Determining the value of a startup is a critical juncture when raising new capital. For new startups it allows the entrepreneur to evaluate the value of the startup using quantitative methods and other measures to answer the pivotal question. What is the start-up’s market value?
The valuation of any company is composed of objective and subjective components. Despite the subjective nature of the company valuation, the ability to explain the rationale behind your company’s proposed value is critical when approaching the negotiating table. An entrepreneur who comes to the negotiating table armed with the relevant data and a solid rational will set the tone for the rest of the negotiations.
Targo help entrepreneurs in the early stages of their venture to prepare a comprehensive business plan and financial model that we will enhance and solidify their ability to raise capital.
Performing a valuation for a startup is different than appraising an established company in several aspects:
- The risk in VC investments is significantly higher than investing in an established company. This risk manifests itself in three different spheres.
- Higher Speculation: The startup has no revenue, so extrapolation from past performance to future performance is not possible.
- Technological: Can the startup’s technology properly execute what the product proclaims to do?
- Market Appetite: Is there a current market for the proposed product?
These differences create a high degree of uncertainty regarding the success of the startup; however, It also complicates the attempt to put a price tag on the startup.
There are a number of ways to reach a startup valuation. The most common method is the famous P/E ratio. The second most common valuation method is a “Discounted Cash Flow” otherwise known as a DCF. The DCF model is considered more thorough than the P/E ratio. The DCF method states that the company’s value is derived from the company’s total free cash flow in the future.
In order to assess the company’s potential future revenue and net cash flow, we help the entrepreneur answer a few questions:
- What is the Total Addressable Market, or in other words, what is the maximum market size of the product?
- What percentage of this market is estimated to be captured within 5 years?
- What is the business and revenue model – How is revenue generated?
- Are there any competitors that might take a bite out of the start up’s market share in the future (which would reduce our market share and force us to lower prices accordingly)?
- What will be the type and the extent of the expenditures needed in order to operate the startup.
The answers to the above questions are the core of Targo’s business plan. Without the answers to these fundamental questions it is impossible to perform a reliable valuation. To illustrate how a startup value is calculated, let’s take an example from the Parental Control app (parent’s ability to monitor and control the use of their child’s phone).
Data Points about Parental Control:
- In 2015, there were 120 million downloads of similar applications
- The business model is charging $ 5 monthly for each premium user
- 10% of the users are premium
A quick calculation will reveal that the maximum market value is: 5*10%*120,000,00= $60,000,000.
The next step is to estimate the penetration rate into the market year by year over the course of the next five years. This will enable us to forecast the startup’s potential cash flow. We will then estimate what the expenditures will be in order to maintain these revenues each year. The revenues net the expenditures will give us the free cash flow for every year.
The facts previously mentioned are not based on gut feeling but are based on calculations using many factors such as competitor data, their market share, growth rate, target market ,macro and micro data and more.
This is the “easy” part of the valuation. The numbers above can more or less be agreed upon with the investor, assuming that the numbers reflect conservative and logical assumptions and of course have precedent (for example – a competitor from this field or a tangent domain which presented similar growth data).
The difficult part of the evaluation, which is where most of the negotiations take place, is determining the discount rate, which reflects the amount of risk inherent in the startup. The higher the number is, the lower the valuation of the company. The following numbers represent the risk that the startup will fail.
Usually, the risk factor is determined by the start-up phase:
- Seed – 80%+
- Angel – 50-70%
- Series A – 40-60%
- Series B – 30-50%
In comparison, Teva’s Discount Rate is about 9%.