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Startups Valuation: Techniques and Stakeholders’ Perspectives (Part 2 of 2)

  1. Earnings-based valuation

Definition

In this method, the price of the company is assessed as the economic value that the entity generates, regardless of the amount of its assets.

With this technique, the earnings will be multiplied by industry’s average price to earnings ratio to estimate the total value of the company. Industry average price to earnings ratio shows the price that investors are willing to pay in average for shares relative to the income that is generated by companies in that industry. Therefore, multiplying company’s earnings by this average ratio could be an acceptable method to evaluate the business.

Stakeholders’ Perspective

  1. Investors are willing to receive specific amount of return on their investment over time. So, investors may use this method to know how much the value of the company will be, compare it against their required return on investment, and determine their ownership percentage for their investment.

Illustration:

If earnings are projected to be $10,000 in year 5 and price to earnings multiple is 10, the company is worth $100,000 in 5 years. An investor who is investing $20,000 today and expects10% over the period of 5 years will therefore require [20,000*(1+10%) ^5] or $32,210.20 in the end of year 5. Investors will then need to invest by 20,000 for 32% of the business.

Concerns and Ambiguities

Three questions need to be answered:

  1. a) Earnings of which duration should be used (past or future, or both)? With current management, or under a new management / strategic direction?
  2. b) How to determine the effect of accounting practices and assumptions on the earnings?
  3. c) Which earning (before or after) taxes and interests to be used.

Similar to asset-based evaluation, there is no definite answer to any of the abovementioned questions.

As first step, historical earnings may be used. There will, however, be three matters to consider. First) it should be noted that past performances may not be a truthful indication of future returns (or losses). Nonetheless, past earnings can be used as a guideline and data point. To use future earnings, income and expenses need to be examined, their trends (year over year or percentage of income) may be determined, and projected to calculate the future earnings. Second) accounting practices may affect earnings to a great extent, especially for private companies that may not follow financial reporting standards and disclosures mandatory for public entities.  Third) the impact of one-time or non-recurring accounting events (such as losses of operation as a result of an earthquake or fire, or costs of reorganization or lawsuit settlement) should be determined and isolated.  And finally) either EBIT (earnings before interest and taxes) or final net earnings can be used for calculation. But it should be noted that the right multiplier is to be used. If valuation will be based on EBIT, then the price to EBIT multiplier should be used to determine the price, and if valuation is based on earnings, then price to earnings multiplier should be the benchmark. However, to study the earnings before financing costs (interests of loans), EBIT would be preferred to investors. It is because they can isolate the earnings, as an indicator of how business performs, from effects of financing (interest) and taxation.

Notes:

Earnings-based evaluation would be more appropriate than asset-based evaluation for high-tech or IT companies with substantial intangible assets and products. However, considering that accounting practices and assumptions may have significant impact on the amount of historical earnings, this method should be used with extra care and expertise. In addition, past trends may not continue in the future, especially in a turnaround scenario, when investors plan to change the management team and company’s strategic direction.

3- Cash Flow-based valuation

Definition

In this method, valuation is based on the net present value of future cash flow regardless of company’s earnings or assets.  Cash-based appraisal would be more preferred than earning-based assessment, especially in turnaround cases when investors plan to change the strategic direction and the management team. In addition, cash flow is less prone to wild swings due to changes in accounting practices.

Stakeholders’ Perspective

  1. Similar to earnings-based approach, in this method investors can determine the ownership percentage for their investment by deciding their desired return on investment and benchmarking it against the net present value of forecasted cash flow to reach at their ownership percentage.
  2. This method is especially useful to the entrepreneurs. Regardless of the earnings, they can calculate the projected (direct and indirect) cash flow. Cash flows include
  3. I) Reduction in cash outflow: business-related expenses are tax-free, and would have been taxed otherwise. Therefore, reduced amount of tax, will have an upward impact on the amount of cash to the entrepreneur. (Details of tax benefits to entrepreneurs is out of the scope of this article).
  4. II) Increase in cash inflow: entrepreneurs may collect salary and/or dividends.

III) Capital gain/ Return of capital: which will materialize in an IPO exit, or else when the business is acquired.

Founders will then be able to manage their expectations on how much salary and/or dividend they would like to collect in the end. Like investors, founders may determine how much return they would be willing to have on their investment, which includes their time as well as money.

Illustration:

Mrs. E decides to start a business with prospects to sell it at the end of year 5.

She can now expense her car lease, fuel, and a part of her mortgage and hydro bills on her business, because she has a home office and uses her car for marketing and meetings. Business-related expenses amount to $10,000, and tax on those expenses amounts to $2,500 (assuming 25% of tax), which she shouldn’t pay because they are now expensed on her business. Now she has $2,500 more in her pocket.

IF she expects to receive salaries, she will need to generate earnings through either financing her business (bank loan or investors), through operations (providing services or products), or through investment (purchasing a real estate, land or other assets). Salaries will increase her cash inflow.

In the end of year 5, she may generate income through selling her business, or an IPO exit. This will also increase her cash inflow.

Mrs. E may calculate the net present value of the cash flows to decide how many hours she is willing to spend on the new business, and whether she is willing to invest in the business. But the most important decision would be, whether she is willing to start the business, or prefers to remain employed. Also, if she plans to start the business, what strategic direction she should take to be able to sell the business in the end of year 5.

 

Please note that the above-mentioned example is extremely simplified is merely for further clarification of the three streams of cash flow, and how an entrepreneur may use this approach to assess his risk tolerance. Further details are out of the scope of this article.

Conclusion:

Evaluating a business is not a simple task. Information is not readily available, many assumptions are made, and different perspectives and methods may be used to make an educated guess. However, even the best estimates based on all available information and reasonable assumptions is not reliable enough in many cases.

However, a clear understanding of different techniques, what each means, how the calculations are conducted, and how different stakeholders should use each number as a guideline would definitely help entrepreneurs to a great extent.

Entrepreneurs who understand prospect buyers and investors’ perspectives, will have a more realistic view of the value of their company and will be better prepared to negotiate for a deal that is fair to them and of value to the investors or new partners. In addition, with this knowledge, founders will be able to evaluate the financial returns of their startup and therefore manage their expectations and devise a more efficient and effective operation and strategic plan.

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Startups Valuation: Techniques and Stakeholders’ Perspectives (Part 1 of 2)

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,

    • 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

 

  1. Asset-based valuation:

Definition

In this method, the value of the company is measured by its net assets value.

Stakeholders’ Perspectives

  1. 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.
  2. 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:

  1. How can one accurately value the intangible assets such as intellectual property or patents?
  2. 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.)

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Startups Definition, phases and financing stages (part 2 of 2)

Startups are dynamic and have different development stages with different characteristics and requirements.

A.

First, an opportunity is identified, followed by the clear definition of the value proposition. It is equally important to determine the target market(s). Offering a solution for a market which is poised to grow is the best strategy. Never target a stagnant or shrinking market; and try to avoid markets with low profit margins. (This merits a detailed discussion, which is out of the scope of this article.)

Once this is determined you are past the first stage: ideation.

By the end of this stage the core idea exists to start forming a business plan (alternatively business map canvas) and marketing map.

B.

Second, milestones should be defined, as well as the ultimate vision of the startup. In other words, the previous step identified the land to be conquered, and this second step devises the plan and milestones to conquer the land. If you are going in a partnership to conquer this new land, your first and major step would be to clarify what each partner will gain if there are victories in the future. It is even more important to make sure your fair share of the land will be secured for you. Procurement strategy is also important in this phase. Similar to a war, you need to have a truthful definition of the required human and financial resources, you need to know how long it takes to capture and claim the land and the benefits that will materialize. I would also recommend you should think about a  surrender strategy. It is important to know when and how to retreat if risks materialize and cannot be mitigated.

At this point, you are past the second stage: Conception.

By the end of this stage, startup has a strategy. The business plan or the business map canvas are clearer. The four major elements, opportunity, people, context and deal are already thought of, and the first draft of the business plan can be prepared. (Further discussion about a business plan or business map canvas is out of the scope of this article). Partnership agreements as well as an article of association can be drafted out. These drafts may change and may be totally different as further discussions, research and investigation are conducted.

It should be noted that from financing perspective, the company is at seed stage at this point. Financing may be provided to entrepreneurs for the further research, assessment and initial development before actual implementation or even forming the startup.

C.

In third step, implementation begins. More than often, this step overlaps with steps two, and even one. It is difficult to find funders at this stage; even though financial resources are very important already.

People and contributors should  commit, and implementation starts. Finances need to be procured in one way or another to make a progress.

This is the third stage of a startup: commitment

By the end of this stage, the final partnership agreement and shareholder agreements are available. The most dedicated founders and teams will have an initial prototype or demo by the end of this phase.

From financing perspective, you are at startup stage, and busy with initial marketing research and the early development of the product.

Up to this stage, major investments are provided by founders themselves, angel investors, or the three f’s, families, friends and fools.

D.

This is when the market fit and product fit are being validated for the first time. Multiple rounds of validation and iteration and product refinement will be conducted. Initial approach to a small friendly market with the pilot product/service is usually the first step. Often, KPI (key performance indicators) are defined in the beginning or during this stage, and compared against targets as iterations continue.

This is the validation phase.

By the end of this stage, the startup has a decent product to offer to a well-defined market, and might have started generating revenue. Many startups never reach this stage, and many others realize that their product was not the right fit for the market.

From financing perspective, this is the early stage. At this stage the startup has completed product development and is ready (and requires capital) to commercialize its product in the next stage. Investments usually come from venture capitals, and in some cases from strategic alliances, mergers or acquisitions.

E.

Commercialization starts at this point. Startup is now past the initial product development and marketing activities, and is ready for growth. Company may stay at this stage for a long time, depending on the nature of the product, its target market, motives and skills of the founders, motives and priorities of investors, and prospective buyers.

This is the scaling phase.

By the end of this phase, a company is not a startup anymore. Revenue, number of customers as well as the team is expected to grow in this phase. Company may reach the breakeven point or even become profitable. Many startups never get to this stage and similar to the validation phase, many ventures fail at this stage.

From financing perspective, the company is in expansion. Financing is required for the faster growth of the company, and is vital to the survival and successful transitioning of the startup to the next phase. Multiple rounds of funding with the same or different investors may happen during this phase. More often venture capitals and investors provide the funding in multiple rounds to limit their risk. Details of preferences and considerations of investors and venture capitals are beyond the scope of the present article.

F.

Congratulations to all startups who are past all previous challenging phases. The company, however, is in growth and transitioning phase, which has its own characteristics and challenges.

This is the establishing stage. Attracting resources and investors is easier now, as the company has a decent and established product and a group of customers. It is important for the company to remain loyal to their vision and mission. But it is equally important to review and revise it if required for their further growth and the growth strategy of the company. New processes should be defined and adopted, even if the management team is determined to maintain and encourage the startup and entrepreneurial culture and spirit despite growth.

From financing perspective, this is bridge financing.   

At this stage a company may attract many more private and public investors (IPO), or major investors and buyers (Acquisitions/Mergers/Partnerships/Joint Ventures). Decision on how to proceed to the next level depends on many different factors, including the nature of the product, industry, economical environment, rivalry environment, motives of the initial investors, deals and contracts with venture capitals, motives and skills of the board members and the management team, etc.

 

Conclusion:

Startups are exciting, dynamic and eventful. Opportunities emerge. Visions shape. Startups are born and founders put not just their hopes, but their lives in them. Some survive, others sink, and many new ones surface. Being forward-looking, focused, and determined are the main elements of success, or as my two favourite quotes summarize it:

“I skate to where the puck is going to be, not where it has been.”  –Wayne Gretzy, Hockey Star

“If you’re going through hell, keep going.”  –Winston Churchill, British Prime Minister

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Startups Definition, phases and financing stages (part 1 of 2)

 

Many definitions are offered for a startup business by the most renown business people and researchers. I like many of those definitions but I, personally and for the purpose of this article, would like to define a startup in very simple terms, as an entity which is recently formed, to grasp a perceived -but yet to be proved- opportunity, with the hope of future growth.  

I, intentionally, try to avoid limiting the definition to the fancy world of technology and IT ventures in Bay Area and Silicon Valley, but expand the term to include all industries. It should however be noted that mature business models that have been tried many times do not qualify as startups, but as micro or small businesses. Their risks, rewards, market and product fit are known already, and their success, financing challenges, capital structures, development phases and exit strategies depend on factors that are different with those of startups.

Some elements are common among all startups, regardless of their product, purpose and location:

  1. They are newly formed; usually within the past three to five years.
  2. They are risky; the future of the company is uncertain, and the market and/or the product fit is to be tested and proven.
  3. Often, they are not profitable. Technically, a startup can be profitable. But in reality, as soon as a business generates profits, it begins its journey towards a more stable and secure standing which doesn’t fit the startup category.
  4. An opportunity is identified and addressed. Usually if an entrepreneur can not explain the opportunity (value-proposition of their solution) in 30 seconds in very understandable, meaningful and definitive terms, startup is less likely to be on the right track.
  5. Startups have less than 100 employees, and very often even less than a handful. Board members do not exceed five people, and up to a certain stage, there is no revenue. But of course revenue may even reach to as high as $100 million in the luckiest and most successful cases!

A careful review of the definition of a startup and the common characteristics of all startups shows that the following matters are critical and should be determined and well thought of in advance. The first and foremost, a startup should have a clear definition of the opportunity and the value proposition of the solution. Second, the target market should be well-defined. Third, required resources should be identified. That includes both human and financial resources. Fourth the expected return on investment, and the timeline for the return should be determined. Fifth the external risks and threats on which the startup will have little or no control or influence, should be identified. Sixth is the exit strategy; whether the founder(s team) is planning to grow the business organically, arrange an IPO offering,or sell it to a prospect buyer.

When the founder(s) bring all these information on paper, two documents as well as some ideas will emerge:

-a business plan (or alternatively, a business map canvas),

-an article of association, as well as

-thoughts and ideas of who and how to approach to fund the startup.