Valuation of startups is an extremely tough task because there are a lot of variables that need to be estimated. The goal of this paper is to build on the research and investment techniques that are used for the valuation of startups and to point out the factors that have effect on the value of startups and try to provide better techniques to quantify those factors.
At P&S CAPITAL we designed a valuation method for startup and early-stage companies. With this valuation method we aim to assist appraisers/investors to determine the number of factors and associated risks that affect the value of startups, so that appraisers are able to dissect the potential and risk of startups into number of components. By being able to dissect the value and risk into more factors, appraisers will be able to come up with better estimates of value and risk than just the general rules of thumb.
Two most important factors which drive the value of startups are expected return and discount rate as a proxy for risk. In addition we introduced additional requirements which are somewhat different when valuing startups when compared to traditional companies. Those include: 1) Management experience and skill; 2) Size of the market (potential); 3) Product or service, mostly in terms of competitive edge and 4) Potential for exiting the investment.
We argue that an appraiser should estimate the future value of the startup as most startups are not generating free cash flows from the beginning of their operations. Operations of the startup should be based on its potential to sale its products/services as sales plan is the easiest (among different estimates) to estimate, while on the other hand costs of operations are much harder to plan. In addition an appraiser should introduce uncertainty into sales plan of a startup, which should work as a sensitivity analysis of the sales and effectively market value of the startup. By applying appropriate market multipliers appraisers are able to estimate the future value of the startup. Future value should be discounted back to the present with the use of appropriate discount rate, where we argue that different startups should be valued with the use of different discount rate to reflect their risk. We propose that the proper discount rate should be calculated with the use of different factors, which we defined as “Probability of Failure and Potential for Exit” or PFPE and which include:
- DMI = Discount for exit/sale potential
- VT = Discount for size of the market
- KPI = Discount for a size of the pool of potential investors
- DI = Other factors (previous investments, maturity of a startup, etc.)
At P&S CAPITAL we provide different services in the area of startup and early-stage companies, from valuation to searching potential investors as we have a continuous presence in the investment community and an established network of contacts between businessmen and investors in Slovenia and abroad.