Traditional valuations methods need a shake up
In an innovative and forward-thinking business environment, traditional valuation tools (such as discounted cash flow or multiples) may not be the right way to fully understand the value of a start-up. Should an alternative, more artistic valuation approach therefore be applied? Both investor (buyer) and entrepreneur (seller) can consider qualitative information to help evaluate the business, although much subjective judgement is involved:
- entrepreneur’s ability to implement the idea
- entrepreneur’s market profile
- compatibility of the relationship between buyer and seller
- the entrepreneur’s capacity to build on the product - and capture the market opportunities (current and future)
- stage of business maturity
- the risks of technology
- likelihood of a lucrative exit.
In this context, a parallel could be drawn with the art market. When buying a piece of art, even though the market is mature, the price paid is inherently based on the subjective view of the buyer. It is not focussed on immediate cash flow generation from the asset, but rather the perception of the potential price increase. This perception depends on the uniqueness and aesthetic appeal of the asset, as well as the creativity of the artist.
Balancing science and art: What are the options?
Today, along with the traditional methods of discounted cash flow and multiples, there are different methodologies to evaluate a start-up. Two commonly used are:
- Berkus methodology - a simple rule of thumb that bases its valuation on qualitative aspects of the business.
- Risk summation methodology– which compares 12 characteristics of the start-up company, from the business stage until potential lucrative exit.
How do I know if one of these methods is right for my business?
There isn’t a pre-made valuation methodology that applies to all kinds of start-up businesses. Nevertheless, there are some adjustments to the conventional financial approach that should always be taken into account. A sound valuation should be based on a model that combines conventional financial approaches with a more qualitative risk based methodology that suits the market and lifecycle stage of the business.
Due to the characteristics of emerging businesses and the uncertainties associated with them, start-ups should be valued systematically. For this to be achieved it is necessary to consider each identifiable variable. These should be adapted for the special characteristics of the company being valued.
In any analysis, the main variables to review and adapt are:
- The profits and cash flow forecast, in particular with a bottom-up or top-down critical approach concerning the company’s market potential.
- The exit value and, if a terminal value is to be used, reasonable assumptions about cash flows growing in perpetuity.
- The discount rate in a discounted cash flow analysis, ideally avoiding the use of arbitrary ‘target rates’ to allow for uncertainty, preferably considering comparative analysis with mature firms within the same sector.
Start-up companies, like fine art, pose a challenge for accurate valuations. However, using a combination of methodologies can result in a more accurate value.
If you are a looking for advice on your next transaction, our valuation specialists can help you make the right decision. Click here to speak to Paulo Funchal, or visit our global website to find an expert in your country.