How can an entrepreneur judge the value of his or her company when it hasn’t even earned its first dollar? It’s crucial that founders know the value of their companies before they pitch to investors, lest they either get shortchanged, or worse, give up a valuable funding opportunity simply because they overvalued their firm.
In the latest installment of Founders Drinks (FD) yesterday, which was held at co-working space The Hub Singapore, Managing Partner of Futurebooks George Mathew explained to a rapt audience how to value a startup during its early stages. The two techniques he introduced were the scorecard and the firm value methods.
Estimate early-stage startups with a scorecard
For early-stage, pre-revenue startups, Mathew recommended the scorecard method, which involves finding a basis for comparison by looking up average valuations, and using a similar company as a baseline. Then a list of comparison factors is drawn up to find out where the startup stands.
Mathew noted that when choosing another company for comparison, it need not be in the same industry as the startup that’s being evaluated; more important factors include the size and growth rate. He added that looking up databases like AngelList can be helpful in getting average valuations, as they filter off outliers and give more accurate estimates, which stand at US$3 million for Singapore-based startups.
Some of the factors that can contribute to a startup’s valuation are:
- Strength of the entrepreneurial team
- Size of the opportunity
- Competitive environment
- Early customer feedback
The startup is then evaluated against a similar company using these factors, which carry different weightage based on their importance. Usually the team is the most important, making up nearly one-third of the total. To find the valuation of the startup, a percentage is assigned to each factor stating how the startup compares with the baseline company, which is then multiplied by the weightage. Summing the products together and multiplying again by the average valuation yields the valuation of the startup.
Put a firm value on a growing startup by projecting earnings
However accurate the scorecard method is, it is ultimately an estimation that relies on a lot of guesswork. For a startup that posts a revenue stream and hence a known cashflow, firm value valuation provides a more accurate handle on the company’s worth. According to Mathew, the firm value method was adapted from traditional methods used by investment banks to evaluate established companies.
To use the firm value method, one would need to project the cashflow, revenue and growth rate for a period of 5-10 years, and use both the Net Present Value and the Terminal Value formulae listed below.
Net Present Value Formula. Ct represents net cash inflow, Co is the initial investment, r represents discount rate, and t is the number of time periods. Image courtesy Investopedia
Terminal Value Formula. CFn is the income measure expected to be received in year n, d is the discount rate, and g is the expected average annual growth rate. Image courtesy ValuAdder
The firm value is obtained by adding up the Net Present Value and the Terminal Value of the company.
Mathew pointed out that the Net Present Value formula is generally available on spreadsheet programmes as a function, and that the discount rate represents the risk to future earnings and opportunity costs. He added that both the scorecard and the firm value methods do not take into account assets and liabilities, and should serve more as estimates rather than definite prices.
Also Read: What we’re reading: Valuation inflation, Facebook style
The art of valuation, or why you shouldn’t throw numbers around
However, Mathew cautioned that numerical estimates cannot be used flippantly, and he used an anecdote from Twitter Co-founder Biz Stone’s book, Things a Little Bird Told Me, to illustrate the point.
In the book, Stone recounts an incident when Facebook’s Mark Zuckerberg offered to buy Twitter over, against the wishes of Stone and Twitter’s then-CEO Evan Williams. Both of them conjured up a plan to inflate Twitter’s valuation to US$500 million, a number they were certain would be too much even for Facebook.
Sure enough, Zuckerberg balked at the price. However, a few days later, Facebook came up with an offer in both stock and cash that totalled US$500 million. The lesson, Mathew said, is that one shouldn’t make up numbers on a whim, without any backing or consideration for what they could represent.
Founders Drinks is a monthly mixer organised by e27 and features speakers from the business and tech community. The slides for this episode of Founders Drinks can be found here.