Valuation of listed and publicly traded companies is relatively easy because it is based on their market capitalization – the prevailing stock market price multiplied by the outstanding shares of the company. However, it gets a bit complex when it comes to the valuation of unlisted companies, particularly start-up companies because there is no relevant data available for them to do the valuation. The fact is that they are in more need of valuation than publicly traded companies.
While business valuation helps entrepreneurs measure the worth of the companies they are building, investors use valuation methods to determine the worth of their investment in a company. Investors typically value startups not just based on the current performance but more on the future potential of the business. Users of business valuation data include Venture Capitals (VCs), Corporate M&A teams, Investment bankers, Entrepreneurs, Startup founders, Employees with stock options, and Lenders, among others.
What do Pre-Money and Post-Money Valuation mean?
The terms pre-money and post-money valuation come into the discussion in any financing round negotiations because they play a major role in determining the value of a deal. The valuation of your startup will determine the money an investor will have to pay for a portion or share of the company that you are willing to let go of. It is, therefore, crucial for entrepreneurs to have adequate knowledge about pre-money and post-money valuations that will have a substantial effect on the financing deal.
Pre-money valuation is the company’s net worth before its last round of funding. On the other hand, post-money valuation is the startup’s worth after investments are brought into the balance sheet. The difference between the pre and post-money valuation is the timing of valuation that determines the share of equity the investors will get after the funding.
As an example, Investor A who is willing to invest $1,000,000 as capital in your company with a pre-money valuation is $3,000,000 will receive 25% of equity shares on the post-money valuation of $4,000,000. If the company’s pre-money valuation is $1,500,000 in place of $3,000,000, then the share of equity to be claimed by Investor A will be 40% of $2,500,000.
The investors use the pre-money and post-money valuation to determine the amount of equity they will expect to receive post funding by using the equations;
Pre-money valuation = Post-money valuation – investment amount
Post-money valuation = Investment amount ÷ percent investor receives.
Methods of Business Valuation
The valuation can be based on the current or projected revenue but must consider other factors such as the return on capital and EBITDA along with both hard facts and soft factors which include the management, market, technology, and financials/funding phase. Rather than a single method, most companies adopt a combination of different valuation methods. We will take a look at some of the widely used methods here:
Also known as the Bill Payne method, the scorecard valuation method compares the startup under the valuation to a similar startup by modifying its valuation average by factoring in weightage for factors such as market, management, stage, region, etc. The average pre-money valuation is determined under this method and the factors are ranked for assigning weightage. Then you calculate and use the weights to derive the valuation. While the ranking is highly subjective, there is a certain fundamental trend in it that most investors rank the management team higher than the product; this is on the assumption that even if the product is flawed the management team will identify and sort it out, but if the management team is not capable of running the business effectively and efficiently, there is no chance for recovery.
Venture Capital Method
This method, often used to value pre-revenue companies, uses two equations under the VC method for pre-money valuation:
- Pre-money valuation = post-money valuation — Investment
- Post-money valuation = Terminal value (Exit Value) ÷ Expected Return on Investment (ROI)
The expected value of a business on a certain future date is the Terminal Value or Exit Value converted into the present value. The terminal value is normally calculated by multiplying – usually by 2 – the estimated revenue in the year of exit/sale. The return on investment is the return an investor could expect on the investment subject to the level of risk attached to it.
Imagine that XYZ Inc is looking to raise $3 million with a projection of $75 million in revenue 10 years later. The terminal value is $75 x 2 = $150 million. Assuming the expected return on investment is 25x for the pre-revenue startup, the post-money valuation will be $150M/25x= $6 million. This gives a pre-money valuation of $3 million ($6 million – $3 million)
In the Berkus method, named after a famous American Angel investor Dave Berkus, an arbitrary value ranging from zero to $500,000 is attributed to five key aspects of the startup company, such as a sound idea, product prototype, management team quality, strategic relationships, and initial sales. The total of these values makes up the valuation of the startup. The derived startup value can range from $2-2.5 million. However, this method which is an over-simplified valuation technique that works on approximations is ideal only for pre-revenue companies.
Discounted Cash Flow (DCF)
The discounted cash flow method, one of the most widely used methods, considers free cash flows generated by the company in the future and discounts them to derive a present value (i.e. today’s value). The discount rate, commonly the cost of capital, applied for discounting is the minimum return that you expect on your investment. If the company has only equity, then the cost of equity is considered and if it has equity as well as debt, the cost of capital of both equity and debt, which is known as the weighted average cost of capital (WACC) factoring in the risk-free rate, risk premium, and inflation premium on equity and debt, is considered.
The DCF formula runs like this:
DCF = Calculated DCF value
CF = Cash Flow
r = Discount rate (WACC: Weighted average cost of capital)
The DCF approach values the pre-revenue startup based on the forecasted cash flows the business is likely to generate in the future. To put it succinctly, the DCF measures the startup value by combining time, risk, and money.
Market Comparables Method
The comparable transaction method attempts to estimate the value of a company based on investments or M&A deals of a similar-sized company in a similar segment. When there is no other data on such deals available for valuation, the metrics of public companies of similar size and industry may be used for comparison. Comparing your startup with other VC investments is a good option, but since it is not easy to collect accurate and relevant data, it is better to compare it with a recent acquisition. A company with the same business model that is looking to do similar things that you are planning to do, is the ideal way. The biggest challenge in this approach is to find the data for comparison as the data related to unlisted companies are not publicly available. You may have to get it through confidential sources or compare it with listed companies of similar size and other characteristics in the same industry.
Multiples Analysis Method
The multiples analysis method involves extrapolation of the value of a company using a multiple of comparable private companies, on the assumption that the type of ratio used in comparing firms is the same across similar firms. There are two categories of valuation multiples; Enterprise value multiples that include the enterprise-value ratios like (EV/Sales), EV/EBIT, and EV/EBITDA, and Equity multiples that involve analyzing ratios between a company’s share price and an element of the underlying company’s performance, such as earnings, sales, book value, or something similar.
The formula for calculating EV is
Where: MC=Market capitalization
Total debt=Equal to the sum of short-term and long-term debt
C=Cash and cash equivalents
It is important for you to be aware that every company is unique, and considering revenue without exploring variables such as market growth, staff quality, or profit margins doesn’t provide enough valuable insight.
Net Book Value Method
Net book value (NBV) is a valuation method ideal for companies with lots of capital assets such as land, equipment, business premises, and other physical assets and intangible assets such as reputation, patents, and brand. This method, however, doesn’t consider the premium the market might place on the company’s value coming from management, growth expectations, market potentials, product, technology, etc. As a result, the NBV method tends to yield a lower valuation compared to other methods.
How to Select The Ideal Valuation Method?
There are numerous business valuation methods for you to choose from. Some are more complex than others or ideal for different stages. Different methods may result in different valuations for the same value of underlying assets and business. Selecting an appropriate business valuation method for the valuation of your startup depends on several factors, including the purpose of valuation, whether sell-side or buy-side, the stage the company is at, the industry the company is in, the unique characteristics of technologies or products that companies offer, the market it serves, the size of the target companies, etc. For instance, a business that pursues promising but unproven technology or is in a pre-revenue stage might prefer a valuation method that is based on future growth potential instead of current performance.
The Bottom Line
The valuation of your startup is not a straightforward process because it is not. Make sure that the investors are on the same page as you. While negotiating with investors keep in mind that in the end, the company will be worth how much an investor is willing to invest. There are many other factors that affect the value of the startup and no value is accurate or permanent. Several other methods than what was discussed above exist that are used for the valuation of private companies. The standard practice is to use a customized combination of more than one method depending on the purpose, side, industry, stage, region, etc. considerations. With PACI financial analysis and management tools, you will get all the relevant data and inputs that are required for the valuation of your business that will help you negotiate with investors.
Paci.ai, a unified finance management platform for SMBs, looks forward to tackling the backward-looking nature of accounting with its insights and predictor modules.