Going through a valuation exercise is absolutely a must in the lifecycle of any startup and there are various methods to do that. It is necessary for startups to understand the importance of and different methods of valuation especially at an early stage in preparation of going into investment rounds.
Joelle Atallah – Berytech’s Business and Finance Advisor, trains our startups on the basics of startup valuation: what it means, the different used methods and how it impacts the future of their business. Here’s her introduction to valuation if you absolutely have no idea how it works.
A company’s valuation is an estimate of a company’s value in dollars. It reflects how much it is worth in the eyes of founders, investors and the general public. Most importantly, a company’s valuation gives an idea of how much a potential investor is ready to pay to take ownership of a share of this company.
Typically, in the case of established companies with running operations and historical financials, revenues and expenses are forecasted based on historical statements, and a method called Discounted Cash Flow (DCF) is applied to value the company. According to DCF, the value of the company is the present value of its expected cash flow in the future. In other terms, a company today is worth the amount of cash it is expected to produce in the future.
In the case of startups, and given that they are just starting to operate, we use several methods to value a company:
- The DCF method is often used using only forecasts, which makes the valuation very dependent on assumptions and speculation.
- We sometimes use a method called the Replacement Cost Method (RCM), according to which the value of the startup is equal to whatever money was invested in addition to dollar value of time invested. Every founder will have to estimate how much he/she would have earned as a salary, in case he/she was employed in a company instead of setting up their own startup. A multiplier is then used in this method to reflect the degree of innovation and disruption that the startup is bringing.
- There are other methods that are based on estimating the value of the company based on industry comparables, i.e. similar companies on the market or by taking a multiple of a company’s revenues in a given year.
Regardless of the method used, it is important for startup founders to understand the key importance of their company’s valuation as well as the factors that would influence it:
- The stage at which the company is at – the more advanced in terms of validation and operations the company is, the higher its valuation would be, hence the importance for startups to stick to the execution of a set strategy and to take action, as this would tremendously accelerate their progress and reflect on their valuation.
- Expected revenues and expenses – the more a company is expecting high revenue growth (and relatively low expenses vs. revenues) in the coming years, the higher the company’s value would be.
- The degree of innovation of the company – the more a company is innovative, the more it is expected to be disruptive, generate revenues and gain market share – and this would positively reflect on its value.
- The correlation of innovation to expected competition – the lower it is, the higher the value of the company would be.
Advice to startup founders
It is also important to keep in mind that a company’s valuation is more an art than a science in the sense it is subjective and depends on every evaluator’s perspective. However, the above-mentioned points generally determine that estimate.
It is critical for startup founders to understand this at this point as they are starting to get investment-ready and would need to speak the language of their potential investors’ during the negotiations. Understanding how their company is being valued would help them actively participate in the discussion and would put them in an advantageous position during negotiations in order to ensure that their company valuation is high, reflecting its future potential and its true value.
Besides, understanding the rationale behind the valuation helps them pay attention and avoid being diluted in the business: this happens when they agree on a low valuation for their business and the investor’s share ends up being quite high. This would translate in terms of dollar value and control in the company.
About the author
Joelle Atallah is currently Business and Finance Advisor at Berytech. She has 10+ years of experience between management and financial consulting helping organizations in finding solutions to their most challenging problems. Passionate about entrepreneurship and growth, she currently works with startup founders to help them build a strong foundation for their businesses, optimize their growth, and drive their companies’ bottom line. Joelle holds a Masters in Economic Analysis from the Barcelona Graduate School of Economics as well as a double-degree in Economics and Finance from the American University of Beirut.