What is the Company’s Value today?
As a potential investor, when you are offered equity in a Company, you are being offered the rights to own and control an asset or part of an asset and the entitlement to future cash flows generated or derived from that asset. So the question becomes “what asset does the Company have to offer from which you (or someone else) can benefit?” How do we value that asset?
An asset is not an asset unless you can derive a future benefit from it – generally an income stream or be able to sell it for more than the cost to create it. Capital gain or capital appreciation is derived again from the potential for future income stream or, in some cases, use value. The point is asset value, in most cases, means potential to generate a recurring income stream from paying customers. That goes for impact businesses and social ventures as well. If it is impact only and no income stream, then it is not suitable for social venture investment and instead is better suited for philanthropy. If the Company generates a blend of financial and impact returns, it becomes a more complex evaluation of asset value, on which we can discuss some ideas and possible approaches, but there are no universally accepted methods of measurement and valuation.
Different Bases of Valuation
Revenue basis: if the Company was generating revenues
As an investor, evaluate how long into the future those revenues could continue. Your risk is that customers will not return or that the customer pipeline does not get developed. There is risk the team will fail to execute the plan. You would value the Company based on a multiple (or fraction) of the annual revenues. High risk and the multiple would likely be 1x or less (1x meaning, the investor can only rely on 1 year’s worth of revenue to reliably continue). High potential would lift the multiple higher. The potential needs to be backed up by solid evidence and research, having spoken with real, live, potential customers.
User basis: if the Company has a customer base that can be mined
Evaluate what revenues could be generated from this valuable customer base by selling them other stuff or advertising. A lot of tech platforms like Facebook, Instagram, and Pinterest fall into this category. In the olden days (i.e. 1990s!!!), people used to sell mailing lists. I had an audit client that made their business brokering mailing lists. It has value because you have an audience you can sell to. But you would still have to estimate the revenues that could be generated. The only way to get more confident about this is to ensure that the Company “gets out of the building” and ask customers.
Asset basis: the Company has patented or built asset or technology
If a revenue stream is non-existent and not apparent, consider whether revenues can be generated by the Company’s team. If down the road, the Company fails, can you get another team in to turn the asset or technology into a revenue generating asset? There is high uncertainty around this.
You could evaluate the real, hard costs invested in building the patented technology and apply a big discount. Labour time and equivalent salaries may or may not be included (is there evidence of outcomes from that sweat equity? What asset was created from the time spent?) You might be willing to pay some amount of cents on the dollar, but it depends upon your evaluation or perception of the value. If you end up with technology that isn’t producing revenue, you will have to spend more time and money to find a way to make it generate revenue.
Comparable basis: are there any comparable companies?
This can be a challenging approach if there are few comparable companies. How much have other similar businesses at the similar stage been valued at? Or how much is a similar business valued at now and discount it back a number of years.
Discounted projected cashflows basis
This method requires the assessment of and trust in the ability of existing team to execute their plan. It requires knowledge of the potential market and trust that the Company will be able to gain market share. If you are a close friend or associate of the Company or you have inside, specialized knowledge of the market or sector in which the Company operates, you may be able to place confidence in projected cashflows. This is entirely dependent upon your comfort level.
The projected future cashflows must be discounted to today’s value. The discount rate would be in the range of 30% to 60%, maybe higher. The riskier the venture is and greater uncertainty around the projected revenues, the higher the discount rate.
Scorecard: for early-stage companies that have limited revenues and other quantitative metrics
The Scorecard method requires comparable early-stage companies in which investors have invested and on which other investors have ascribed a valuation. To apply this method, you start with a median valuation from a group of recent deals in your locality or investment ecosystem, for a particular industry and region. A series of critical factors for the company that you are valuing are then evaluated and the weighting or importance of each is estimated. The sum of the weightings should equal 100%. If you ascribe a factor of 1.3 to the management team, for example, you are assessing the management team as being 30% stronger than the average team you have experienced. For example:
- 1.30 for a strong management team x weighting 25% = +0.33
- 1.25 for a huge, compelling opportunity x weighting 20% = +0.25
- 1.05 for an adequate prototype x weighting 20% = +0.21
- 1.10 for strong sales and marketing channel x weighting 15% = +0.17
- 1.10 for lack of credible competitors x weighting 10% = +0.11
- 1.10 for good relationships in the supply chain x weighting 5% = +0.06
- 1.00 for connectedness with strategic advisors and other investors x weighting 5% = +0.05
Other factors may feature. The sum of those factors gives you a multiple which you apply to the median valuation. In our example, we arrive at a factor of 1.18x and if the median valuation was $1 million, you could estimate the valuation of the subject company to be $1.18 million.
Other Factors to Consider
As an investor, you are trying to mitigate risk and protect their investment. So if things go wrong and you are at risk of losing your money, what can you do? Can you incentivize the Company’s team to take a different direction? Can you fire the Company’s team and replace them? Can you take control over the asset? Can you sell your share to someone else? Is it worth something to someone else? You may want 50% or 51% of the company, so you have control if things go south. Or you might have a high degree of trust in the team and therefore happy with less than 50%.
If the amount of the investment is a lot to you and the venture is high risk, you might want more control in the form of an influencing shareholding or at least triggers where you can step in and guide decisions and the direction of the business. Where a founder retains control, like in the case of Facebook, the founder is inextricably linked to the business. There is an implication that Facebook doesn’t exist without Mark Zuckerberg and all investors accepted that. But they were convinced enough by the rate of users signing up that there was an asset to be mined.
Keep an open dialogue with the start-up company’s team and find out what their valuation expectations are. A final, agreed upon valuation number won’t be reached until after due diligence, but it is useful to gauge where expectations lie.
Additional resources on valuation are available at MaRS.
This is the first of a 2-part series on Valuing a Start-Up Company. The second part contemplates valuation of a blended-value start-up, in other words a company that has a social mission embedded in their business model, aims to deliver positive social impact or change, or tracks itself based on a triple bottom line.
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