Business valuations for divestiture, M&A, and investments. Learn about company valuations. What makes a company valuable? What is your company worth?

Challenges in Startup Valuations

Startup valuations are challenging for many reasons. The risks involved in investing in a business with no proven track record are prominent. There is a low probability that the business will be highly valuable and there is a high probability that the businesses will be worth little to nothing. From a Harvard Business Review (HBR) study, it shows 95% of the startups can’t meet their projections. For investors 70% of the time they lose money, 20% of the time they make some money. How about those unicorns and big exits we hear from our neighrbours? A whopping 2% of the chance you will be landing those.

Each Startup is unique

Each startup is also unique. After all, they were built to solve an unfamiliar problem. The nature of the business engender another challenge to startup valuations…There are lack of or no comparable companies. So many startups create a projection that is often based on the founder’s subjective forecast. Unfortunately, the forecast is often incomplete as there is insufficient information on the company’s financial clarity, business operating models, and value proposition in the industry.

Startup Valuation methods

To compensate the unknown areas, valuators rely on multiple valuation methods and try to measure the pros and cons of each. Here are some of the methods often used to value a startup company:

  • Discounted cash flow – as mentioned, the challenge in discounting cash flow is the quantification of discounting rate and growth rate. These assumptions are vital for the fundamental of a fair market valuation
  • Scorecard method – in another article, we discussed How Venture Capitalist Value your Company. A method for investors to line up the opportunities by scores
  • Cost-based method – if the company had invested in intellectual property (IP) this method is often used to provide the opportunity cost for the investor to create the same product
  • Multiple method – for startup, this method relies on its user base and its customer lifetime value (CLV). Investors would measure the net benefit building the CLV vs buying it.
  • Scenario-based method – the scenario-based method is a statistic model that based on the assumptions provided by the investors

Bottom line

When valuing a startup, make sure you understand the risks involved in the business. How can the company go from $1M revenue to $100M revenue? The fundamental assumption is that people must need and want the product and services provided for a sustainable period of time. Believing in the product itself is also not enough. As a valuator, you must also understand the people behind the products. The qualification of the management team. What milestones have been achieved? Challenge on the underlying assumptions and question the operating models and valuation methods. Make sure the forecasts are being discounted with a reasonable rate of discount. The management team might not have all the answers right now. But it is essential for the valuator to corroborate facts and make sure assumptions made are justified.

What are Environment, Social, and Governance (ESG) concerns?

  • Environment

Environment criteria involves the energy resources a company uses and the waste it creates.

  • Social

Social criteria is about the relationships a company has with its people, communities, and related parties.

  • Governance

Governance is the internal system of controls a company has to govern itself to comply with the law and interact with other stakeholders.

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What is Fair Market Value (FMV)? How much does my company worth?

What does my company worth? Many investors and business owners make the mistake by jumping right into the numbers and the multiples. The truth is, valuation is based on the availability, completeness, and the relevancy of the financial and operating information about the subject company. For example a startup with little financial data and industry data would heavily rely on the owner’s financial projections, hence the valuation would be highly subjective. In that case, financial partners or authorities would consider the valuation as “lack of context” or “insignificant”, meaning the valuation is unreliable. So, what makes a valuation reliable?

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The Venture Capital Dream

You may have considered raising money for your startup from a venture capitalist (VC).  Not only it’s a great achievement to get your products or services validated but it’s also financially rewarding. A suitable venture capitalist can drastically shorten your market development time and speed up productions, not to mention a successful exit.  After all, who doesn’t like another story about a visionary entrepreneur carrying a start-up company from his or her own garage to the New York Stock Exchange? Before you get too excited, let’s take a look and see how much your company is worth to a VC.

How Venture Capitalists Value Your Company

If your start-up is not generating revenue, it is considered a pre-money startup. VC generally uses a scorecard approach to value your company. As the name suggested, the scorecard approach is about the score of your company. And the score is generated by comparing your company with other funded start-up companies.  In another words, it’s a market approach.

VC firms pull comparable companies at a similar development stage. If your company is funded by seed capital or angel investing, your company would stand side by side with other companies in the same seed group. The mean value of all comparable companies will be used as a benchmark for your VC capital. Each VC has its scorecard system to generate a weighted-average multiplier for your company. For example, if the VC cares about management and assigns a 50% weight on the experience of the management team and your startup gets a score of 80%. The assigned score for management would be 40% for your startup. The sum of all weighted scores will then be multiply by the benchmark valuation.

Nonetheless, the VC approach is appropriate if your company is generating income or has a solid chance of doing so. The VC approach is a form of income approach and venture capitalists typically value start-up companies based on their required rates of return on the investment and required exit values.

Although there are no standard requirements for a business valuation report or who can legally provide a valuation report, company owners should ensure the professional they hire has one of the following professional designation – CPA, CBV, ABV, or CFA.

For U.S., ABV or Accredited Business Valuator are awarded to CPAs or valuation professionals whom have passed a list of courses and an exam and fulfilled a number of valuation hours. For Canada, CBV designation is the most recognized credential for professional business valuators in the Country. CFA is the gold standard for the financial industry and CFA charterholders might or might not be specialized in private company valuation but the designation warrants a high level of expertise and professionalism in the industry.

For Canada, the history of professional valuation goes back to 40 years ago since the 1971 tax reform, where Canada Revenue Agency (CRA) required valuation for income tax purposes for gift and estate tax, capital gains tax purposes. CICBV were designed to fulfill these formal valuation needs. Ontario Securities Commission (OSC) later issued valuation-related policy and the standard for business valuation reports. As a result, CBV by CICBV was introduced.

For businesses with over 500k revenues, owners should seriously consider having a valuator report done by a professional with one or more of the above designations. Business buyers and investors typically have sufficient resources and knowledge about the valuation metrics and will investigate the facts, reasonableness, legitimacy of the business valuation. A poorly prepared valuation report will not only have bad representation of your business reputation and lower the true value of the exit value but also invite future expensive law suits.

Business Valuation Report