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How start-up valuation works

How start-up valuation works

Business valuation means to value the firm or business with the help of known methodologies. One may always use a known public or paid database to obtain multiples or similar companies and adjust them accordingly to find the value of a firm or a business, though valuation of a start-up-up is somewhat difficult due to a number of factors like non-availability of similar multiples, absence of initial cash flow, and the absence of fair/market value of shares, convertibles, cost of debt , beta, and more.  The valuation of a start-up done, is for a specific date and will differ across locations, industries, and time.

There are many methodologies to value a start-up, and we will discuss some of the most common techniques used by industry experts.

  1. Discounted Cash Flow Method: The Discounted Cash Flow Method involves the preparation of free cash flows, terminal value, beta, cost of equity, cost of debt, market value of equity, market value of debt and convertibles, weighted average cost of capital, the taxes applicable, market rate of return, growth rate, working capital, capex expenditure, depreciation applicable. The concept behind this is that investing in start-ups is a high-risk move compared to investing in firms already operating and achieved a stable growth rate.
  2. Net Asset Value Method: The net asset value method is quite simple, and only followed in exceptional circumstances. It is obtained as total assets minus its liabilities and taking the market value or principal value of asset and liabilities as far as possible. The book value of any asset or liability is only taken in case of absence of fair/ market value.
  3. Comparable Companies Method: The Comparable Transactions Method is one of the most common methods of start-up valuation techniques because it’s built on the premise of finding a multiple of a company/ firm with similar cash flows, revenue, liabilities, intangibles and growth rate. The most common multiples used are Enterprise Value/ EBITDA, Enterprise Value/Revenue and PE ratio. For example, the selling price of a comparable start-up company called XYZ is INR 10,000,000. Their annual revenue is $2,000,000. Using the formula, 10,000,000 (selling price) / 2,000,000 (annual revenue), the multiple of revenue is 5.0x. Now, the same calculation is performed for few more start-ups of the same industry and the average multiple of revenue equals 2.5x. To estimate the value of the target start-up company called ABC Corp which has an annual revenue of INR 3,000,000, multiply the revenue by the average revenue multiple of 2.5x. The result is an estimated valuation of INR 7,500,000.
  4. Venture Capital Method: This method is used for the firms funded by venture capital firms, and reflects the mindset of investors who are looking to exit a business after several years via IPO offer in primary markets or via stake sale when the valuations are at their peak.

 

There are two formulas which are used for valuation of start-up firms and businesses:

 

Return on Investment (ROI) = Terminal Value ÷ Post-Money Valuation

Post-Money Valuation = Terminal Value ÷ Return on Investment

First, the start-up’s terminal value, or the expected selling price of the start-up firm after the VC firm has invested, is calculated. This can be calculated by using estimated revenue multiples for your industry or the price-to-earnings ratio. Next, calculate the anticipated ROI, such as 8x, and put everything in the formula given to find the post-money valuation. From there, subtract the investment amount to get the pre-money valuation of the start=up firm.

  1. Liquidation Value Method: The liquidation value is, as per by its name, the value of the firm or a company when it is going out of business. Things that are taken in consideration for calculating the liquidation value estimation are all the tangible assets: real estate, inventory, Plant, property and equipment. Do remember to exclude the value of intangibles like goodwill and brand value. All the intangibles, are considered worthless in a liquidation process (the underlying assumption is that if it was worth something, then they would have already been sold at the time you enter in liquidation): patents, copyright, etc.

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