A friend of mine was once asked how much his house was worth at dinner. He said “I guess whatever someone will pay for it.” I was pretty young at the time and don’t think I fully appreciated the wisdom of the comment. These days, I get a report from Zillow once a week that shows me how much they think my house is worth. And they’re pretty close to what I see houses in the neighborhood good for. But ultimately, the house is worth what someone would be willing to pay to buy it. If sold, I would walk away with the sale price of the asset (the house) minus any liabilities (the mortgage).
Companies are similar, although there are a few different methodologies we can use to get a good idea of what a startup or business is actually worth. Traditionally these would mainly be the assets minus liabilities, a comparable look at other similar businesses, the income of the business, and a replacement value. The valuation then becomes the basis for any investments or capitalization done to accelerate the growth of the company or to buy out any partners if a principal exits.
Valuation can be one of the more contentious aspects of a company. When money is involved, things often get weird. So it’s often best to let a third party handle doing so. Once a company goes public, the valuation is easy. The market sets the value based on the outstanding shares and the price per share. But let’s look at other ways to do a valuation in a pre-IPO scenario.
Appraising the value of a company by assets is a common means of looking at the value for a number of types of businesses. This is an easier approach where we look at the assets and subtract the liabilities, much like the example of selling the house earlier in the article. Assets would include contracts for future services, cash, furniture, accounts receivable, products (like software), property, computers, etc. Liabilities would include any debt incurred, unrecognized revenue, outstanding accounts payables, taxes, mortgages/rents, and outstanding salaries for the year.
The Going Concern approach looks at the value of the business if the business were to continue to running as it had prior to valuation. This means no assets or product line changes and no further capitalization to introduce new big changes. This is great for private equity where a business will continue to run to provide monthly recurring income.
Liquidation is an approach that looks at the value if the business were to sell of some or all of the assets and satisfy any outstanding liabilities with the proceeds. This is usually going to be lower because the business is likely not doing well.
Valuations based on assets introduce very few assumptions, so they can be popular. However, they don’t often provide a real snapshot as, especially in a software or SaaS-based startup, the biggest asset is software written over time that is hard to assign a fixed price that can be used to evaluate that asset.
Valuation by Comparison
Another common methodology used to provide the valuation of a company is Comparison, or Comps for short. However, here we can introduce a lot of assumptions.
Most companies will have competitors. Comparing our companies to the value of a competitor can be tricky, though. No two companies are identical, otherwise there would likely be no need for multiple companies. For example, another company might have more or less sales and a correspondingly larger or smaller sales force. We might be in different geographies or appeal to different niches within an industry.
Comparing our company to others though, can set a baseline. Here, we dig into market sizes and see how red an ocean is (or how many vendors are in the space) in order to set an upper limit on a valuation. And we look at others as a means to assess what’s possible. Provided of course, that we can ascertain a sale price from public records.
Discounted Cash Flow Valuation
The Discounted Cash Flow (DCF) method is much more complicated but looks into the future performance of a company. Here, we look at cash flow by calculating future revenue, taking price, volume of sales, competitors, and renewals into account. We then project future expenses and any new assets required to satisfy those sales and calculate a terminal value, or the total value of cash flow over a given term.
This doesn’t require finding similarly valued companies and allows for modeling around multiple scenarios. Many startups, though, will operate at a loss for a given period of time in order to build a large and loyal customer base. And the velocity that we can attract new customers is quite a large assumption to make and those are usually quite optimistic and based on the total market size rather than a more realistic bottoms-up approach to customer acquisition. The complexity of DCF also allows for errors and business owners and entrepreneurs often start tinkering with this cell or that and end up with a butterfly effect across the entire spreadsheet.
Replacement or Startup Value
Another means to find the value of a company is to go from the bottom, up and look the cost to build it from scratch. This is most applicable when looking at a valuation of a company that doesn’t yet have customers, or when a larger organization in an adjacent market is looking to acquire the company to get into that market.
Calculating startup costs have a number of facets. Here, we calculate the cost to buy any required equipment, office space, and the salaries required. Future earnings and cash flow are often not considered when looking at Startup Value, especially if it’s an acquisition by a larger company. Instead, those earnings are calculated based on the larger company being able to cross-sell products. Instead, what we’re really trying to get at is the cost versus the opportunity cost in not getting to market faster.
Licenses, compliances, patents, the supply chain, transferable partnerships, and logic that takes years to develop are all assets in this case, where they might not otherwise be. And technical debt might be considered a liability where it otherwise might not be. The longer entrenched the company and the larger the company base, the more that becomes a factor. - but neither are always necessary.
We talk about the investment thesis a lot. This is really why we think a company will succeed, the reason we’re making the investment. Sometimes this is a great set of experienced founders. Or it might be a great idea in an emerging market, or a transformational technology.
Established industries have standard multiples. Here, we look at revenue and multiply EBITDA or SDE times the standard multiplier. These should be disclosed to potential investors in a financial statement compiled with generally accepted account principles, or GAAP, and include:
EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization is a great way to look at net income. Especially in SaaS-based companies, where we aren’t overly invested in capital investments like property or large, industrial equipment.
SDE, or Seller Discretionary Earnings is Revenue minus Costs of Goods Sold minus Operating Expenses and the Owner Compensation. This shows the earning power of the business.
For example, a florist has a 1.78 multiplier. So if one is looking for an investment then on an EBITDA of $1,000,000 (for easy math) we might assign a value of the organization to $1,780,000. Electronic parts manufacturers have a 2.4 multiplier so on EBITDA of $1,000,000 the value would be $2,400,000.
Looking at multiples is usually more useful with fast growing, young companies. Pre-defined multiples are really just a baseline and then the capabilities of founders, market potential, likelihood to enter a market and other factors can add or subtract from the multiplier. But that multiplier is a pretty big assumption. Search the web for “multiplier by industry” to get a decent idea of what information is out there about a given industry or slice of an industry. And ultimately the multiplier usually acts as an upper limit for the value of a company. Ultimately multiples are mostly a mix between a comparison and a DCF method, but adding in assumptions.
Choosing A Methodology
I like to see a valuation using each method (by the way, there are more methodologies than these). But I’m weird. If I don’t see it, I’ll figure it out myself and then I’m making assumptions an owner might rather me not make. I prefer to see a third party appraiser to a startup who is throwing a dart at a dartboard in Excel.
Choosing a methodology has a lot to do with the intent of calculating the valuation. Looking to sell the company or looking to woo investors? Multiples are a great way to go, especially software companies (except those where founders automatically assume it’s a unicorn). Looking to buy a company and averse to risk? Focus on the assets. Also focus on assets if there’s a large startup cost that involves property, heavy machinery, and patents. And take the industry into account as many, such as services businesses, can’t be properly valued using the assets of the company.
The most honest and transparent relationships are best and displaying the estimated value using a number of different options is going to help investors get down to the heart of whether they think a company is worth backing. The average of a number of methods is likely to get us closer to the real value of an organization.
Ultimately, this is not financial advice. This is to help founders have a more honest conversation with appraisers and with themselves about what they want and why. The more deliberate we can be about laying out our intentions the better the long term choices we can make about investors and potential outcomes. Many organizations get weighed down by a great investor who is bad for them and the effort to maintain that relationship takes valuable time and focus away from having an amazing product. And neither party wants that.