Valuation of Start-ups

In his blog, Robert Polthier, Certified Valuation Analyst (CVA) and responsible for the controlling at bmp Ventures, writes about startup assessment:

“Valuation of start-ups is rather an art than a science.”

Valuation in the early stages of a business
When using science and mathematics to evaluate early-stage investments, one quickly reaches reasonable limitations. As a rule, start-ups in the early stages have neither significant revenue nor customers and generate high losses. They do, however, have an idea of how to generate positive cash flows in the future. Now, one could say that there is a (potential) market volume X and a target share of the company in this market of Y and from this it would be possible to calculate an enterprise value. However, the venture is subject to a variety of risks that can lead to the total loss of one’s investment, and which need to be taken into account when ascertaining an enterprise value. This risk is in turn reflected in the expectations of the investor regarding returns and is usually expressed in the calculation in the security markdown and/or the discount rate of future cash flows.

Factors such as management skills, business organization, market potential, unique selling proposition, or competition must first be assessed by the investment manager. This can also be summarized as a “score” in a standardized assessment form. It is then up to the evaluator to include these factors in his or her assessment and express them in "hard" numbers.

Founders, in contrast to investors, want a high valuation, so that not too many shares are "lost". This often creates an area of tension resulting from the overly high expectations of the founders, who count in business plans with numbers that go beyond any reasonable benchmark, and, on the other side, financial investors who want to see the many risks reflected in the valuation and thus have high expected returns.

A commonly used method for evaluating start-ups is the venture capital method. In this method, future expected sales and/or results in the year of the expected exit of the investor are estimated and an enterprise value in the year of the exit is calculated using market multipliers. This is then deducted with the return expectation of the investor. This method is easy to apply, but due to the high uncertainty about the future financial figures in the year of exit and further financing needs (keyword dilution) and because of high value fluctuations due to variation in return expectations, it leads to broad valuation ranges and often overestimates the "true" value in the early stages.

Valuation of more mature businesses
The IPEV (International Private Equity Valuation Guidelines) lay out principles for the valuation of private equity investments and require a strong focus on observable market values. The derivation of the value by means of third-party valuation, that is to say, transactions made by other investors "at arm's length" – in typical market conditions – in this or similar companies, stands at the top of the "valuation hierarchy" as regards the validity of a valuation.

If the company to be evaluated (in the ideal case) already appears to promise positive results, peer group comparisons with companies that are similar (multiplier method) would be suitable. Multipliers can be turnover and/or result indicators, but they can also be key performance indicators such as unique user, paying user, conversion rates, downloads, etc. When comparing with market-listed peers, however, it is essential to calculate a deduction for illiquidity and other factors that reflect the differences with regard to the peer group. Experience shows that this deduction is 30-50%.

In the discounted cash flow method (DCF), projected cash flows are usually discounted over three years or more. The problem is, however, that the smallest changes in the estimation of the figures in the terminal year – the last year of the detail forecast, in which the figures are continued in a perpetual annuity and which usually accounts for approximately 80% of the total value – lead to major changes in the enterprise value. The discount factor should be at least 10% due to the risk characteristics of start-ups.

At bmp, the recommendations of the IPEV were implemented in an internal evaluation guideline. Often, for mature companies, if there is no third-party transaction involved, we use a combination of peer group comparison and DCF, with a greater emphasis on the former. Using DCF alone as a valuation method is not common, but it is often used as a plausibility check for other methods. As long as the initial valuation is still justified (e.g. by plan completion), investments are valued for at least one year after acquisition at acquisition cost.

Business valuation of start-ups in the early stages is determined to a large degree by personal subjective judgment, intuition, and gut feeling. The evaluator should, however, always incorporate a maximum of scientific evaluation methods and thus a quantifiability, so long as this is possible and reasonable. For more established companies, one should follow the IPEV Valuation Guidelines, which provide a suitable framework for the valuation.