start-ups that do not grow quickly enough will not survive, and start-ups that do grow quickly usually have operating expenses and investment needs that exceed revenues, at least until the growth starts to slow down (and the resource needs begin to stabilize). This means that long-term projections, all the way out to the time when the business has sustainable positive operating margins and cash flows, need to be prepared. These projections will depend on the assumptions made about growth.
Growth in operating income is a function of management’s investment decisions - how much a company reinvests and how well it reinvests. Examples of this reinvestment include research and development, expansion of distribution and manufacturing capacity, human resource development to attract new talent, product pricing to undercut competitors, and development of new markets, products, or techniques.
Growth also depends on market acceptance of the product, the skill of the company’s execution, competition, finance, and risk. Of course, all of these factors are interrelated.
How to project growth
There are basically three ways of estimating growth – extrapolation (if the company already has history), industry projections from securities analysts (not a source acclaimed for accuracy and objectivity), or qualitative evaluation of the company’s management, marketing strengths, and level of investment. Obviously, the results of this analysis will highly depend on the assumptions made, and good judgment is critical.
Once growth rates have been estimated, the valuator can turn to the three basic valuation approaches – assets, income, and market. Since growth is the primary attraction of start-up firms, you might think the asset values would have little relationship to company valuation. In turbulent markets, however, the level of cash and the liquidity of the company may be primary drivers of value.
I recently prepared a valuation of a high-tech company in the telecom market, and was surprised to find that none of the traditional value drivers showed strong relationships to the price-to-revenue ratios. After regressing nine different variables against the price-to-revenue ratio for 72 different companies, I found that the only variables having a decent correlation to value were working capital and debt-to-equity ratios. Even the size of the company didn’t matter – recent start-ups flush with IPO cash but with minimal sales were selling at much stronger valuation ratios than industry giants such as Lucent, Nortel, Ericsson, and Solectron.
Other than in turbulent markets, the asset approach is generally not used for valuation of start-ups. Valuing a start-up company is very similar to valuing intellectual property or innovative technology, in that the value rests more on the potential than on the assets in place. For this reason, many more subjective factors enter the income methods of valuation for start-ups than for established companies. Value is derived from profits that the new company is expected to generate. Sometimes superior technical innovation and subsequent production efficiencies do not suffice. Lack of reliable distribution systems and availability of the product in only a few outlets, for example, may limit its appeal. Sometimes large additional investments in selling, advertising, and marketing are needed. Poor administration and management can generate losses no matter how great the product, [making investments in management and systems a necessity]. A company that does not take steps to control expenses, for example, will choke on new growth rather than profit from it. These expectations of future investment needs may eliminate the value potential from what originally seemed like a brilliant idea.
With Discounted Cash Flow valuation methods, the analyst forecasts free cash flows and then discounts them to the present using a risk-adjusted cost of capital. A big problem with this method: Start-up cash flows typically exhibit non-linear behavior, and Discounted Cash Flow is a linear model. Cash flow spreadsheets often cannot reflect managerial flexibilities and the strategic options to expand, delay, abandon, or switch investments at various decision points. The biggest problem in projecting income from a new company, technology, or product remains assessing the likelihood of success and the risk of failure. This assessment by definition will be speculative, rendering any discounted cash flow valuation speculative as well, no matter how precise it appears on the spreadsheet.
In start-ups, even more than in established businesses, cash is king. Estimating cash flows is critical. The value of an asset, or a company, comes from its ability to generate cash. When valuing a company, cash flow should be evaluated after taxes, before debt payments, and after reinvestment needs.
For young firms that are growing rapidly, historical numbers are often obsolete by the time they are available, and therefore the valuation is going to heavily depend on the use of estimates.
The market approach to valuation also presents special problems for start-ups. This valuation process involves finding other companies, usually sold through private transactions, that are at a similar stage of development and that focus on existing or proposed products similar to those of the company being valued. Generally a good source of information is press releases from publicly held acquirers. Complicating factors include comparability problems, differences in fair market value from value paid by strategic acquirers, lack of disclosed information, and the fact that there usually are no earnings with which to calculate price-to-earnings ratios (in this case price-to-revenue ratios may be helpful).
Growth is easy
Good entrepreneurs (especially since the dot-com bust) know that a good idea does not equal positive cash flow, and technical success does not equal commercial success. It is not growth that creates value, but profitable growth. Businesses need to earn more than their cost of capital, or the growth will be more detrimental than positive.
Increasing growth is often easy – doing it profitably is not. When it comes down to it, the valuation of a start-up is very often a valuation of the company’s managers and their ability to perform.
Some investors use a “back-in method.” This approach uses the following logic. Each investor has different expected rates of return on their investments depending of the riskiness of the investment. Money market and certificates of deposit have low risk and low rates of return in the range of 2% to 5%. Expectation of return for mutual funds and stocks might be in the 12% to 15% range since they are more risky than savings. New venture investment rates of return will fall in the 25% to 50% range depending on the progress and performance of the company.
In the case of a back-in valuation, assume the investor’s pre-determined expected rate of return for high risk deals is, say, 40% per year. Assuming a deal with the following variables: P/E of 15; projected payback in year 5 after investment; net earnings in year five of $2,000,000; and a $300,000 investment, the calculations would look something like this:
Expected total return on investment (1 + .40)5 x $300,000 = $2,258,860.
Market valuation at time of sale: P/E 15 x $2,000,000 net = $30,000,000.
Percentage of investor’s equity: $2,258,860/$30,000,000 = 7.5%
In this case the investor's percentage of ownership is based upon an anticipated future valuation of $30,000,000 and an anticipated future return of $2,258,860. While this is a legitimate valuation approach, investors are well aware that much can happen between the date of investment and the intervening time before liquidation and the future valuation is not a realistic reflection of the value today.
Most investors prefer a more temporal approach using a discount method to allow for the fact that the company today does not meet the performance criteria of a mature company. Discounts are assigned based on the stage of a company’s development. If the deal is an idea without a business plan, the discount might be as high as 80% to 90%. A deal with a business plan and a prototype but no product or sales could garner a 60% to 80% discount while companies with product and sales will range from 25% to 60% depending on their profitability. These discounts are applied against current comparable sales in the market using a multiple of sales or earnings. Companies with the potential for continued high growth will sell for higher multiples than ordinary companies with steady or declining growth prospects. For example, a medical company with a strong pipeline of new products might sell for 4 times sales or 8 times earnings where an old manufacturing companies might sell for less than 1 times sales. Looking at this method to value a pre product, pre revenue startup medical company seeking a $1,000,000 investment, the investor would compare the startup to a comparable sale and discount the valuation. For illustration, say similar medical companies are selling for 4 times sales (e.g. 4 x $10,000,000 = $40,000,000). The discount for still being a small pre product, pre revenue company is, say, 80%. The discounted value would be $8,000,000 ($40,000,000 x (1.0-.8) = $8,000,000). The total valuation after the investment would be $9,000,000 ($8,000,000 + $1,000,000 = $9,000,000). The investor’s equity would be 11% ($1,000,000/$9,000,000=.11).
My preferred method for a startup is a risk approach to valuation. My preference is based upon the fact that it is difficult to project realistic revenues of a company that is still an idea, future P/E values, and the market environment for mergers and acquisitions five years in the future. My approach takes the national high-average for funding for startup stage deals which today is about $3 million and discounts that amount by analyzing the amount of risk in the deal. The risk profile considers the five primary risk factors investors use in assessing a deal: product, market, finance, management, and execution. Each of these risk factors is assigned a weighted share of the $3,000,000 with each having a maximum value of $600,000. Each factor is then discounted based upon a variety of measures to derive a value for each risk factor. The risk factors are then summed to generate a total valuation. For example, assume risk values of: product, $500,000; market, $400,000; finance, $300,000; management, $500,000; and execution, $300,000. The total valuation of this startup deal would add up to $2,000,000. The total valuation after an investment of $300,000 would be $2,300,000 giving the investors an ownership percentage of 13%.
As you can tell, valuation is as much art as math. At the end of the day, it comes down to a negotiated agreement. But, it is important to realize that failure to understand the valuation process puts the entrepreneur at a distinct disadvantage. If the valuation is too low, the entrepreneur is giving more equity than necessary. If the valuation is too high, the investor usually assumes the entrepreneur is too financially unsophisticated or unrealistic to justify an investment. In either case, it is critical that entrepreneurs seeking private equity investment be just as knowledgeable as investors in arriving at a valuation.