Introduction:
Valuation is important to startups for many reasons and in all stages of their life-cycle, including and most importantly when investors or individuals become interested in partnership with the venture, or when ventures are ready for IPO exit, or otherwise for being acquired.
Valuation is more an art than science due to many different factors involved. In this article, the focus is on the fundamentals and the three main approaches to valuation in very simple terms. Details and secrets of valuation merits many pages, case studies, articles and books.
The ultimate purpose of valuation is to determine the value (price) of a business, regardless of the size, industry, or the age of that business. This is not a challenge for public companies; they can be easily valued by multiplying their stock price by the number of stocks. (Details and why their real value, especially for merger and acquisition scenarios might be different is out of the scope of this article). Assessment will be more complicated and very uncertain for private ventures, for many reasons. Startups are young entities -mainly 3 to 5 years- and their aim is to test a new business model, . Therefore,
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- Startups do not have a long history of revenue, expenses and net earnings as a solid indicator based on which their future economic values can be estimated.
- Their risk is unknown because they are testing a new business model; new products may or may not be the right fit to the target market.
- There is no knowledge of their fair market value, because there is usually a handful of owners, hence no high volume transaction activity in a public stock exchange. It is very difficult to know what their stock price would be due to the absence of demand and offer information.
Valuation Techniques:
Current valuation techniques are:
- Asset based
- Earning based, [and comparison against the industry (multiple-based)]
- Cash flow based
- Asset-based valuation:
Definition
In this method, the value of the company is measured by its net assets value.
Stakeholders’ Perspectives
- Investors or creditors will have some leverage for the money they invest or lend. Investors could be exposed to no risk if the market value of assets equals the price of the company minus its liabilities.
- Founder(s) will not sell the company for anything less than the liquidation value of its assets.
Illustration:
For a business with $150 worth of assets and $50 of liability, investors will be exposed to NO downward risk if they buy the company for $100.
Concerns and Ambiguities
The two following questions should be answered:
- How can one accurately value the intangible assets such as intellectual property or patents?
- Which value (book value, market value, liquidation value or replacement value) would be of mutual consent and fair to both investors and founders for the most truthful assessment of the company?
For example, for a manufacturing business with equipment, plant and land, the fair market value of land could be higher than its book value (initial purchase price) due to appreciation in the price of land, while the market value of plant and equipment could be much less than the book value because of depreciation. Now replacement value would be of interest to the investor, because if they purchase plant and equipment ‘as is’, they will not have to replace them and pay high prices for the new equipment or building a plant.
Notes
This is the main reason why banks or investors would be reluctant to lend to high tech, software or IT companies whose major products and assets are intangible with no inventory or little or no tangible assets to leverage.
Therefore, asset-based valuation could be more apt in manufacturing, real estate, retail or even finance industries, whose assets are mostly tangible.
(The other two methods are explained in part 2 of this article.)