What is a business valuation?
Business valuation is simply the process of determining the current (or projected) value of a company. However, many startups have limited revenue or profits and are in a relative stage of instability. Hence, it’s likely that their product or service has not reached the market or has not reached maturity.
While this can make it difficult to place a valuation on a startup—it’s a vital process that helps entrepreneurs make better data-driven decisions and measure their progress and growth—and accurately informs potential and current investors.
In this blog post, you’ll see traditional valuation methods—and their corresponding pros and cons—and the only valuation methods that are truly valuable for startups.
What are the most common traditional business valuation methods?
You love your startup—it’s like your baby. You love the product or service. No matter how much you love your startup—at some point, you’ll need to find out an accurate valuation level. This will help you gauge your own metrics and/or inform potential investors.
Luckily, there are several different business valuation methods you can use. Unfortunately, most traditional valuation methods are not suitable for small or high-growth startups. But the good news is that—like a modern artist mastering the basics of their art—by learning the traditional valuation methods, you will be prepared to leverage the best valuation methods for startups properly. Let’s start with some advantages and disadvantages of the most common valuation methods:
Traditional business valuation methods
The discounted cash flow method
Does your business have a solid cash flow? Then the discounted cash flow (DCF) method—which involves analyzing the cash flow of a business to determine its worth—may be right for you. DCF models are based on the premise that a company’s value is determined by how well the company can generate cash flows for its investors in the future.
When investors see that the DCF is bigger than the present cost of investing in a company, they may give the green light to invest in the startup. In turn, companies usually implement the weighted average cost of capital (WACC) for the discount rate—as it accounts for the rate of return expected by shareholders.
What’s important about WACC?
The weighted average cost of capital (WACC) is the average rate that a business pays to finance its assets. WACC is determined by averaging the rate of all of the company’s sources of capital (both debt and equity), weighted by the proportion of each component.
Startups can refer to their WACC in order to gauge the optimal balance of their company’s ratio of equity to debt.
Capitalization of earnings method
The capitalization of earnings method is a classic process that determines the value of a business by calculating the current earnings of a business, its cash flows, and the annual rate of return for investors to determine future profits of the business.
For example, imagine that your favorite local restaurant has taken in annual cash flows of $600,000 for the last decade. Based on forecasts, said cash flows are expected to continue for the foreseeable future. The restaurant’s annual expenses have also remained constant at $150,000. Hence, the restaurant takes in $450,000 annually ($600,000 – $150,000 = $400,000), which it uses for its valuation—and expected future earnings for the restaurant.
Asset-based valuation method
The asset-based valuation approach is a method used to determine the value of a company based on its assets—or the fair market value of its total assets after deducting liabilities. Fair market value is obtained after assets are accurately evaluated. Said approach is particularly useful for the manufacturing, real estate, and retail businesses, respectively.
Determining the fair market value of a company’s assets includes:
- Tangible assets, such as property, equipment, and inventory
- Intangible assets, such as patents, brand equity, trademarks, and goodwill
Remember that—whilst cost does include real machinery and equipment and items like furniture—cost also comprises lost income. Also, remember that nothing lasts forever—items wear out, and they will need to be replaced at one point or another.
There are two main asset-based valuation methods:
- Asset accumulation valuation: Like a balance sheet—this method shows the difference between the value of assets and liabilities that give the company’s equity value or net worth. The method considers all the assets and liabilities—even those items not found on the balance sheet.
- Excess earnings valuation: Developed by the U.S. Treasury Department in 1920 to estimate lost goodwill suffered by breweries and distilleries as a result of Prohibition, this method melds asset-based and income-based models aggregating asset and income information.
Replacement cost method
The replacement cost method involves determining the cost of replacing the assets of a business with similar assets in a similar condition (plus, if appropriate, payment of any taxes due). The belief is that a buyer will not pay more for an asset—nor will the seller accept less—than the price of a similar asset.
For example, if Factory X bought a machine for $20,000 10 years ago, and the current value of said asset—minus depreciation, is $5,000 dollars, then the book value of the asset is $5,000. However, the cost to replace that machine in the current market might be $10,500.
The best first alternative valuation method
The market cap method
The market cap—or market capitalization method valuation approach—is among the simplest ways to get a valuation of a business. Simply multiply your company’s current share price by its total number of shares outstanding at that point in time.
As privately held companies don’t have shares traded in the open market, this method is usually suitable for publicly traded companies. Even so, it’s good to know what your market cap is as you might need to compare your privately held company to the market cap of publicly traded companies.
As you have seen some of the most well-known traditional startup valuation methods, it’s now time to see what truly works best for high-growth startups.
The best valuation methods for startups
Venture capital valuation method
Back in the heyday of Reaganomics (1987), Harvard Business School professor Bill Sahlman put forth what has come to be known as the Venture Capital Method—for determining a company’s valuation. Sahlman proposed multiplying a company’s projected revenue by its projected margin and industry price-to-earnings to help VCs determine a company’s future value.
To this day, many VCs still widely use this formula—with a few different variations. The formula can also be used by VCs and angel investors alike to calculate pre-money valuation by first determining post-money valuation with common industry metrics.
As this method involves analyzing the potential for future earnings and applying a discount rate to reflect the risks associated with investing in startups—the venture capital valuation method jives well with startups looking to raise capital. VCs value the method as it helps realize their returns when the company is expected to be sold (terminal value), and they expect a baseline rate of return for their investments.
How is exit value determined?
The Exit Value (EV), or Terminal Value, is a crucial component in the Venture Capital Valuation method, which is used to determine the potential value of an early-stage startup company.
The selling price can be estimated by establishing a reasonable expectation for your revenues in the year of sale and—based on those revenues—estimating your earnings in the year of the sale.
The Exit Value represents the amount of money that the venture capitalist is expected to receive when the company is sold or goes public.
Comparable company analysis or comparable company valuation (CCV)
Comparable Company Analysis, or Comparable Company Valuation (CCV), is a method of valuation where you use peers who share similar business characteristics to generate value for your own company.
CCV is also a commonly used valuation method to determine the potential value of a high-growth startup. This method involves analyzing the valuation metrics of similar companies in the same industry to estimate the potential value of the startup. Common steps involved in a CCV analysis for high-growth startups include the following:
- Identify comparable companies: Find companies in the same industry that have similar business models, growth potential, and market positioning.
- Gather financial data: Get hold of key performance metrics and valuation metrics such as price-to-earnings ratio, price-to-sales ratio, and enterprise value-to-revenue ratio.
- Calculate valuation metrics: Determine the valuation metrics for each comparable company to provide a benchmark for the high-growth startup being valued.
- Determine valuation multiple: Select a relevant metric (such as price-to-sales ratio) and use the median or average multiple of the comparable companies as a benchmark.
- Apply valuation multiple: Apply the valuation multiple to your high-growth startup’s financial data (such as revenue or earnings) to estimate its potential value. This provides a valuation range for the startup based on the valuation metrics of the comparable companies.
What is the best way to get a valuation for your startup?
Startup valuations are big news in the financial world. Everyone wants to know your valuation—and we hope that your next valuation shows up across all the financial news feeds and LinkedIn.
However, valuations are a tricky business, and—based on your metrics—you need to consult a seasoned pro to get the most out of your valuation.
Waveup leverages cutting-edge approaches and deep industry experience to help clients develop the right valuation strategies that help measure the progress of their growth engine and take the startup to the next level. Get in touch with us today.