Valuation - Valuing Early Stage Companies

The question of startup valuation is at the forefront of both investors' and business owners’ minds, and can be a difficult and imperfect science. Revenue projections are difficult to obtain, and without precise tools by which to measure them, it’s difficult to furnish a stable financial forecast. Valuing early stage companies, however, is such a common task for many that there are more foundations on which to base an accurate forecast, without the obvious distraction of personal bias playing too large a role in the calculation.

The relative science of early stage valuation is becoming clearer.  First, it must be acknowledged that the biggest factor determining value is the market forces at play – the industry, and sector, in which the company is operating. The tools out there to assess early stage companies – such as discounted cash flow, the First Chicago Method, Market & Transaction comparables, and asset-based valuations – should be considered in conjunction with this key point. The difficulty with measurements such as DCF is that they require financial histories for the assessment – for early stage companies this may not be possible.  Instead, there are simple calculations that are used – such as a basic valuation calculation.  It’s important to understand the basic valuation calculation will depend on whether the company in question is (this blogpost is an effective summary of the maths).

For the bulk of investors who are looking at the broader market picture, this has a huge bearing on their investment. For example, a startup, no matter how innovative, that is operating within a depressed market, will attract a correspondingly low valuation, as it’s difficult to increase equity without prior knowledge of a forthcoming market or paradigm shift.  The assessment is based on the state of the industry today, not at any future time.

The investor must, apart from this, look at the likely maximum value of the company upon exit. This demands a mixture of both instinctual and qualitative assessment. The sector, the management team, the functioning product, and traction, are all signs that will be used. By contrast with companies operating in depressed sectors, those in a “hot” market may attract higher valuation, especially as there may be more evidence of successful exits – investors frequently look to these as a gauge. This is then assessed in conjunction with the company’s stage of development – demonstrating a high growth rate, establishing good unit economics, and beating the industry average will be positive factors.

Angel Bill Payne, founder of four angel groups, and instructor of angel-investment courses, has stated “it really is an art…. There is no perfect methodology to establish the pre-money valuation of pre-revenue ventures, making it even more important for investors and entrepreneurs to know how the number is derived”.  Remember to keep all these valuation trends in mind, and not to favour a single factor – the market or the team – in isolation, only by considering them in conjunction, and by consulting experts of the sector in which the company operates, will you come close to an accurate financial forecast.

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