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How do you value a Startup?

FairStreet Staff, Sep 16, 2013

This post is in continuation of "How do you value a Business?" post.

The valuation that your startup will command depends to a large extent on

  • The market forces in operation at the time you seek investment,
  • The attractiveness of the investment sector that you operate in,
  • The demand supply dynamics of available startup investment opportunities versus the money chasing these opportunities

The cash flows from successful startups follow the classic hockey stick graph - initial small losses followed later by bigger profits. The return for the investors is in the form of capital appreciation rather than dividends.

One way of arriving at a valuation of a startup is as follows:

Suppose you project that your business will have post tax earnings (on pure equity) of $500,000 per annum after 3 years. And, at that point your sector will be able to command a P/E ratio of 20, so you expect to have a valuation of $10,000,000 3 years from now.

At this point you are seeking a $500,000 in equity financing with no other investment required in 3 years.

The investors will typically discount the valuation 3 years from now at 40% to 70%. Let us use a discount rate of 50%.

So the post money valuation (Valuation after equity funding) now will be:

$500,000 X 20/ (1+50%)^3 = $2,962,962 which is approximately $3,000,000

Now, your implied pre-money valuation is:

$3,000,000 - $500,000 = $2,500,000

Equity that you will need to offer according to this valuation is:

$500,000/$3,000,000 = 16.7% which is approximately 17%.

Equity that you will retain:

$2,500,000/$3,000,000 which is approximately 83%

Typical startup valuations currently are in the range of $2M to $5M.

Another popular way of investment in startups is through convertible notes, which allows the question of actual valuation to be deferred till a formal VC investment comes in (or a second round through another offering, when more is known about the company’s possible valuation). The intricacies of convertible notes will be covered in another article.

How do you value a Small Business

FairStreet Staff, Sep 08, 2013

This post is in continuation of "How do you value a Business?" post.

At a very minimum you will need the following:

  1. Income statement, ideally for the past 3 years, showing your revenue, costs, EBITDA and net income.
  2. Balance sheet which shows the value of assets and liabilities of your business
  3. The value of all tangible assets in the firm, also known as FF & E (Furniture, fixtures and equipment)

SDE: Seller's Discretionary Earnings

In an owner managed business it is often difficult to segregate what the earning of the business from the earning of the owner. So a better estimate of the value of the business is obtained by clubbing the two under the head Seller's Discretionary Earnings (some sources seem to use the term Seller's Discretionary Cash Flow interchangeably with this, but we prefer not to since the SDE is not truly a cash flow). The Firm Value/SDE multiple is less than the Firm Value/EBITDA multiple because the value of the SDE is more than the EBITDA.

SDE = EBITDA + Owner's Salary + other discretionary expenses by owner which are not critical to the operations of the business.

Illustrative Example

It is common to value a small business by multiplying the gross revenue or SDE by the appropriate industry specific "rule-of-thumb" ratio or a ratio calculated by finding appropriate group of comparable firms that have been sold recently and using the average (or median) ratio.

The owner of a Restaurant in New York wants to raise equity finance for his company with the following financials. Note that this is a made-up example - do not rely on the values here for valuing your business!

Revenues = $800,000

SDE = $150,000

Rule of thumb:

2X SDE or 25% - 35% of annual sales

Value From Revenue Multiple = $200,000 to $280,000

Value from SDE = $300,000

Using a group of comparable firms

Suppose you learn of some transactions in businesses similar to yours with the following financials. We are using just 3 to illustrate the concept; typically you will have to choose more:

Company Name Revenues SDE Valuation (Price for which it was sold) Implied Revenue multiple Implied SDE multiple
Acme Restaurant $700,000 $200,000 $300,000 43% 1.5
Joe’s Eatery $900,000 $90,000 $270,000 30% 3.0
Jim’s Diner $600,000 $150,00 $300,000 50% 2.0

Median Revenue Multiple: 43%

Median SDE Multiple: 2.0

Value From Median Revenue Multiple = 43% X $800,000 = $344,000

Value From Median SDE Multiple = 2.0 X $150,000 = $300,000

Some manifestations of this model also use the mean instead of the median but we prefer the median for a variety of reasons.

Now you have some numbers ranging from $200,000 to $344,000 on the valuation of the business.

How do you decide on which exact number to use? This is where the "art" of valuation comes into play. You make the decision on how you feel your business compares with the others (Yes, that is a difficult thing to be objective about!). When you get a valuation expert to value your business you will often get back a range of values and you will need to make the final call on the value of the business.

For example, based on a number of objective and subjective reasons and multiple rolls of the dice you can decide that the valuation you want is $300,000.

How do you value a Business?

FairStreet Staff, Sep 06, 2013

What are we valuing?

Assets = Debt + Equity

This is the fundamental equation for calculating the value of a business. When we say the "value of a firm" we typically mean the "enterprise value" which is the value of the assets of the firm.

If you are looking at issuing equity you want to be able to calculate the value of the equity of the company, which is:

Equity Value = Enterprise Value of the firm - Debt

Financial Accounting Terminology For Valuation

To better understand this post, you will benefit from a basic understanding of these financial accounting terminologies and acronyms.

EBIDTA Earnings Before Interest, Taxes, Depreciation and Amortization, also called Operating Income
EBIT Earnings Before Interest and Taxes, also called Operating Profit
NOPAT Net Operating Profit After Tax
CAPEX Capital Expenditure
Working Capital The Capital required to run the business, essentially Current Assets - Current Liabilities
Depreciation The Decrease in the value of assets

From Revenues to Net Income

This graphic gives you a high level understanding of how you arrive at the net income from the revenues.

From Revenues to Free Cash Flows

First, calculate your EBIT-


EBIT = EBITDA - Depreciation

Now calculate your Free Cash flow-

NOPAT = EBIT - Taxes

Free Cash Flow = NOPAT - CAPEX - Change in Working Capital + Depreciation

Different approaches to valuing a firm

There are multiple approaches to valuing a firm. Theoretically all these approaches should lead to similar answers but in practice they might not because all the approaches rely on estimating some parameters, which is not an exact science.

Some approaches are more relevant for firms in a particular stage of maturity or in particular industry verticals.

The best way is to use multiple approaches and then arrive at a range based on a combination of approaches. If you are in a situation where you are forced to choose a single number then use your best guess!

Future Earnings Based Valuation

The most popular manifestation of this technique is the Discounted Cash Flow Valuation. The value of a firm is the present value of the cash flows (i.e. cash flows discounted at the appropriate rate) of the firm.

To use this method you will need to estimate-

  1. The projected cash flows to the firm
  2. The life of the cash flows (i.e. how long will they continue)
  3. The appropriate discount rate, technically the weighted average cost of capital

A variation of this technique is used to value equity directly - you use cash flows to equity (i.e. free cash flows after removing any payments to and from debt) and discount them at the appropriate "cost of equity".

Market Comparison based Valuation Or Relative Valuation

The philosophical basis of this valuation method is that the intrinsic value of a firm is difficult (if not impossible) to determine with accuracy. So, a good estimate of its value is whatever the market will pay for it. This value can be determined by looking at how the market prices similar firms. For example, if you are restaurant in Brooklyn with a certain profit your value will be twice that of a similar restaurant with half the profits.

The idea is that certain financial ratios e.g. Price/Earnings ratio, Firm Value/EBITDA, Firm Value/Revenues must be comparable within industries especially for firms with similar characteristics like size and location.

To do the relative valuation of a firm you need:

  1. An identical firm or a group of similar firms and information about their valuations
  2. A standardized ratio to use, and these ratios for the firms above

Now compute these ratios for similar firms for which the valuations are known. It is also possible to use some "rule of thumb" ratios for different industry verticals.

Then compute the value of your firm by taking the average/median of these ratios and multiplying it by your revenues, profits etc. as applicable.

This, of course, leads to an approximate value and is highly dependent on the set of similar firms that you choose but it is easier to justify and gives investors some confidence that the valuation you seek is not just some number you have picked out of thin air.

Other Techniques

Other valuation techniques include:

  1. Asset based valuation: where the business is valued by accounting for all the assets of the firm and adding up the cost of procuring all the assets. In this method it becomes difficult to arrive at a fair value of the "goodwill" that a business has earned.
  2. Option based Valuation: where the equity is considered as a call option that the equity holders have to buy the firm from the debtors at a value equal to the total debt.