Finances: Statup Valuation

Valuation of statup is a difficult and complex task. In some cases such assessment isn’t feasible because of a plenty of reasons. Regardless technical hurdles the project team will encounter with, entreponeurs always face a problem of financing sources. Frankly saying, that’s the general obstacle for the vast majorty of startups.

In this topic I’ll to put a glance view on the most popular approaches of new initiatives, mostly for IT area. Well, as mentioned above, along with technical issues statups meet most of following challenges:

High level of uncertainty. Statups leaders are responsible for the progress of their venture, but lots of factors affect on the project. Since, new technologies and new ways for socioeconomic life of general public are pretty risky to implement, any statup should be suggested as risky;
No comparable examples. Since we’re talking about statups (therefore, something new-brand), statups leaders couldn’t have similar examples of completed projects - neither histories of success nor failues. Because of absence of comparable examples, leaders are compelled to create vague and flawed business plans;
No historical data. That point refers to the first point - the field of high uncertainty. Leaders couldn’t have data from another data, not to mention their own experience;
Not applicable standard financial analysis. Actually, fundamental economic rules are constant and cannot be changed by any project or individual. Meanwhile, at the first stages of a statup the standad investment valuations are mostly meaningless (such methods as Price-Earning Ratio, P/E, EBITDA assessing or Enterprise Value, EV);
Positive CF is a foggy dream. Statups are unprofitable for years (definitely legal businesses).
Systematic risks. Along with technical problems and financial ignorance, the statups leaders will encounter with critical view of the market on the new product or service. That will entail to a survival mode of the project as a whole. Sometimes, event a thorough analysis of the market wouldn’t be enough - the evolution of the public will not mature to apply the results of the project - that might be called with synthesis term “socioeconomic risks of the market”;
Accidential leap. If you’ll check succesfull statups financial reports you can notice that their revenues skyrocketing at a point of time. The most succesfull statups income graph reminds hockey stick - for a relatively long period of time income remains flat but in an accidential moment an income start to growth rapidly.

Regarding to the list of issues above, the financial planning is compicated task for statups companies. Meanwhile, none will invest to the initiative without funding strategy, albeit superficial. Statup leaders can plot funding periods, approximate first paybacks time, imagine the moment of the project paramount and the “exit” for invertors.

Startup company founders shouldn’t forget the point that potential investors always have a myriad of project for investment - they will prefer those with the best financial opportunities (buy cheap sell high principle).

There a several methods to assess the potential value of the statups. Some of them will be reviewed bellow.

Market background

The most important to enter the market neither to create a product. Probably, that’s more difficult task, particularly, when a product strive to change psychological attitude to the subject.

Standard financial plan might to be insufficient for a particulat economic area or business. Every product must be oriented (at the initial phase, at least) on the definite customer, choose its niche and expend in time. Furthermore, before initating the project company can suggest several business plans to prefer the most viable and optimistic.

Discounted Cash Flow

In basis, DCF evaluates forecasted Free Cash Flows, FCF at today’s lower value. In respect of new-brand products or services, initiators must perform the following steps for a feasible financial justification based on DCF approach.

Conduce a standard superficial DCF analysis.
In circumstances of riskness of startups, leaders need to predict and add costs of tremendous risks influencing on the project.
Together with the standard DCF calculations, startup entreponeurs must perform risk-adjusted discount rate measures.
Suggest ways to handle revealed high-level risks. These suggestions should reflect Cash Flow for each year and, consequently, influence on the DCF.
Perform rought Terminal Value calculation using Liquidation Values, Exit Multiples, and a Growing-Perpetuity Model.

What is DCF

DCF can be summarized with the following graph:

Discounted Cash Flow

Briefly, the DCF graph can be explained as:

Estimate future Cash Flows. That’s the first step - to identify incomes and outcomes. Because at the initiating phase of the project it’s almost impossible to conduce precise estimation, that would enough to perform it superficially. That might include the following:

assess how much funds is required to complete the project (succesfully, definitely). That point must the most detailed review at this phase as possible;
suggest the sources of fundings;
predict liquidity usage at every important moment (let’s call it milestone);
That can be grouped into Financial Plan, i.e. the general part of Business Plan.

Calculate Cost of Capital (or Weighted Average Cost of Capital, WACC). Depending on the country and industry of the startup, capital will have different price at a moment. That will affect the budget of the startup, sources of funding and revenue streams.
Terminal Value modeling. Basically, Cash Flow model forecast flows for a limit period. Terminal Value modeling will help to propose strategies of startup company evolving beyond presented period.
Assess risk of Misscalculations. At initial stage none of statup canc be calculated precisely, thus the risk of misses in DCF calculation is actual for each of them. Several techniques can be applied to alleviate these misses negative affects.

Simplified example

Let’s suppose that a company decided to initiate the project to provide a digital service. Forecast horizon is years and each year Free Cash Flows, FCF has been calculated superficially for three different strategies:

Strategy	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
A	-1,000	-1,000	700	1,500	2,000	3,000	4,000
B	-1,000	-1,000	-1,000	1,800	2,500	3,000	5,500
C	-1,000	-1,000	500	1,000	2,000	3,000	5,000

As mentioned above, the product will be the same for each strategy, only a distribution fashion will differ. Let us assume that strategies has the following probabilities: Strategy A - 30%; Strategy B - 30%; Strategy C - 40%. The project management applied baseline 10% risk-adjustment (Weighted Average Cost of Capital, WACC) for each strategy.

Accordig to the given data, we can calculate DCF for each strategy:

DCF_A = 0 / 1.1⁰ + -1,000 / 1.1¹ + -1,000 / 1.1² + 700 / 1.1³ + 1,500 / 1.1⁴ + 2,000 / 1.1⁵ + 3,000 / 1.1⁶ + 4,000 / 1.1⁷ ≈ 4,802.800
DCF_B = 0 / 1.1⁰ + -1,000 / 1.1¹ + -1,000 / 1.1² + -1,000 / 1.1³ + 1,800 / 1.1⁴ + 2,500 / 1.1⁵ + 3,000 / 1.1⁶ + 5,500 / 1.1⁷ ≈ 4,810.667
DCF_C = 0 / 1.1⁰ + -1,000 / 1.1¹ + -1,000 / 1.1² + 500 / 1.1³ + 1,000 / 1.1⁴ + 2,000 / 1.1⁵ + 3,000 / 1.1⁶ + 5,000 / 1.1⁷ ≈ 4,824.189

Regarding to the calculations above, Strategy C is the most promising, in particular, if a probability will be taken into account. Now, we can calculate DCF of the company:

DCF_company = 4,802.800 * 30% + 4,810.667 * 30% + 4,824.189 * 40% = 4,813.716

That assessment shown that Current Value of the company would be 4,813.716 in case of project will be successful. With a high change, management would prefer the Strategy C.

We can calculate DCF for a company another way - by calculating different DCF for each year:

DCF_Y0 = 0
DCF_Y1 = -1,000
DCF_Y2 = -1,000
DCF_Y3 = 700 * 30% - 1,000 * 30% + 500 * 40% = 110
DCF_Y4 = 1,500 * 30% + 1,800 * 30% + 1,000 * 40% = 1,390
DCF_Y5 = 2,000 * 30% + 2,500 * 30% + 2,000 * 40% = 2,150
DCF_Y6 = 3,000 * 30% + 3,000 * 30% + 3,000 * 40% = 3,000
DCF_Y7 = 4,000 * 30% + 5,500 * 30% + 5,000 * 40% = 4,850
DCF_company = 0 - 1,000 / 1.1¹ - 1,000 / 1.1² + 110 / 1.1³ + 1,390 / 1.1⁴ + 2,150 / 1.1⁵ + 3,000 / 1.1⁶ + 4,850 / 1.1⁷ ≈ 4,813.716

DCF recomendations

Management should prepare several strategies for a single project. Moreover, that would be worthy to generate multiple scenarios for each strategy (the standard set of Pessimistic, Intermediate, Optimistic);
Afterwards management should model consequences of all proposed alternatives. That will help to find circuitous ways to avoid hurdles and identify key growth drivers (i.e. positive risks);
And, eventually, cumulative financial plan should be based on the suggested strategies. The final plan can be a compilation of various decisions from different strategies. The final plan will be offered to stakeholders as a financial profile of the project (or company).

Risk-adjustment

The fundamental indicator, Weighted Average Cost of Capital, WACC, isn’t applicable to startup companies by several reasons:

There is no historical data for the company;
Financial policy is very risky and, in some cases, vague;
Absence of revenue history;
Most often, risky field of economy (technological and socioeconomic risks);

Despite WACC, some experts prefer to use Minimum Acceptable Rate of Return, MARR as an indicator of lucrativeness of investment.

In respect of the first letter ‘M’ in MARR acronym, meaning ‘Minimum’, tels that MARR exposes the minimum rate of outcome that invertors are ready accept. MARR is represented by a single figure (with a floating dot). The indicator that MARR is compared to is IRR.

IRR vs MARR

Internal Rate of Return, IRR, shows annual return rate of the project provided that the income is reinvested at the same rate.
Let’s say, some entgreponeur needs $200 thousands for a project and he wants to borrow that sum from investors. He promised that a payback period will be in 5 years with extra $300 ($500 in total). In other words, in 5 years the return of the project will be 250% in comparison with starting point. Let’s calculate annual rate of return for the project:

IRR = {(\frac{500}{200})}^{\frac{1}{5}} \approx 20.11%

The project annual return rate is 20%. After that, investor should decide if he’s ready to invest to the project - he will weight the bucket risks that accompanied with the project and compare IRR to his own MARR (for instance, if MARR of investor is 25% then project’s IRR of 20% is’t attrractive for funds investment).

Worthy to note, that IRR doesn’t response to risks, it’s just an indicator in pace of return rate. Investor have to consider all risks and decide if proposed IRR feasible or not.

Handling risks

Normally, any new venture requires extra funding. Regardless the source of funds, entreponeur will be compelled to pay for a capital of potential investors. There are two general cases:

negotiate about extra premia to the cost of capital, therefore establishing Minimum Acceptable Rate of Return, MARR;
find similar project and apply its cost of capital to the target project; cost of capital can be adjusted both upward and downward.

Minimum Acceptable Rate of Return, MARR

Risk premiums can vary depending on the project field, current market situation, economic stability, etc. MARR calculation is pretty simple:

MARR = DCF + risk premium

Depending on the stage of the initiative, MARR will fluctuate (mostly, downwards):

Project initiation. Significant risks and huge risk premium. For our example, let’s assume that investors add up to 20% on top of the baseline WACC, 30% in sum (10% + 20%) for 3 years (0-initial, 1st and 2nd);
Project growth. Amount and weight of risks decline. In our case, additional 10% to baseline WACC will result in 20% overall for a period between 3rd to 5th year;
Project maturity. WACC turns to become close normal as the majority of crutial risks has been passed. Eventually, the project has reached the baseline WACC, equal to 10% starting at year 6.

It’s worthy to use indicator that helps to estimate Present Value (PV) in the future based on the expected date of receipt and discount rate assumption. To simplify, the indicator estimates how much will future’s $1 will cost for a company today. That’s called Discount Factor, DF and calculated as:

DF = \sum_{n = 0}^{m} \frac{1}{{(1 + Discount Rate)}^{n}}

or, alternatively:

DF = {(1 + Discount Rate)}^{(– Period Number)}

Say, for the project’s 3rd year DF will be:

{DF}_{3} = \frac{1}{{(1 + 30%)}^{3} * {(1 + 20%)}^{1}} = $0.38

(1 + 30%)³ means that for 3 years a discount rate will be 30% (0-initial, 1st, 2nd years); (1 + 20%)¹ rings that for only one period a rate will be equal to 20% (3rd year). Calculation for every year is in the table bellow:

Strategy	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
FCF	-1,000	-1,000	500	1,000	2,000	3,000	5,000
DF	0.769	0.591	0.455	0.379	0.316	0.263	0.239
PV	−769	-591	227.5	379	632	789	1195

As you’ve noticed, PV calculation is very simple: by multiplication of FCF with DF.

Total PV will be 1,862.5. Previous PV calculation gave us the value 4,813.716. That significant difference (over 65%) appeared because of high risks that reflect in rates of external capital, we didn’t take them into account before.

Professional investors distinguish projects by stages to determine cost of capital of a project. The summary table is represented bellow:

Stage	Plumer	Scherlis and Sahlman	Stevenson and Bhide
Startup	50-70%	50-70%	50-100%
First stage	40-60%	40-60%	40-60%
Second stage	35-50%	30-50%	30-40%
Third stage	25-35%	20-35%	20-30%

Frankly, the is no clear guidence how to calculate risk factors to a particular project because lots of factors cause different affects (either positive and negative).

MARR approach estimates Company Value with suggestion of probability of company failure for each particular period. Probability of failure for every year effects DFC of that explicit year but not the company as a whole.

Modelling Survival Probability

That approach estimates Company Value with respect to two scenarios simultaneously - Going Concern and Liquidation scenario.

Company Value = Going Concern Value * Survival Probability + Liquidation Value * (1 - Survival Probability)

Suggested that company achives Going Concern conditions close to the maturity phase - the discounting rate is equals to “normal” WACC. Liquidation scenario is opposite - the “normal” WACC couldn’t be reached and company stops its operating activity. In most cases, the Liquidation Value for startup copmanies are near zero, apparently. The Survival Probability indicates a change of a company to reach Going Concern scenario starting current moment.

Regarding to our hypothetical company example, the “normal” WACC will be reached at year 6 with the Company Value of 4,813.716. In sake of simplification, let’s assume that Liquidation Value will be equal to 10% of the Company Value - 481.371. And, let the Survival Probability to be equal to 25%. Now, that would be easy to calculate Company Value in present:

{Company Value}_{now} = 4,813.716 * 25% + 481.371 * (1 - 25%) \approx 1,564.457

How to assess Survival Probability?

Venture expert, Bob Zider, offers eight components that helps to estimate probability of the copmany to pass through the startups valley of death:

Sufficient Capital
Professional Management
Going-well product Development
Flow of Production goes well
No extraordinary actions by Competitors
The product is in demand by Customers
Forecast for Prices is correct
Enforced and issued Rights

He noted, that re-estimation needs to be performed regularly during the company lifecycle. Failure in any dimension will open gates to the valley of death… The statement that each component is crucial for success of the company is reaffirmed by the statistics of startup failures - over 90%.

Let’s assume that each component of our project has relatively high chance of success - 77%. Easy to calculate summary Survival Probability for the whole company - 77%⁸≈12.357%.

Dimension	Probability
Capital	77%
Management	77%
Development	77%
Production	77%
Competitors	77%
Customers	77%
Prices	77%
Rights	77%
Overall	12.357%

Despite MARR approach, Survival Probability doesn’t take into account single periods, but calculates the whole change of the company to survive.

Survival Rate

To calculate Survival Rate of the company the following indicators are required:

Present Value, PV. We’ve already calculated PV in MARR section above. That was equal to 1,564.457;
Going Concern Value of the company. For our case that’s equal to 4,813.716;
Liquidation Value. Previously we assumed that for our case that will be 10% of the Company Value, thereby equal to 481.371

Well, the Survival Rate equation is as follows:

Survival Rate = \frac{Present Value - Liquidation Value}{Going Concern Value - Liquidation Value}

Thus, for our case the rate will be:

Survival Rate = \frac{1,564.457 - 481.371}{4,813.716 - 481.371} \approx 24.999%

Period Rate Adjustments

Depending on a particular period of time the capital cost of the company may vary. For our simple example, for instance, first two years have guaranteed cash outflows. Meanwhile we didn’t take into account that fact before - we applied baseline risk-adjustment equal to 10%. But what if for the first two years cost of capital will be equal to risk-free rate, say, 5%? Then, we can recalculate DCF:

DCF_A ≈ 4,766.972
DCF_B ≈ 4,686.794
DCF_C ≈ 4,700.315
DCF_company ≈ 4,716.256
Company Value_now ≈ 1,532.898
Survival Rate ≈ 25.002%

Obviously, all indicators has changed - that tells that all of them are interconnected with each other and micro-adjuctments will entail to significant changes for the company survival.

Modeling Terminal Value

In different sources that indicator can be named as Horizon Value.

Terminal Value is critical for a continual assessment of any company, and primarily statups. The reson is that in most cases statup management doesn’t look beyond the horizon, it’s general target is to pass through the valley of death. Meanwhile, any investor is interested about far-going plans to be confident that the company isn’t a money-laundery project and will not be liquidated just after forecast period.

There are several ways to calculate Terminal Value. Let’s contemplate the most popular.

Liquidation Value

There are 3 widely used options to assess Liquidation Value:

forecast book value of the company with net liabilities substruction;
believe in expanded book value. the difference between that value and actual Liquidation Value should be calculated with taxes;
Liquidation Value can require additional expenditures. For instance, property dismantling, juridicial closure of activities, etc.

We’ve already calculated PV for a given exaple. Let’s assume that it’s 7th year right now and we are facing exit from the business. We’ve got the following indicators:

Total Assets: 4 million
Cost of Assets: 7 million
Liabilities : 1.5 million
Cost of Closure: 0.5 million
Tax Rate: 30%

Let’s calculate Liquidation Value, LV with the following formula:

LV₇ = Cost of Assets - Liabilities - Cost of Closure - Taxes

Taxes derive from the difference of Assets and Liabilities:

Taxes = (Cost of Assets - Total Assets - Cost of Closure) * Tax Rate

Eventually, we’ve got:

Taxes = (7M - 4M - 0.5M) * 30% = 0.75M

LV₇ = 7M - 1.5M - 0.5M - 0.75M = 4.25M

Hence, Discount Factor (of 7th year) could be taken into account to calculate proper Present Value, PV:

PV_LV = 4.75 * 0.239 = 1.015M = 1,015

And, eventually, the Company Value:

Company Value₇ = PV_FCF + PV_LV = 1,195 + 1,015 = 2,210

In most cases, liquidation is the most negative scenario amid others. Liquidation Value method helps to estimate minimum price of the company at the aprticular period of time - that will help investors to weight all risks that could entail company to the worst scenario.

Exit Value

This approach is popular among venture investors. The principle is pretty easy and clean - to perform estimation we need the forecasted EBITDA and Earned Value, EV to EBITDA multiplicator (based on experience of another similar companies). Let’s imagine, that the forecasted EBITDA₇ (the EBITDA at the last period) is 10M and similar companies EV to EBITDA ratio is equal to 4. Then, the Exit Value will be calculated with the following equation:

Exit Value₇ = (EV / EBITDA) × EBITDA₇

Applying our assumptions, the Exit Value for 7th year will be:

Exit Value₇ = 10M * 4M = 40M

Next, let’s apply Discount Factor, DF received previously to assess Present Value, PV for Exit Value:

PV_EV = DF₇ * Exit Value₇

With the result:

PV_EV = 40,000 * 0.239 = 9,560

The overall Company Value will be:

Company Value₇ = PV_FCF + PV_EV = 1,195 + 9,560 = 10,755

Such big number shouldn’t confuse use. Hard to name this estimation as integrated - that result is expected value of the company after 7 years of success, no risks are included. Venture investors like to use this estimation approach, but that doesn’t mean that it represents and accounts all hurdles and difficulties that might be guessed.

Despite simplicity of this approach, there are several issued:

Are there comparable initiatives?
What would be driver for the company’s value in 2 year? Or in 5 years? Wil it be the same as tomorrow?
Can we suggest situations of similar companies as comparable (taking into consideration different environment)?
Is it plausible to harness current valuation multiple to forecasted period?

In respect to all mentioned drawbacks of the Exit Value approach, this method is very usefull for a superficial and quick analysis.

Continuing Value

The last but not least approach implies that the company will become a normal, eventually. After passing all infant risks company will be to a phase with standard WACC and could be treated as mature. Moreover, the company will continue to grow with similar to previous periods tempo.

Continuing Value = \frac{{FCF}_{T} * (1 + g)}{(WACC - g)}

, where FCF_T is the FCF at the last forecasted period; g is continuing growth rate; WACC is a cost of capital for mature company.

Applicable to our proposed company, FCF₇ is suggested to be equal to 5,000; the standard WACC is 10%; talking about continuing growth rate (g), let’s say it will be equal to 2.5%. Then, the Continuing Value after period 7 will be:

{Continuing Value}_{7} = \frac{5,000 * (1 + 2.5%)}{(10% - 2.5%)} \approx 68,333.(3)

Next, let’s apply Discount Factor, DF, as we’ve done before:

PV_CV = DF₇ * Continuing Value₇

With the result:

PV_CV = 68,333.(3) * 0.239 = 16,331.(6)

The overall Company Value will be:

Company Value₇ = PV_FCF + PV_CV = 1,195 + 16,331.(6) = 17,526.(6)

For Company Value the following keys should take place in mind:

The upper bound for continuing growth rate (g) is long-term expected global GDP growth;
Opposingly, continuing growth rate (g) cannot be lower than inflation rate for in long terms;
The most highly anticipated continuing growth rate (g) should be between 1.5% to 3%;
To expand the company needs to invest it’s capital;
- If company growth rate is close to inflation, then highly likely that company had performed a series of investments. Thus, in the long run, company’s capital expenditures should be approximately equal cost of depreciation and amortization;
- Otherwise, if company growth rate is higher then inflation, that might signal that company’s investments are in a close future. Hence, in the long run, company’s capital expenditures should be approximately greater then cost of depreciation and amortization;

Keep in mind that none company can grow eternally. Sooner or later the thriving phase will slow down and turn to the standard growth rate.