Startup Valuation and Due Diligence
Startup Valuation and Due Diligence reliably estimates the Fair Value of a Startup and Spin-off
Investors and entrepreneurs have to agree on a valuation whenever an investment round takes place. In theory, the startup valuation appropriately incorporates the return potential and the risk of the venture resulting in a fair price. In practice, however, founders as well as venture capitalists encounter several challenges to objectively quantify the value of a startup. This is particularly the case because the valuation process takes into account quantitative data as well as several qualitative characteristics. Assessing these factors is as demanding as determining their impact on the valuation. But there is a way to reliably set the price of a startup and significantly reduce mispricing and investment risks. A good starting point for negotiations between startups and investors.
Apply a Multi-Valuation-Approach to reduce Mispricing and Investment Risk
Each valuation approach requires a different set of assumptions to calculate the value of a business. We can therefore apply and compare the results of valuation methods where the set of assumptions is largely independent from each other and can be reliably estimated. If the calculated valuations fall within an acceptable range of variation, then we can safely say that the price estimate for the evaluated startup and spin-off is sound and reliable.
The four valuation approaches generally accepted by venture capitalists and business angels are the following.
- Discounted Cash Flow (e.g. Venture Capital and Chicago Method)
- Market Approach (e.g. Market Multiples and Comparable Transaction)
- Scorecard (e.g. Payne and Berkus)
- Cost-to-Duplicate (e.g. Replacement Value)
We directly demonstrate how the multi-valuation approach works with the company, market and financial data provided in the table below.
1) Application of the Discounted Cash Flow Approach
The discounted cash flow method calculates the value of a company based on its ability to generate cash in the future. The reliability therefore heavily depends on the accuracy of the financial forecast. Based on the information provided in the table above, we constructed the following financial forecast and discounted cash flow valuation.
In the financial forecast we first projected the revenue and the annual growth rate with the financial data provided in our example. Bottom-up and top-down we reflected the gross margin, average profitability observed in the industry respectively, to estimate the yearly expenses such as cost of goods sold, management, research & development, marketing & sales and general & administration. Further, we considered the applicable tax rate for the company's location and simulated a working capital in accordance with the startup's industry and business model. It allowed us to calculate the annual burn rate of the startup represented by the free cash flow in the financial forecast. For the valuation we determined a discount rate that reflects market and company-specific risks related to the stage of the venture, product development and market risk. After applying an industry-specific exit-multiple, we received a pre-money valuation of USD 2.8 million.
Let us now take a look at the set of assumptions and our assessment of their reliability.
The discounted cash flow approach requires us to make several assumptions of which at least half of them we could estimate reliably. This circumstance was supported by the fact that the startup generates revenue and seems to be able to predict its short-term future revenue growth. Uncertainty remains with regard to long-term revenue growth, operating expenses and working capital employed, as a lack of historical performance data forced us to base our assumptions only on industry benchmarks. All other assumptions such as the tax rate, exit multiple and discount rate, together with external resources, could have been reliably estimated.
The company and market information provided in our example enabled us to construct a fairly reliable financial forecast and therefore valuation with the discounted cash flow approach.
2) Application of the Market Approach
The market approach is a relative valuation technique that compares the price of similar companies to the one being assessed. Two different methods exist.
- Comparable transactions
- Market multiples
The comparable transaction method considers the valuation of startups and spin-offs that are similar related to industry, founding year, stage, size, market potential and team quality. The market multiples model considers the same characteristics but additionally relates them to the performance of the assessed startup with valuation ratios such as EV/R, EV/EBITDA, EV/EBIT and EV/users.
Let's have a look how the market approach works in our example.
The table lists five startups and spin-offs that are similar to our example. We have calculated the median for the pre-money valuation and the valuation ratios in each case. After applying the appropriate multipliers for the comparable transaction and market multiple approach, we obtain a pre-money valuation between USD 2.6 million and USD 3.0 million. The EV/EBITDA multiple is not applicable as it is negative.
The set of assumptions is indicated below.
The set of assumptions for the market approach is restricted to finding similar startups related to the attributes industry, founding year, stage, company size, market potential and quality of team as listed in the table above. In our example we identified five similar startups with corresponding valuation data and ratios. In such a scenario the market approach results in a fair and mostly unbiased valuation.
3) Application of the Scorecard Approach with the Berkus Model
The Berkus method compares five characteristics of a startup with recently angel-funded ventures in the same geographical area. The five characteristics consist of four risk factors and a basic value for the business idea as listed below.
Basic value for idea
In the original form, the value for each factor was restricted to USD 0.5m. In more recent publications, however, the author himself, Dave Berkus, points out that the risk factors can be changed as well as the maximum amount per element to better reflect circumstances in regional markets and industry-specific risks.
See the following table for an illustration with our example.
Taking the same similar companies from the market approach above, we have to estimate the value that each element contributes to the overall valuation. We can then relate it to the startup that we are evaluating, and finally estimate the fair value with the Berkus method. In our case that would be USD 2.0 million.
Let's take a look at the set of assumptions we had to make and what is our opinion concerning their reliability.
The Berkus method requires us to estimate the company-specific risks as well as the value of the business idea of recently funded startups in the same geographical area. In our opinion, it can be hard to objectively assess the inherent technological risks as well as market risks of other companies without any special expertise or insider information. The same goes for execution and production risk as we have no detailed information. The applicability of the Berkus method can be questioned in our example.
4) Application of the Cost to Duplicate Approach
The cost to duplicate method estimates the financial amount needed to recreate the startup and spin-off under assessment. The method estimates the time as well as the human and the capital resources required to rebuild the assets. The cost to duplicate method is particularly suitable for strategic investors when deciding on make or buy a new product or service line.
Let us have a look how the cost to duplicate method works for our example.
Based on the founding year and company size in our example, we estimate that it takes two years to duplicate the startup under assessment. The required resources involve a project manager, thee software engineers and one UX/UI designer over the specified periods. Additional capital resources are needed for software licenses, hardware and marketing & sales efforts to acquire the first customers. The cost to duplicate the startup is USD 1.3 million in our example.
The set of assumptions looks as follows.
The cost to duplicate makes assumptions about the amount of human and capital resources required to rebuild the assets of a startup. In our example we can reliably forecast the capital resources, but the amount of human resources is more uncertain because we lack the information about whether a special expertise is hard to acquire in the market.
The multi-valuation-approach reduces price and investment risk by applying valuation methods with sets of assumptions independent from each other. This way we can estimate a fair and reliable value for a startup and spin-off that constitutes a strong basis for price negotiations between investors and founders.
The results of the four valuation approaches from our example are summarized in the table below in descending order of reliability for illustrative purposes.
Price for Startup Valuation & Due Diligence
Estimating the fair Startup Valuation is equally relevant to Founders and Investors
- Mutual agreement on a fair valuation balances ambitions and expectations between an entrepreneur and an investor (Clercq et al. 2006)
- Founders and venture capitalist share ownership and decision-making power in proportion to the value they bring to the table (Tarek Miloud, Arild Aspelund and Mathiew Cabrol, 2012, p. 152)
- A fair price reduces the potential of future conflicts between founders and venture capitalists (Zacharakis, Erikson and Bradly 2010, p. 152)
Startup Valuation is one of the most Challenging tasks faced by Entrepreneurs and Venture Capitalists
- The application of commonly used valuation techniques such as Discounted Cash Flow and Market Multiples leads to large price variations for the same venture
- Investors and entrepreneurs have to consider many qualitative factors in the valuation process such as market attractivity, quality of the team, value of strategic relationships as well as product development stage and risk
- Both the reliability and credibility of several valuation methods are rather limited for early-stage startups, especially when they are in the seed stage and pre-revenue