By its very nature, valuation is not an exact science, and this becomes even more obvious for valuation of start-ups. Start-ups usually have negative but growing cash flows, limited or no historical financial data and forecasts, and often their proof of concept has not been developed yet. For that reason, the traditional valuation approaches such as the income approach, the market approach or the net assets approach might not be helpful because start-ups and most early-stage companies do not have the financial performance indicators necessary for those approaches.
Valuation of a start-up brings various challenges, which require potential investors to approach the process differently. As historical information is unavailable/limited and forecasts are uncertain, qualitative elements play a significant role. Accordingly, indicators such as management/team experience, first customers and revenue, defined target group and minimum viable product (MVP) should be taken into account in the valuation process.
Start-up valuation methods
PwC sets out six different methods, which are often used in practice and applied to different stages of a start-up. Valuation practitioners will often use a combination of the methods as per the table below:
Source: PwC analysis
The selected valuation method depends on the maturity stage of the target entity:
- As provided in the table above, for valuation of companies in the idea/seed and seed/start-up stages, the fixed ranges approach, the cost approach, and the scorecard valuation method might be used. When using the fixed ranges approach, incubators propose a ‘take or leave’ investment in exchange for a share of equity. The cost approach sets the idea that an investor is willing to cover the costs that have already been incurred to get the target entity to its current stage. Finally, in order to assess the value of the target company using the scorecard valuation method, potential investors have a list of criteria based on which the target entity and its peers are evaluated.
- Valuation of companies in the early growth and expansion stages might be based on the venture capital (VC) and discounted cash flow (DCF) methods. Using the VC method, the value of the target entity is estimated as the value after a few years (the so called ‘exit-value’). That value is then discounted to the present value using a discount rate. The DCF method is used for companies where cash flows can be reasonably estimated. Those cash flows are then discounted to the present value using an appropriate discount rate, being the weighted average cost of capital (WACC). DCF method is based on an idea that the target’s value is based on its ability to generate positive cash flows in the future.
- Companies that have reached the sustainable growth stage could be evaluated using the DCF or one of the market approach methods. When using the market approach, the potential investors could consider either the current market price of publicly traded peer companies or the previous comparable transactions with disclosed multiples. Usually, the following multiples are used in start-up valuations: enterprise value-to-revenue (EV/R), enterprise value-to-EBITDA (EV/EBITDA), enterprise value-to-EBIT (EV/EBIT), and enterprise value-to-free cash flows (EV/FCF).
A start-up valuation performed by PwC
PwC has recently performed a start-up valuation for one innovative transport system developer located in Lithuania (the Target). As the Target had already reached the early growth and expansion stages, the DCF method was selected as the main valuation approach with the VC method chosen as a supplementary method. The discount rate used in the analysis was estimated with the scorecard method, which can be used for determining a start-up’s value as well as for estimating the discount rate. In the following paragraphs we have shortly focused on the use of the VC and the scorecard method.
Application of the VC method
During the valuation under the VC method, firstly, the Target’s expected exit value was assessed. The value was estimated at the time of exit from the investment, as expected earnings were multiplied by an average earnings multiplier based on the comparable peer group companies. Then, the value of the Target was calculated by discounting the exit value to the present value. It is important to note that the discount rate calculation for start-ups differs from the traditional discount rate estimation.
Depending on the maturity stage of the target, a range of discount rates may be used when estimating the specific discount rate. The table below shows a breakdown of potential ranges of discount rates by maturity stage and source of information:
Sources: PwC analysis and:
1. Plummer, QED Report on Venture Capital Financial Analysis, 1989;
2. Scherlis and Sahlman, A method for Valuing High-Risk, Long Term, Investments: The Venture Capital Method, 1998;
3. Sahlman, Stevenson, and Bhide, Financing Entrepreneurial Ventures, 1998;
4. Manigart and Witmeur, Venture Capital guide for Belgium, 2009;
5. Damodaran, Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges, 2009.
As the Target was in the early growth stage, the initial range of discount rates was chosen from the early growth column and the specific discount rate was calculated with the scorecard method.
Application of the scorecard valuation method
The scorecard method was introduced when a qualitative assessment was performed by completing a questionnaire about the Target. Even though the Target had already passed the seed/start-up stage, it still had some characteristics applicable to start-ups: historical financial data is limited or unavailable; product/service development is still in process; cash flows are negative.
Under the scorecard method, the potential investors were provided with a list of criteria, based on which the Target was compared to its peers. Questions in the above-mentioned questionnaire were grouped into two categories:
a) the Target’s management/team and services/product; and
b) the Target’s market and business strategy.
Each answer received a certain score. Using the questionnaire’s total score and the initial range of discount rates, the specific discount rate could be calculated based on the following formula:
Estimated discount rate = minimum value from the discount rate range + (maximum value from the discount rate range - minimum value from the discount rate range) * (100% - share from the questionnaire’s maximum score).
As mentioned above, valuation is not an exact science, which is even more true in case of start-ups. Instead of the traditional valuation methods, alternative valuation methods might be more appropriate, of which we have described (among others) the VC and the scorecard method. Regardless of the chosen valuation method, each valuation requires a good understanding of the target, the market and the valuation process itself.
Footnotes
1. A minimum viable product (MVP) is a version of a product with just enough characteristics to be usable by early customers who can then provide feedback for future product development.
2. Start-up incubators help entrepreneurs solve some of the problems commonly associated with running a start-up by providing workspace, seed funding, mentoring, and training. Start-up incubators are usually non-profit organisations, which are usually run by both public and private entities.
One the same subject: Äripäev
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