How to Value Start-ups and the Importance of Valuation

Generally, family offices are increasingly viewing start-ups as having the potential for outsized returns. However, the main question is, do people know how to properly value a start-up?

Here are three methods to valuing start-ups

1. Comparable Companies Analysis

A good place to start is to identify the start-up’s direct competitor offering similar goods or services to the valuation target. Next, gather financial information from their statements such as EBIT/EBITDA, enterprise value, PE ratio that are most relevant to be analysed relative to the targeted firm. With this, a valuation range is achieved.

Of course, the downside of this method is that it’s heavily dependent on the market conditions, the extent of the similarity of the businesses, and their development phase. In a case where financial statements are not readily available, more relatable market indicators can be used for comparison instead. For instance, number of outlets (Retail), patents filed (Biotech), weekly active users (Messengers).

2. Precedent Transactions

The process follows similarly to the first method above. However, the valuation range is derived from financial multiples paid for companies in recent M&A deals or venture investments. Given the difficulty of selecting close comparables only from recent deals, a less stringent rule may be applied, and the final list of comparables are compared with the targeted start-up firm to reach a valuation range.

3. Discounted Cash Flow Method

For most start-ups, especially those in the earlier stages and have yet to generate earnings, a huge portion of the value comes from their future growth potential. In short, a DCF analysis values companies based on the present value of its potential cash flows. This is done by forecasting and projecting future cash flow the company will produce. A higher discount rate can be utilised for the valuation of the start-up firm to account for higher risk.

How do you know whether a business’s claims are over-inflated?

Conducting due diligence on a business is extremely important. Whether it’s a health start-up claiming its platform will save patients money or a biotech company claiming its new therapy can cure cancer, those claims should be quantified and measured.

Earlier this month, Uber, with a targeted valuation of US$82.4 billion went public, raising US$8.1 billion at the price of $45. Within a matter of days, however, the stock plummeted to $37.10, losing over 17% of its value. This made investors wonder, what went wrong?

NYU stern professor Aswath Damodaran, who is known as Wall Street’s “Dean of Valuation” and is widely respected as one of the foremost experts on corporate valuation, has something to say regarding Uber’s valuation. Using his “Rider-based Valuation”, a valuation of $58.6 billion was derived, which is way below the valuation that was announced to the public. His valuation approach took into account the values by existing users, by looking at revenues and cash flows generated by them over their lifetime. It also includes the value of new users, netted with the cost of user acquisition. The full break down of his approach can be found here. Overall, this approach shows that Uber’s real value could be very much lower than the price its public debut is set.

Ultimately, valuations are simply estimates and prone to errors. Most start-ups fail due to various reasons; flawed business model, mismatch in the founding team or simply running out of cash. This is why more independent valuation should be encouraged to properly ascertain the true value of a start-up business.

Uber valued at low end of US$82b in IPO as market jitters, Lyft woes weigh [The Straits Times]