4 Ways to Value Your Startup
One of the pertinent questions an entrepreneur needs to answer is what his business is worth. Business valuation is the process of determining the economic value of the whole company. Calculating the valuation is critical for a startup especially when it comes to raising funds. However, the process of ascertaining the company’s worth is complicated and faulty results can have a bearing on the investors’ decisions.
Regardless of whether you choose to evaluate yourself or have an expert do it for you, knowledge of the basic methods is crucial. Although there are numerous ways to arrive at a valuation, here is a list of the four most commonly used methods.
Market-Based or Market Value Approach
The market-based approach is frequently used to evaluate the appraisal value of a business by comparing it to similar companies that have been sold or are available in the market. The comparison can be made with both public and private companies. This approach makes room for small adjustments in case size and quality vary, to arrive at an appropriate valuation. It also gives an idea of what the market feels is a fair value for such a business.
While finding comparable businesses, entrepreneurs should keep in mind the following points:
- The size of the companies should be similar
- They should be a part of the same industry and selling related products/services
- They should ideally be competitors in the market
- They should have similar financial metrics, i.e., revenue, sales and profit figures
- They should be selling in the same geographical location
The market-based approach is thus a relatively easy way of calculating a business’ worth subject to information being publicly available. However, the biggest challenge is to be able to find an adequate number of companies that you can compare with to get the right value for the business.
Asset-Based Approach
The asset-based approach is concerned with the balance sheet of the company. Under this method, startups can understand the value of their company by subtracting the total liabilities from their total assets. Although it sounds simple, entrepreneurs need to keep a tab on each asset and liability, while having adequate knowledge about their intangible assets, such as technology, patents and copyrights.
A better way to calculate valuation under this approach is to use the net asset method. When assets are recorded in the balance sheet, their values are written relative to that period. The task for an entrepreneur in this method is to calculate the current value of those assets to find their respective fair market values. On the other hand, liabilities are usually recorded at their fair market values, so no further calculations need to be done.
The difference between the fair market value of assets and liabilities is the valuation of the company. The asset-based approach comes with its own set of challenges such as miscalculating the worth of intangibles and disregarding future earnings.
Discounted Cash Flow (DCF)
DCF is one of the most used approaches to calculate the worth of a startup. In simple words, this method tries to figure out the value of a company today based on how much money the company is expected to make in the future.
To find the valuation through DCF, a company must have an account of how much it is going to earn in the present year and the growth it expects in the next 5 to 10 years. After this, an appropriate discount rate needs to be applied. Choosing the correct rate is a tricky task because if you use a lower rate, it means you expect the company to achieve its targets. On the other hand, higher rates may imply high risk and high stakes. The rate of inflation is also taken into consideration in DCF.
For investors, the opportunity is ripe only if the value of DCF is higher than the current cost of investment. This method becomes complicated if many variables need to be considered, and there is uncertainty regarding the discount rate to be applied. Investors are also wary of underestimating or overestimating the risk involved in investing in a company along with changing economic conditions.
Times Revenue Method
This method is used to determine the value of a startup by multiplying the present revenues with an appropriate factor. While deciding the multiplier, multiple factors need to be considered, such as market share, economic environment, team management and size of the business.
Usually, the valuation is derived after multiplying the revenue by a multiple between 1 and 2, but it may be higher in some cases. It also puts a ceiling on the expected income. Since the times revenue method uses actual figures, it is considered a more reliable option, especially for small businesses and startups. One drawback of this method is that it focuses on revenue rather than profit, although the latter is a better indicator of the company’s performance.
To overcome this drawback, the profit multiplier can be used to value the company wherein the present profits are multiplied by a suitable factor. However, it is a good idea to look at the earnings of the past few years so that valuation is not based on a year with abnormal profits.
