Taming a Market Gone Haywir

5-Step Methodology to Improve Startup Valuations and Empower the Negotiation Process 

Determining the value of startup companies in a rational way is inherently tricky.  The company may have no operating history, no financial metrics of significance, and may not even have a product to sell.  The company could even be months or years away from reaching that point.  Startup companies are generally financially distressed at birth – they are statistically more likely to fail than continue to exist after 2 years.  The result is strange, semi-engaged negotiations that is akin to two people with blurred vision trying to navigate a dimly lit room with floor obstacles in the way.  It is very hard to negotiate effectively when you don’t have a handle on what a rational number would look like in the first place.

Accordingly, entrepreneurs, investors, and even professional business appraisers struggle with producing values that seem little more than elaborate guesses.  To the extent that analytical rigor is applied to startup valuations at all, it tends to take some form of discounted cash flow (DCF) model, where revenue, profit and cash flow forecasts are somehow produced, and the resultant projected cash flows are discounted to equal present dollars by some, semi-arbitrary discount rate.

The pitfalls of the DCF model as a valuation tool are well-known: uncertainties heaped upon educated guesses.  I advocate relying on market metrics instead because all startups share one, fundamental value characteristic.  They all promise high return potential in exchange for taking on extraordinarily high risk.  The following steps comprise a sound process for determining the value using a market methodology, whether by way of guideline public companies or venture capital transaction data:

Step One – Identify the industry that the company plans to operate in, as well as similar industries.  For example, 3D printing is very similar to robotics.

Step Two – Identify the size of the total addressable market (TAM) for the company’s core product.  This can be accomplished through diligent research.

Step Three – Identify and characterize the relative stage of development for the company (research, prototype, some customers, etc.)  This is particularly easy for medically-related companies, that have specific stages of clinical trials.  In other cases, this analysis is qualitative in nature.

Step Four – Identify public companies that are very small (little to no revenue).  There are over 4,000 publicly traded companies in North America, Europe and Israel that meet these criteria.  They are effectively publicly traded startups.

Step Five – Identify transactions involving direct investments into startups.  You may be able to find such transactions with sufficient Google research, but your job will be made much easier if you have access to information services (such as Pitchbook), although they are somewhat expensive.

Now that we have that data assembled, we can do something with it.  The key is to ignore multiples.  They don’t matter because you often have very little or nothing to put in the denominator anyhow.  Take this group of startup companies in the mobile app space (dollar amounts in $ millions) that are publicly traded (as of this writing):

Pre-money valuation is market capitalization less cash.  Per this particular data set, the median pre-money valuation of similar companies is roughly $5.1 million.  If you like, we can knock off around 25% of the baseline value for the lack of share liquidity for your privately held startup for a value of $3.8 million.  We then can make some adjustments based on the relative development of these companies compared to ours and total addressable market sizes, which means we have to do our homework not just on our company, but on the comparable set also.

There’s no such thing as a perfect valuation methodology, especially with startups.  Neither this nor any other technique will be definitive.  But this approach does provide a degree of rigor, supportability and realism that inspires confidence.

With this information in hand, you can negotiate from a perspective of information strength and have a degree of solid footing for your decisions that is precious in early stage company transactions.

[Image courtesy of adamr at FreeDigitalPhotos.net]

About the Author

Michael Blake is the founder of Arpeggio Advisors (www.arpeggioadvisors.com), a boutique business appraisal and corporate strategy advisory firm in Atlanta. Michael’s background has included work in venture capital, investment banking, and public accounting. Michael has particular expertise in the appraisal of firms in the fields of professional services, information technology, aerospace, and alternative energy. In addition, he has developed specific expertise in the appraisal of intellectual property and intangible assets.  Michael is an active educator. He is a Special Instructor of Business Valuation in the Georgia Tech/Emory University TI:GER (Technology Innovation:  Generating Economic Results) program. In addition, he is regularly invited to provide instruction on entrepreneurship, corporate finance, and business valuation to graduate level classes at prominent universities across the South. He can be reached at mike@arpeggioadvisors.com. Or, follow him on Twitter: @unblakeable.