We wanted to share with you a case study of Pre-Money Valuation for a pre-revenue tech startup that we conducted earlier. Here we have used weighted average of 3 prominent methods of Pre-money Valuation ( Scorecard Method, Risk Factor Summation Method and DCF Method) for arriving at the Pre-Money Valuation. The detailed calculations are discussed below.
Valuation is a process and a set of procedures used to estimate the present economic value of an enterprise (or business) or the present value of owner’s interest in a business (equity valuation). Business valuation or equity valuation can be used to determine the fair value of a business or the value of owner’s interest for a variety of reasons, including sale value, looking for new investor or lender, mergers & acquisitions, private placements etc.
A company’s pre-money valuation, or PMV, is its estimated value immediately prior to accepting funding (Valuation Calculator). Every time entrepreneurs seek to sell ownership in their company in exchange for financing, they must figure out PMV. It determines how much ownership existing shareholders or members will give investors in exchange for financing.
Startup valuation methods are the ways in which a startup business owner can work out the value of their company. These methods are important because more often than not startups are at a pre-revenue stage in their life-span so there aren’t any hard facts or revenue figures to base the value of the business on.
Because of this guesswork, an estimation has be to be used, which is why several startup valuation method frameworks have been invented to help a startup business more accurately guess their valuation.
Choosing a valuation method is one of the many confusing challenges with valuing early stage companies. There are several popular methods, each with their own approach on how to best determine how much a venture is worth.
WHY ARE STARTUP VALUATION METHODS IMPORTANT?
When an early stage investor is trying to decide if they should make an investment into a startup he will guess what the likely exit size will be for that startup of a type, and in a specific industry. If a business owner has used methods to show their startup is worth a high amount that investor is likely to invest more into the company.
Using these methods or frameworks is also important because startup companies lack reliable past performance and predictable future performance that most established businesses use to estimate their value so having a way to guess a valuation is useful, even if it is all guesswork and predictions.
Ideally, a business owner should use several startup valuation methods to get the most accurate valuation possible. A business owner will want all of the valuations they come to from each of the methods to be within a sensible average.
WEIGHTED AVERAGE METHOD OF PRE-MONEY VALUATION
Knowledge of other businesses in an industry, geographical location and critical risk factors are key to figuring out the value of a startup in the same industry and location, which is why several of the startup valuation methods include this. A startup valuation method needs to consider a lot of critical factors which a single method of valuation fails to address. So a valuation method that addresses all these factors by averaging the most prominent 3 method, giving a clear weights to each method based on current situation, would be ideal and realistic.
We strongly feel that the management should not stop with one approach as most angel investors will recommend using a blend of methods rather than relying on one method. Investors and business owners will want to use several methods because no single method is useful all of the time. Multiple methods also help the business to determine an average valuation. Finding this average valuation is important because none of the startup valuation methods are scientifically or mathematically accurate; they are all based on predictions and guesswork.
Based on these key factors, we have adopted a method of valuation, called Weighted Average Valuation (WAV) Method that uses the Weighted Average of 3 prominent, proven and globally accepted methods of valuation, that are:
- Scorecard Method of valuation;
- Risk Factor Summation Method; and
- Discounted Cash Flow (DCF) Method.
RATIONALE FOR THE SELECTION OF THE WEIGHTED AVERAGE VALUATION (WAV) METHOD
The WAV Method takes into consideration the Weighted Average of 3 prominent methods of valuation that are:
- The Scorecard Valuation, also known as the Bill Payne valuation method, is one of the most preferred methodologies used by angels. This methodcompares the startup (raising angel investment) to other funded startups modifying the average valuation based on factors such as region, market and stage.
- The Risk Factor Summation Method is a valuation technique based on a base-value adjusted for 12 standard risk factors.
- Discounted cash flow is a methodology of future cash-flow actualization. It transforms future cash-flows in their equivalent value today. The main underlying assumption of this methodology is that money tomorrow is worth less than money today.
The WAV method helps to cover several critical factors that are important for the valuation of a pre-revenue startup, such as:
- A median valuation of similar startups under similar stage of development from similar sector in a similar location or country.
- A number of most important and critical quantitative and qualitative factors per categories, on a weighted percentage basis.
- All basic key factors instrumental for the success of the startup.
- Actual Industry data and market information.
- Major risk factors usually associated with startups, the important 12 exogenous factors.
- Future cash flows and the revenue earning capacity of the startup, converted into equivalent value today using discount rate calculated under globally accepted and most scientific CAPM method.
- A terminal value at the end of the explicit forecast period determined and that value is also discounted back to the valuation date to give an overall value for the business.
- A forecast period to be of such a length to enable the business to achieve a stabilized level of earnings.
Overall, a weighted average of the above key methods will help to realize a more realistic and accurate valuation for the business. A detailed analysis of rationale behind the selection of each methods of pre money valuation, used under the WAV method, has been discussed in some other blogs.
Dileep K Nair
Investment Banking/ Corporate Finance