How to value a start-up?!

Valuing a start-up or young company can be problematic. Key problems can include:

• little or no financial history
• dependency on key people to make it a success
• requires private capital to survive
• making little or no revenue and likely loss making

Another key issue is the likelihood of failure. According to the Australian Bureau of Statistics, of the new companies established in the 2020 financial year, only 50% survived to 30 June 2023.[1]

So how do you value a start-up? We recently discussed this with a panel of experts specialising in early capital raising, and mentoring and developing early-stage companies

Value or price?

Often founders of a start-up will work out how much funding they require and then what percentage share of the company they are prepared to sacrifice in return for that funding.

For example, a start-up may require funding of $0.2 million and is prepared to offer in exchange a 10% interest in the post-money company. The implied post-money “value” is then $2.0 million and the implied pre-money “value” is $1.8 million.

But what if the investor wants a 20% equity stake for the same $0.2 million funding? Then the implied post-money “value” reduces to $1.0 million and the pre-money “value” to $0.8 million. Has the value of the business really changed or just the price?

What if the firm cannot raise any funding? What is the “value” then? Nothing?

It appears that founders and investors may use the term price and value interchangeably.

However, according to the International Valuation Standards, the two maybe different. Value is the opinion resulting from a valuation process compliant with the standards. Price is the amount offered or paid for an asset.[2]

Value is a function of future cash flows. Price is based on supply and demand, the mood and momentum of the market, liquidity, and timing.

Phases of funding

According to our panel discussion there are several funding stages a successful rapid growth start-up may go through before it reaches maturity:

• Pre-seed funding. This funding required to get the venture of the ground. Typically funded by family, friends and fools.
• Seed funding. This is the first official funding stage and helps fund market development and product development.
• Series A to C funding. In Series A, Investors are looking for a strategy turning the ideas into a money-making business. Series B to C rounds attract funding once the business is well-established and becomes progressively more successful.

Investors understandably expect the “value” to increase as the start-up climbs the funding ladder. Setting a price too high at the early stages may impede an entities ability to raise capital in the future.

According to our panel, in Australia there is very little funding past Series A. Really good start-ups need to venture overseas to fund rapid growth.

Pricing by founders and investors

According to our panellist a common valuation “method” adopted by founders and investors is the Berkus method.

Berkus method. The Berkus method is a simple qualitative early-stage method developed by the venture capitalist Dave Berkus that focuses on risk factors rather than projections. The method attributes a value of between zero to $0.5 million for each of five key areas: sounds idea, quality management team, prototype, strategic relationships, and product rollout.

According to google, other industry “methods” include the venture capital method, which involves forecasting future earnings to the time of exit and then discounting the exit value to a present value, and the cost to duplicate approach, which only considers the costs involved to date and ignores future potential for sale growth and profitability.

As a word of warning, per the International Valuation Standards, anecdotal or “rule of thumb” valuation benchmarks should not be given substantial valuation reporting weighting unless it can be shown that buyers and sellers place significant reliance on those benchmarks.[3]

Discounted cash flow approach

Professor Damodaran argues that the fundamentals of valuation do not change for a start-up or young company. The value of start-up form is the present value of the expected cash flows which is established through the discounted cash flow method.[4]

Steps in the discounted cash flow method for start-ups include:

• Estimating revenue growth and the reinvestment to generate growth; factors to consider include the past growth rate, the growth rate in the overall market and the competitive advantage.
• Estimating a sustainable operating margin in stable growth by looking at competitor margins and analysing expenses to remove any capital expense components.
• Estimating risk and discount rates, including how risk and leverage over time will impact the rate.
• Consider failure and adjust the value to reflect the probability that the firm will not survive.

According to our expert panel, the consensus was that the use of any cash flow-based valuation approach was irrelevant. This was on the basis that investors do not expect a rapidly growing company to generate free cash flow in the foreseeable future. Any free cash flow is invested in growth.

Summary

The valuation of a start-up or young business may be problematic. Many input factors may be difficult to determine. Given this difficulty, founders and investors may adopt a rule of thumb benchmark like the Berkus method to provide pricingguidance. Be careful though, a benchmark approach may not be acceptable when valuing a start-up under the valuation standards.

Simon Cook

Simon specialises in valuing private businesses and quantifying damages. He is a Chartered Accountant Business Valuation Specialist and Forensic Accounting Specialist with Chartered Accountants Australia and New Zealand (CA ANZ). He chairs the CA ANZ Business Valuation group for Queensland, is a member of the CA ANZ Trans-Tasman Business Valuation Committee and likes running long distances in the hills!

[1] Australian Bureau of Statistics, 8165.0 Counts of Australian Businesses, including entries and exits, June 2019 to June 2023

[2] International Valuation Standards Glossary paragraphs 20.18 and 20.29, pages 7 and 9, effective 31 January 2022, International Valuation Standards Council.

[3] International Valuation Standards 105 paragraph 30.16, page 39, effective 31 January 2022, International Valuation Standards Council.

[4] Damodaran, A, Investment Valuation: Tools and techniques for determining the value of any assets, third editions, chapter 23.