Startup Valuation: It's not what you think.

Get ready to trash a lot of things you've heard about start-up valuation in bits and pieces. Or read no further.

The sun rises in the west, man is immortal and pre-revenue start-ups can be valued precisely.

All of the above are universal truths. Except they aren't.

There has always been and always will be controversy around the valuation of startups. Some say that DCF valuation has no place in startup valuation and only multiple valuations should be used.

But it is extremely difficult to explain to even the most experienced professionals that even a market-based approach or "multiples valuation" is nothing but short-hand for DCF valuation.

Why is the market pricing certain companies at certain multiples?

Because they expect those companies' sales and EBITA to grow at a certain rate (higher or lower than others) and because they expect free cash returned to them as a result.

Everything is tied to cash.

This is exactly why both approaches fail when we try to value a pre-revenue start-up.

This is because we have no quantitative historical information to assess and evaluate. All we have is qualitative information or quantitative research which is not a precise science and can have a range of optimistic and pessimistic interpretations.

Startups?

Before we talk more about startup valuation, let's first have a look at what makes startups different.

A startup cannot be clearly defined in terms of age. Businesses usually cease to be viewed as startups after 3-5 years of commencement of operations. However, this does not mean that all businesses within 0-2 years of commencement are startups.?Surprised?

Jan Koum, the co-founder of $19 billion WhatsApp says, “A startup is a feeling”.

Let me press on this point a little harder. How do you value a feeling? Are you even supposed to value it?

Technically, startups are new businesses that have a rapid growth potential either due to a promising product idea or a disruptive business model. These species of entities usually need sizeable funding to develop/fine-tune its offering and get off the ground. These usually have an egalitarian work culture and are dynamic and rapidly changing.

Risks and returns are both higher than traditional businesses.

So, what really binds together all of the usual characteristics on a startup is really feeling. How the promoters feel, how the investors feel, and how the employees feel. It's all different from traditional businesses.

Pre Revenue Startup Valuation

How do you examine a child that is not born?

But let’s get back to the real world and the real problem! Many a time the promotors may have a great prototype but no revenue at the initial stages.?And when they are seeking investors to fund their development or launch, they may have a hard communicating their business’s value to those investors.

DCF really?

Discounted Cash flow models are not very relevant when valuing a pre-revenue startup as none of the detailed assumptions matter if the market participants do not receive the idea or solution as well as expected or if the promotors or management team fails to execute the plan.

So let's discuss an insightful yet a simpler approach of valuation for startups.

If you are a business looking to pitch your idea to investors, the following discussion would hopefully give you an insight into the investor's mindset and better introspects as entrepreneurs on what exactly are you putting on the table.

If you are an investor, here is what to assess when deciding whether the startup is worth the investment. We must disclaim, however, that any approach for valuing a startup would be based on judgments and the investors need to develop an eye for the opportunity.

Wrapping our heads around the Berkus Method

Named after its inventor, Dave Berkus, a well-known Californian angel investor, Berkus method attempts to value a startup based on the key factors?necessary to make the startup a success.

The approach is simple but rigid. It caps the maximum value of a pre-sales startup to $2 million, while the maximum possible value of a startup earning revenue has a cap of $2.5 million. There is no minimum possible value under the approach.

Although these maximum value thresholds represent what the angel investors and Venture capitalists have been valuing most promising start ups at, we recommend the value should still consider the market size and competitiveness.

So here is how it works: the original approach splits the value in 5 equal parts or components, whereby each component of value corresponds to a significant success factor.

-??Valuable business model (base value)

-??Available prototype (reducing technology risks)

-??Abilities of the founding or management team (reducing implementation risks)

-??Strategic Relationships (reducing market risks)

-??Existing customers or first sales (reducing production risks)

The maximum value that can be associated which each of the above factors is $500,000.

Give me a proper example, please.

For example, consider the above five factors in the context of a fictional e-commerce startup called **“Taizz”**

Business Model

This business has a disruptive business model which is visibly fool proof. Based on the strong potential of future growth expected from the business model itself, a high value of say $490,000 may be associated with it under the Berkus approach.

Prototype

On the other hand, if the prototype is still not ready, a very low value of $20,000 may be added to it. Such low value represents the fact that there are excessive technological risks associated with the completion of the prototype. Additional research and development may be incurred if the design does not work as anticipated.

Team

If our founders or management team is a serial entrepreneur and has a proven track record of success, the third factor may be assigned a value of $410,000. The higher value of this component almost compensates?a lower value assigned to the previous component. This about it, if Elon musk is raising fund for a new company that will sell an automatic hairstyling hat that you only need to wear for three minutes every day before you leave for the office.?How worried would you be if the prototype isn’t still ready? Hardly at all. You know that Elon Must and his team has the knowledge and ability to resolve any design issues.

Strategic Relationships

If our startup has some signed MOUs and some industry relationships the forth factor may be assigned a value of $250,000.?If your promotors have succeeded in tech businesses in the past and are now planning to start a handmade leather shoe which expands as your feet swell by the end of the day, they may have a hard time finding the best leather shoe makers, best trainers, best management and suppliers.

First Sales

Finally, as the prototype is not ready, the fifth factor which is existing customers would usually be valued at $0.

Conclusion

In total, our hypothetical start-up would be valued at $1.17 million, which is simply the sum of values assigned to each of the 5 factors. This particular startup is valued at $ 1.17 million because it has a strong team to back it up, a solid business model, and reasonable standing in terms of strategic relationships.

My Analysis

Is Berkus's approach superior to Discounted Cash flow Models for startups?

The Berkus method may be preferred over the Discounted Cash Flow model by many investors because it shifts all the focus on factors that are more relevant to the success of the startup rather than assumption made with or without significant consideration to those factors.

One key recommendation we have is to reassess the final value to see if it makes sense in the light of actual sales revenue and margins you expect from such business. And of course how like are the expected results!

No matter what peole tell you in sophisticated language. At the end of the day it is all tied to the business capacity to generate cash.

Put your sleeves in the investor's shoes and you will feel it in your gut

What you would think when giving a million dollars to someone...Would the team be able to pull it off? Would the economic conditions and competition allow it? Is it technologically realistic? Do customers really need the solution in the prices required to be set to achieve our target margins? Is there an unattended market segment whose needs have been ignored? What is the size of the addressable market?

In the end, it all boils down to common sense, your understanding of the market, opportunity, technology and other factors.

Caution

However, my primary criticism on this way of valuing the business is that it does not consider any dependencies. As in our example the prototype still needs significant development. And if the technology required to develop the porotype is not yet available the entire business would collapse.?Therefore, In our view, it is not always wise to view the value of an entity into compartments. For this you should look into "risk-adjusted NPV method"

The second piece of criticism I have of the approach is that it is rigid. There may be several startups whose market size would dictate that their maximum value is lower than $2.5 million. Or in the case of an new Elon Musk’s startup, it would be way higher.

Recommendation

I strongly recommend that any assessment of business value must use more than one approach and should be cognizant of the market and economic conditions at the time of valuation. Whenever you apply a simple approach to value a startup, make sure you consult an expert. Take risks, but measured.

Let me know if you would like more corporate finance insights in this newsletter.

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