Valuing a startup company can create a cornucopia of challenges. Unlike valuations for an established business, a valuation analyst does not have the benefit of analyzing historical performance. Often, a startup company has not yet generated positive cash flow or even revenue.
Specific approaches to valuing a startup company are beyond the scope of this article; however, here are some factors to consider when you are at the starting point of understanding what your startup might be worth:
- Forecasts – Future cash flow expectations are the most critical value driver for any business. While historical cash flow generation provides the best starting point for understanding future cash flow potential, this luxury is largely nonexistent for startup companies. This makes forecast modeling even more critical for understanding the value of a startup. The story supporting the forecasts should reflect thorough research (SWOT, market, industry, competition, etc.) and as much quantitative data as possible, to convince potential investors of its accuracy. Given the uncertainty of a startup’s future, it is beneficial to prepare multiple forecast scenarios based on potential outcomes. Each potential outcome could then be attributed an estimated probability of occurrence.
- Risk/Expected Return – What level of return are the company’s target investors expecting? What will compensate them for the risk associated with an investment in the startup company? Ranges of expected return can vary depending on the type of investment being sought (angel, venture capital, private equity, mezzanine). The range can be wide (~20-100% or more!), so it is important to know where your company stands, and what level of return your potential investors are seeking. The higher the return expected by your investors, the lower the company valuation, and vice versa.
- R&D/Capital Investment – As indicated, estimating forecasts and rates of return for a startup can be very subjective. One starting point to understand a startup’s value with less subjectivity is to analyze the cost of investments already made in the business. Answering some of the questions below can help to establish a basis for what the startup company might be worth.
- How much money was spent on fixed assets?
- How much time have engineers/scientists/marketing put into their research and what is their market rate of compensation?
It is important to be mindful that sunk costs don’t add value. For example, did some engineering time lead to a dead end that required significant rework? Is some equipment no longer useful for the current needs of the business? In addition, considering that future cash flow growth potential could be significant for a startup, historical costs may only provide a floor value for the business.
- Capital Raises – The best indicator of fair market value for a business is an actual ownership transaction. Granted, there are some things to consider before using the transaction to estimate current value:
- Transaction Date – When did the transaction take place? Is it still relevant on the valuation date? An acceptable timeline can be a moving target, depending on the activity of the business. If the business is beating, or missing, growth targets, or the business has fundamentally changed since the transaction date, the transaction price will be less likely to provide a relevant indication of value.
- Parties Involved – Who is involved in the transaction? If the transaction was between existing owners, it might not provide a relevant indication of value since many other factors could be considered in the purchase consideration. When an outside third party is involved, it increases the likelihood of the transaction price reflecting fair market value.
- Security Type – What type of security was issued? The startup company may already have many different types of securities outstanding (e.g., different share classes, warrants, options, etc.) with various owners. It is important to be mindful of the rights attributed to the security issued in the identified transaction and how those rights impact value and fit into the overall capitalization table for the business. Pricing models (e.g., Black-Scholes, Monte Carlo simulation) can be used to extrapolate the value of the transacted security to the implied value of the entire company.
The factors outlined above are important to consider when beginning the valuation exercise for a startup company. Schneider Downs has significant experience providing business valuation services for a wide range of purposes. For more information, please contact Adam Goode (412.697.5411) or Steve Thimons (412.697.5281) of our Business Advisory Group.
About Schneider Downs Emerging Technology Services
Schneider Downs understands the ever-changing landscape and business challenges facing companies focused on emerging technologies and software. Our clients represent a wide range of organizations, from emerging growth companies to large mature companies, and we are well-versed in the unique challenges they face. Our team of seasoned professionals has experience working with emerging technology companies in all phases of their evolution.
To learn more, visit our Emerging Technology page.
