Startup valuation

Startup valuation

If every business starts with an idea, young companies can range the spectrum. Some are unformed, at least in a commercial sense, where the owner of the business has an idea that he or she thinks can fill an unfilled need among consumers.

Others have inched a little further up the scale and have converted the idea into a commercial product, albeit with little to show in terms of revenues or earnings. Still others have moved even further down the road to commercial success, and have a market for their product or service, with revenues and the potential, at least, for some profits.

Startup valuationSince young companies tend to be small, they represent only a small part of the overall economy. However, they tend to have a disproportionately large impact on the economy for several reasons.

  1. Employment: While there are few studies that focus just on start-ups, there is evidence that small businesses account for a disproportionate share of new jobs created in the economy. Some estimates are that about two-thirds of the new jobs created in the recent years have been created by small businesses, and that start-ups account for a large share of these new jobs.
  2. Innovation: In the early 1990s, Clayton Christensen, a strategy guru from the Harvard Business School, argued that radical innovation, i.e., innovation that disrupted traditional economic mechanisms, was unlikely to come from established firms, since they have too much to lose from the innovation, but more likely to come from start-up companies that have little to lose. Thus, online retailing was pioneered by a young upstart, Amazon.com, rather than by traditional retailers.
  3. Economic growth: The economies that have grown the fastest in the last few decades have been those that have a high rate of new business formation. Thus, the US was able to generate much more rapid economic growth than Western Europe during the 1990s, primarily as a consequence of the growth of small, new technology companies. Similarly, much of the growth in India has come from smaller, technology companies than it has from established companies.

Characteristics of young companies

As noted above, young companies are diverse, but they share some common characteristics. In this section, we will consider these shared attributes, with an eye on the valuation problems/issues that they create.

  1. No history: At the risk of stating the obvious, young companies have very limited histories. Many of them have only one or two years of data available on operations and financing and some have financials for only a portion of a year, for instance.
  2. Small or no revenues, operating losses: The limited history that is available for young companies is rendered even less useful by the fact that there is little operating detail in them. Revenues are small or non-existent for idea companies and the expenses often are associated with getting the business established, rather than generating revenues. In combination, they result in significant operating losses.
  3. Dependent on private equity: While there are a few exceptions, young businesses are dependent upon equity from private sources, rather than public markets. At the earlier stages, the equity is provided almost entirely by the founder (and friends and family). As the promise of future success increases, and with it the need for more capital, venture capitalists become a source of equity capital, in return for a share of the ownership in the firm.
  4. Many don’t survive: Most young companies don’t survive the test of commercial success and fail. There are several studies that back up this statement, though they vary in the failure rates that they find. A study of 5,196 start-ups in Australia found that the annual failure rate was in excess of 9% and that 64% of the businesses failed in a 10-year period.
  5. Multiple claims on equity: The repeated forays made by young companies to raise equity does expose equity investors, who invested earlier in the process, to the possibility that their value can be reduced by deals offered to subsequent equity investors. To protect their interests, equity investors in young companies often demand and get protection against this eventuality in the form of first claims on cash flows from operations and in liquidation and with control or veto rights, allowing them to have a say in the firm’s actions. As a result, different equity claims in a young company can vary on many dimensions that can affect their value.
  6. Investments are illiquid: Since equity investments in young firms tend to be privately held and in non-standardized units, they are also much more illiquid than investments in their publicly traded counterparts.

Valuation Issues

The fact that young companies have limited histories, are dependent upon equity from private sources and are particularly susceptible to failure all contribute to making them more difficult to value.

Valuation Rules of thumb

  • (Net) Burn rate for the next 18-24 months  >>> Achieve milestones for next round
  • Investors want to have 20-35% of the company to have substantial returns
  • Multiples regarding your industry / your company

Startup valuation

Traditional methods of valuations

(Past : assets) -> not for tech startups

Present : multiple

(Future : Discounted Cash Flow) -> not for early stage startups

Risk Factors Summation

Startup valuation

Revenue multiples

Multiple valuation models use a few metrics like

  • Revenue
  • Growth
  • (EBITDA) -> most of the time negative
  • (P/E ratio) -> most of the time negative
  • (Price book ratio) -> no sense
  • (Dividend Yield) -> most of the time none

Note: Shares of a public companies are more liquid then you will have a discount as a private company => lower valuation

Startup valuation

Sources of investment

Startup valuation

Factors Impacting Valuation/Forecasting method

The steps involved in the process are the following:

  1. Potential market for the product/service: The first step in deriving the revenues for the firm is estimating the total potential market for its products and services. There are two challenges we face at this juncture.

    1. Defining the product/service offered by the firm: If the product or service offered by the firm is defined narrowly, the potential market will be circumscribed by that definition and will be smaller. If we use a broader definition, the market will expand to fit that definition. For example, defining Amazon.com as a book retailer, which is what it was in 1998, would have yielded a total market of less than $ 10 billion in that year, representing total book retailing sales in 1998.

      Categorizing Amazon.com as a general retailer would have yielded a much larger potential market. While that might have been difficult to defend in 1998, it did become more plausible as Amazon expanded its offerings in 1999 and 2000.

    2. Estimating the market size: Having defined the market, we face the challenge of estimating the size of that market. For a product or service that is entering an established market, the best sources of data tend to be trade publications and professional forecasting services.

      Almost every business has a trade group that tracks the operating details of that business; there are almost 7600 trade groups just in the United States, tracking everything from aerospace to telecom.5 In many businesses, there are firms that specialize in collecting information about the businesses for commercial and consulting purposes. For the Gartner Group collects and provides data on different types of information technology business, including software.

    3. Evolution in total market over time: Since we have to forecast revenues into the future, it would be useful to get a sense of how the total market is expected to change or grow over time. This information is usually also usually available from the same sources that provide the numbers for the current market size.

  2. Market Share: Once we have a sense of the overall market size and how it will changeover time, we have to estimate the share of that market that will be captured by the firm being analyzed, both in the long term and in the time periods leading up to steady state. Clearly, these estimates will depend both on the quality of the product or service that is being offered and how well it measures up against the competition.

    A useful exercise in estimation is to list the largest players in the targeted market currently and to visualize where the firm being valued will end up, once it has an established market.

    However, there are two other variables that have to be concurrently considered. One is the capacity of the management of the young company to deliver on its promises; many entrepreneurs have brilliant ideas but do not have the management and business skills to take it to commercial fruition. That is part of the reason that venture capitalists look for entrepreneurs who have had a track record of success in the past.

    The other is the resources that the young company can draw on to get its product/service to the desired market share. Optimistic forecasts for market share have to be coupled with large investments in both capacity and marketing; products usually don’t produce and sell themselves.

  3. Operating expenses/margins: Revenues may be the top line but as investors, but a firm can have value only if it ultimately delivers earnings. Consequently, the next step is estimating the operating expenses associated with the estimated revenues. We are stymied in this process, with young companies, both by the absence of history and the fact that these firms usually have very large operating losses at the time of the estimate. Again, we would separate the estimation process into two parts.

    In the first part, we would focus on estimating the operating margin in steady state, primarily by looking at more established companies in the business. Once we have the target margin, we can then look at how we expect the margin to evolve over time; this “pathway to profitability” can be rockier for some firms than others, with fixed costs and competition playing significant roles in the estimation.

    One final issue that has to be confronted at this stage is the level of detail that we want to build into our forecasts. In other words, should we just estimate the operating margin and profit or should we try to forecast individual operating expense items such as labor, materials, selling and advertising expenses?

    As a general rule, the level of detail should decrease as we become more uncertain about a firm’s future. While this may seem counter intuitive, detail in forecasts leads to better estimates of value, if an only if we bring some information into that detail that otherwise would be missed. An analyst who has a tough time forecasting revenues in year 1 really is in no position to estimate labor or advertising costs in year 5 and should not even try. In valuing young companies, less (detail) is often more (precision).

  4. Investments for growth: When owners are asked for forecasts of revenues and earnings (step 2 and 3), it is natural that they go for optimistic values: revenues increase at exponential rates and margins quickly move towards target values. In any competitive business, though, neither revenue growth nor margin improvement is delivered for free. Consequently, it is critical that we estimate how much the firm is reinvesting to generate the forecasted growth.

    With a manufacturing firm, this will take the firm of investments in additional production capacity and with a technology firm, it will include not only investments in R&D and new patents, but also in human capital (hiring software programmers and researchers). There are two reasons to pay attention to this step in the process. The first is that these investments will require cash outflows and thus affect the final bottom line, which is the cash flow that can be delivered to investors.

    The second, and this is especially so with young firms, this reinvestment will often result in negative cash flows, which will then have to be covered with new capital infusions. Thus, existing equity investors will see their share of the ownership either reduced (when new equity investors come in) or be called upon to make fresh investments to keep the business going.

  5. Compute tax effect: With healthy firms, computing the tax effect is usually a simple exercise of multiplying the expected pre-tax operating income by the tax rate; the only real estimation question we face is what tax rate (marginal or effective) to use. With young firms that are losing money, there are two estimation challenges. The first is that these firms have generally never paid taxes in the past (since they have never generated earnings) and thus have no effective tax rates.

    The second is that the losses that have been made in the past and that you often expect them to make in the near future will create net operating losses that can be carried forward and used to shelter positive earnings in future years. The most direct way of dealing with these losses is to cumulate them as they are expected to occur over time, and keep track of the net operating loss carry forward (NOL).

    In the first few years of positive earnings, we can draw on this NOL and essentially not pay taxes. When the NOL is exhausted, we should move to a marginal tax rate, based on the statutory tax codes; this is a conservative solution, and the alternative is to use the average effective tax rate paid by healthy firms in the sector.

  6. Check for internal consistency: One of the perils of this top down approach is that operating income and reinvestment are estimated separately, and there is the possibility that these numbers are not internally consistent. In other words, we may be reinvesting too little, given our forecasts of expected revenue growth, or too much. One simple test that can be used to check for consistency is to compute an imputed return on capital, based upon the earnings and reinvestment forecasts.

Something else -   Fair value hierarchy

Imputed Return on capital =

Expected Operating Income after tax (t)

Capital Invested in firm (t -1)

The numerator is the forecasted operating income and the denominator is computed as the accumulated total of all reinvestment (net capital expenditures and change in non-cash working capital) over time, through period t-1, added on to the initial capital invested (at the time of the valuation).

Startup valuation

The imputed return on capital, as you approach steady state, can then be compared to both the industry average return on capital (to ensure that you are not making your company an outlier) and to the company’s own steady state cost of capital.

An imputed return on capital well above the industry average and the cost of capital is an indication that the reinvestment forecasted for the firm over the forecast period is insufficient, given the expected earnings. Conversely, an imputed return on capital below the cost of capital would indicate that the reinvestment numbers are too high, given the revenue and earnings forecasts.

Case – Secure Mail Software

This top-down approach will be demonstrated with Secure Mail Software. Secure Mail is a small software company that has developed a new computer virus screening program that it believes will be more effective than existing anti-virus programs. The company is fully owned by its founder and has no debt outstanding.

The firm has been in existence only a year, has offered a beta version of the software for free to online users but has never sold the product (revenues are zero). During its year of existence, the firm incurred $ 15 million in expenses, thus recording an operating loss for the year of the same amount.

1. Total Market: Secure Mail is planning to sell anti-virus software. We used the estimates of total size of the security software market (which includes the anti-virus software) globally, from Gartner in 2008: The table below summarizes their estimate of the market size in 2008 (current year) and their forecasts from 2009 to 2012:

Forecasted Global Market for Security Software (in million US $)

Year

2008

2009

2010

2011

2012

2013

Market growth rate

N/A

5.50%

5.50%

5.50%

5.50%

5.50%

Overall market

10,500

11,078

11,687

12,330

13,008

13,723

Beyond 2012, we estimate a growth rate, in the overall market, of 5% from 2013-2018 and 3% afterwards.

2. Market Share: To estimate the market share, we looked at the largest anti-virus software firms in the market in 2008, in terms of market share. The following table, also from Gartner, lists the five largest firms, with their market share:

Largest Anti-virus Software companies – 2007

Startup valuation

Secure Mail’s software offering measures up well against the competitions, both in terms of features and price. In addition, the management of the company includes the founder who has had experience in other successful software start-ups. Consequently, we estimate that Secure Mail will be able to capture a 10% market share in steady state (expected in ten years).

3. Operating income/margins: To estimate the expected operating margin in ten years, we examined the pre-tax operating margins and after-tax returns on invested capital of the largest publicly traded competitors that operated primarily in the anti-virus business in 2007 in the following table:

Company

Operating margin (Pre-tax)

Return on invested capital (After-tax)

Symantec

13.05%

17.07% Note

McAfee

12.91%

22.80%

Trend Micro

14.50%

17.89%

Note – Symantec had $ 11 billion in goodwill on the balance. We netted out a portion of this goodwill, in computing return on capital.

We assumed that Secure Mail’s pre-tax operating margin would converge to 13%, close to the margins reported by Symantec and McAfee, by 2018. However, the pathway to profitability is likely to be rocky, with margins staying negative for at least 3 years. The following table lists the estimated revenues and operating margins for Secure Mail for the next 10 years.

Expected Revenues, Operating Margins & Earnings – Secure Mail

Startup valuation

4. Taxes: In computing taxes for Secure Mail, we started with the fact that the firm had accumulated net operating losses of $15 million over its lifetime. In the first three years, where we are anticipating operating losses, we added the losses to the net operating loss carry forward (NOL), and then used this NOL to shelter income in year 4 and partially in year 5.

We will use the marginal tax rate for the US of 40% as the tax rate on income thereafter. The following table lists the NOL and taxes paid each year, based upon the 40% tax rate, each year:

NOLs, Taxes and After-tax Operating Income

Year

Pre-tax Operating Income

NOL at start of year

NOL at end of year

Taxable Operating Income

Taxes

After-tax Operating Income

2009

-5.54

15.00

20.54

0.00

0.00

-5.54

2010

-8.77

20.54

29.30

0.00

0.00

-8.77

2011

-3.08

29.30

32.39

0.00

0.00

-3.08

2012

26.02

32.39

6.37

0.00

0.00

26.02

2013

68.62

6.37

0.00

62.24

24.90

43.72

2014

91.64

0.00

0.00

91.64

36.66

54.99

2015

118.62

0.00

0.00

118.62

47.45

71.17

2016

149.97

0.00

0.00

149.97

59.99

89.98

2017

186.15

0.00

0.00

186.15

74.46

111.69

2018

227.69

0.00

0.00

227.69

91.08

136.61

5. Reinvestment: We are assuming that revenues will increase to $1.35 billion in ten years, as Secure Mail expands its market share of this growing market. To estimate how much Secure Mail will need to reinvest to generate this additional revenue, we use the ratio of revenues to capital invested in this sector of 1.95 (based upon revenues and book capital at publicly traded firms in the business) and a one-year lag between reinvestment and growth to estimate the reinvestment in each year. The following table summarizes our estimates:

Estimated Reinvestment by year

Year

Revenues

Change in revenues in next year

Sales/Capital

Reinvestment

2009

55

120

1.95

61.49

2010

175

133

1.95

68.17

2011

308

212

1.95

108.75

2012

520

166

1.95

85.05

2013

686

178

1.95

91.49

2014

865

195

1.95

99.76

2015

1,059

212

1.95

108.62

2016

1,271

230

1.95

118.13

2017

1,501

250

1.95

128.31

2018

1,751

53

1.95

26.95 Note

Note – Revenues in 2019 at $1,804 million are 3% higher than revenues in 2018.

Note that the reinvestment in year 1 is computed based upon the change in revenues from year 1 to year 2, and using the sales to capital ratio of 1.95:

Reinvestment in year 1 = (Revenues Year 2 -/- Revenues Year 1) / Sales to capital ratio =

(175 -/- 55) / 1.95 = 61.49 miljon

The process is repeated for the ensuing periods.

6. Internal consistency check: As a final check on our estimates, we compute the capital invested each year, starting with the initial capital investment of $ 5 million and adding to this amount the reinvestment each year to get to cumulated capital invested at the end of each period. Dividing by the after-tax operating income each year yields the after-tax return on capital in the table below:

Estimated Capital Invested and ROIC

Year

After-tax Operating Income

Reinvestment

Capital invested at start of year

Capital invested at end of year

Return on capital

2009

-5.54

61.49

5.00

66.49

-110.78%

2010

-8.77

68.17

66.49

134.67

-13.18%

2011

-3.08

108.75

134.67

243.42

-2.29%

2012

26.02

85.05

243.42

328.47

10.69%

2013

43.72

91.49

328.47

419.96

13.31%

2014

54.99

99.76

419.96

519.71

13.09%

2015

71.17

108.62

519.71

628.34

13.69%

2016

89.98

118.13

628.34

746.46

14.32%

2017

111.69

128.31

746.46

874.78

14.96%

2018

136.61

26.95

874.78

901.72

15.62%

We computed the return on capital each year, based upon the capital invested at the start of the year. The return on capital in 2018 is 15.62%, below the industry average return on capital reported in the table ‘Pre-tax Profitability Measures – Anti-virus Software Business‘, but close to what we will assume Secure Mail’s return on capital will be in stable growth of 15%.

The end result of these assumptions is the table below, which summarizes the expected cash flows, after taxes and reinvestment needs, to Secure Mail as a business for the next 10 years.

Expected Free Cashflow to the Firm – Secure Mail Software

Year

After-tax Operating Income

Reinvestment

Expected Free Cashflow

2009

-5.54

61.49

-67.03

2010

-8.77

68.17

-76.94

2011

-3.08

108.75

-111.84

2012

26.02

85.05

-59.03

2013

43.72

91.49

-47.77

2014

54.99

99.76

-44.77

2015

71.17

108.62

-37.45

2016

89.98

118.13

-28.15

2017

111.69

128.31

-16.62

2018

136.61

26.95

109.67

Note that earnings become positive well before cash flows do; the latter are weighed down by the reinvestment needs to sustain future growth.

Something else -   4 proper uses of Residual value

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Something else -   Valuation of shares and the enterprise

Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation

Startup valuation Startup valuation Startup valuation  Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation

Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation

Startup valuation Startup valuation Startup valuation  Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation

Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation

Startup valuation Startup valuation Startup valuation  Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation Startup valuation

Leave a comment