The quantitative and qualitative approaches that help value startups and early-stage businesses
When it comes to making investment decisions it can be a difficult and overwhelming task to choose which businesses to back. Compared to mature, established businesses, startups and early-stage businesses are difficult to value due to their limited track-record and often unproved model.
We have put together a guide to give you the tools to determine whether an investment is fundamentally good, and whether the price you are paying is fair.
Pre-Money And Post-Money Valuation
The first step to take if you want to invest in startups is to understand the concepts of pre-money and post-money valuation:
- Pre-money: is the value of the company at the beginning of the investment round, before any additional funds have been added.
- Post-money: is the value of the startup after receiving financing. The value is the sum of the pre-money valuation and the amount of new equity.
For example, if a company is valued at $600,000 pre-money and receives an additional $600,000 of funding during the first round, its post-money valuation is $1,200,000. Moreover, it’s necessary to keep in mind the different stages of a startup lifecycle, as each startup stage means a different valuation:
- The Idea Stage: at this point a lot of excitement surrounds the innovative project and usually family members and friends invest in it.
- The Early Stage: investments at this stage are called seed investments and funding typically ranges from $250,000 to $1 million from Angel investors, if the startup has credential and a good business plan and financial model. Otherwise on the startup might rely on friends and family members.
- Funding/Rollout Stage: usually called “A-round” with funding amounts of roughly $1-$10 million. It’s the right stage for venture capital professional investors and Angels. The startup should be selling a commercial offering, have price and cost validation and show consistent customer sales and a real revenue stream.
- Growth Stage: additional funding rounds are usually called “B-round” and “C-round”. Venture Capital investors are the usual investors and investments can range from $5 million to more than $50 million. At this stage companies must have a large market, good traction and high revenue.
- Exit Stage: where investors expect to see the returns from their original investment. At this point the business either negotiates a merger or acquisition (M&A), turns private or is listed on the stock exchange as an Initial Public Offering (IPO).
But how is it possible to understand what the right valuation is and if you are getting a good or bad deal for your money?
There are different business valuation approaches and we will go through the quantitative and qualitative methods.
Quantitative: Is It A Good Business?
What makes a business good? This is a complex question to answer and requires a broad perspective of a company’s industry, competitive advantages, management team, product offering and track record.
"Know what you own, and know why you own it." - Peter Lynch
- Assess the likelihood of new entrants in the market – how likely and easily could a competitor enter the market? Similarly, assess to what extent substitute products or services could compromise the business.
- Additionally, consider the bargaining power of customers and suppliers. High bargaining powers means businesses have little control over their costs and therefore margins.
- Another consideration is the degree of competitive rivalry in the industry. Costs tend to be higher, and margins slimmer, the more competitive an industry.
- Be wary of key risks that could fundamentally change the way a business operates, such as changes in regulation, exchange rates and interest rates.
- Making a broad judgement of a company’s strategy and managerial competency, and identifying competitive advantages will help you gauge the future potential.
- Identifying drivers, such as industry trends, is a way of assessing whether a business is aware of, and responsive to, the conditions in which they operate.
Qualitative: Is The Price Fair?
"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip FisherWhen it comes to valuing a company, you can be sure of only one thing: your valuation will often be wrong - either too high, or too low. Each of following simple startup valuation methods will give you a rough idea of a price:
Value Invested To Date
This very simple approach values the business as the amount of cash invested thus far, plus an allowance for ‘sweat equity’ - the time and energy invested. Adjustments can be made using the qualitative techniques described above. For example, you may wish to decrease your valuation if competitors can easily enter the market.
Previous Founding Rounds
If the business has previously sought funding, this can provide a historic valuation to use as a benchmark. For example, if a company has sold 10% of their equity to a venture capitalist firm for $100,000, it would imply a $1,000,000 valuation at that time. This can be used as a starting point to predict the current value of the firm.
This approach looks at similar transactions that have occurred recently to provide a basis for comparison. It can be difficult to find similar transactions in the start-up and early stage arena. The New Zealand Venture Investment Fund releases details on their investments and details on previous equity crowdfunding rounds are publicly available.
The Final Word
"An investment in knowledge pays the best interest."- Benjamin Franklin
When it comes to investing, nothing gives higher returns than educating yourself. Always undertake in thorough research, educate yourself of the risks, and seek independent financial advice before making any investment decisions.