Valuation of startups
In our Insights Robert Polthier, Certified Valuation Analyst (CVA) and responsible for investment controlling at bmp Ventures, talks about the valuation of start-ups: “Valuation of start-ups is rather an art than a science.”
Valuation in early company stages
When valuing early-stage investments using science and maths, you quickly reach the limits of what makes sense. As a rule, early-stage start-ups have neither significant sales nor customers and generate high losses. But they do have an idea of how to generate positive cash flows in the future. Now you could say that there is a (potential) market volume of X and a target share of the company in this market of Y and from this a company value could now be calculated. However, the venture is subject to a variety of risks that can lead to the total loss of the investment and must therefore be considered when calculating the enterprise value. This risk is then reflected in the investor’s return expectation and is usually expressed in the calculation of asafety discount and/or the discount rate for future cash flows.
Factors such as management skills, company organisation, market potential, unique selling proposition or competitive situation must primarily be assessed by the investment manager. This can also be summarised in a standardised assessment sheet to form a “score”. It is then up to the valuator to include these factors in their valuation and express them in “hard” figures.
In contrast to the investor, the founders want a high valuation so that not too many shares are “lost”. This often results in a field of tension between the founders’ far too exaggerated expectations of success, who calculate figures in business plans that go beyond any reasonable benchmark, and, on the other hand, financial investors who want to see the many risks (probability of failure!) reflected in the value and therefore have high return expectations.
A frequently used method for valuing start-ups is the venture capital method. Here, expected future revenues and/or earnings in the year of the investor’s expected exit are estimated and a company value in the year of the exit is calculated using market multiples. This is then discounted with the investor’s expected return. This method is easy to apply, but due to the high level of uncertainty regarding the future financial figures in the year of the exit and the further financing requirements (keyword: dilution) and also due to high fluctuations in value when the expected return varies, it leads to high valuation ranges and often overestimates the “true” value at an early stage.
Remain realistic when assessing the value of your start-up! Valuing always means comparing. Use something comparable in your weight and price class as a benchmark!
A tip for start-ups from Robert Polthier
Valuation of mature companies
The IPEV (International Private Equity Valuation Guidelines) provide basic principles for the valuation of private equity investments and require a strong focus on actual observable market values.
Ideally, if the company to be valued is already earnings-positive, peer group comparisons with similar companies are also possible (multiplier method). Multipliers can be sales and/or earnings, but also key performance indicators such as unique users, paying users, conversion rates, downloads, etc. When comparing with listed peers, however, it is essential to calculate a discount due to illiquidity and other factors that reflect the differences compared to the peer group. Experience shows that this discount is 30-50%.
With the discounted cash flow method (DCF), the projected cash flows are generally discounted over three years or more. The problem, however, is that the smallest changes in the estimated figures in the terminal year – i.e. the last year of the detailed forecast, in which the figures are then continued in perpetuity, and which usually accounts for around 80% of the total value – lead to major changes in the company value. Due to the risky nature of start-ups, the discount factor should be at least 10%, although much higher values are not unusual.
Another valuation method is to derive the value via a third-party valuation, i.e. transactions by other investors “at arm’s length” – i.e. at standard market conditions – in this or similar companies. However, “internal” financing rounds and transactions that took place a long time ago should generally not be considered here.
At bmp, the IPEV recommendations have been implemented in an internal valuation guideline. We often use a combination of peer group comparison and DCF for more mature companies, provided there is no third-party transaction, with a higher weighting of the former. DCF as the sole valuation method tends to be the exception but is often used as a plausibility check for other methods. As long as the initial valuation is still justified (e.g. due to fulfilment of plans), investments are valued at acquisition cost for at least one year after entry.
The company valuation of start-ups in the early phase is determined to a large extent by personal subjective judgement, intuition and gut feeling. However, the valuer should always incorporate a maximum of scientific valuation methods and thus quantifiability as long as this is possible and reasonable. For more established companies, the IPEV Valuation Guidelines should be used as a guide, as they provide a suitable framework for the valuation.
