Using multiple methods for startup investing valuation will help to get a better idea of startup investing returns
We’ve covered everything from market research to understanding different types of startup investing deals. When it all comes down to it, estimating the potential return on startup investing deals is what it’s all about.
Finding the potential return for an startup investing investment is more than just figuring out how much money you might make. More importantly, it can help you avoid some of the worst investments.
In an asset class where half or more of the investments end up returning less than the original investment or even nothing, avoiding as many losers is just as important as finding the best deals.
But valuing startup investing deals isn’t easy. You’ll need to estimate the company’s potential for sales even against market competition and many unknowns. You’ll need to estimate how much companies are willing to pay for those sales and how much the company might be worth in the open market.
Because of all the assumptions and unknowns that go into estimating startup investing returns, I use multiple valuation methods on each deal. Working through multiple valuation methods helps to get different perspectives on the company and a valuation for different types of investor exit.
Using ProForma Estimates for Startup Investing Valuation
I’ve seen entrepreneurs try to talk investors into funding simply by the size of the potential market, especially in deals for a simple agreement of future equity. In an attempt to avoid a realistic valuation, they argue that the size of the market will be enough for millions or even billions in sales and lead to a profitable exit.
Sorry but investing just doesn’t work that way. Your equity crowdfunding valuation has to start with good proforma estimates of future sales and the potential for earnings. We walked through how to develop proforma estimates for equity crowdfunding in a previous article.
The idea is to put all your market research into a rational expectation of sales and expenses for the next few years. Not only will it give you an idea of revenue and whether management expectations for costs are realistic, it will help understand how much more funding the company might need in the future.
Don’t miss this article on doing market research for equity crowdfunding deals
Will your proforma estimates be perfect? Of course not but they will help you understand the company better and avoid some of the worst deals that don’t have a chance of being successful.
In an asset class where more than half the investments go bust or pay out less than the original investment, just being able to avoid some of the failures is a huge advantage.
With a good idea of sales potential, you can start to plug your estimates into different valuation measures.
Using Discounted Cash Flows for Equity Crowdfunding Valuation
Discounted cash flow (DCF) attempts to value the future free cash flow of a company from a cost of capital, an estimated growth rate and some proforma financial numbers. From the sum of cash flows, we get an estimate for the enterprise value of the company.
We will use the table below, a DCF analysis I did on an startup investing deal, to walk through how to do your own valuation.
Free Cash Flow – Cash generated from operations minus any capital spending on equipment or other assets to keep the company in business. This is the amount of cash that can be distributed to owners without limiting the long-term potential of the company.
Cost of Capital – This is the cost of funds for the company, both debt funding and equity funding. It is found by weighting the amount of capital funded by each type and multiplying that by the rate investors or debtholders require to make the investment. It is also referred to as the Weighted Average Cost of Capital (WACC) and is used to discount future cash flows to a present value.
Terminal Value – While you will estimate cash flows over the next few years with your proforma estimates, the company’s future sales and earnings will also have value. The terminal value is an estimate of the worth of all the cash flow over the life of the business beyond your forecasts.
Perpetual Unlevered Free Cash Flow Growth – An estimate of the growth in cash flows the company can expect into the future. This is needed to estimate a terminal value of the business beyond the proforma period. The easiest way to find this mature-company growth rate is to look at other companies in the market that have been in business for a while.
Net Present Value – This is the discounted value of all future cash flows (or other metrics such as earnings or sales). A dollar today is worth more than a dollar five years from now because of inflation and the potential for investment returns. To get the value of future cash flows, we have to reduce them by a discount rate for each year into the future that they occur.
If you estimate the statement of cash flows then you can just use the free cash flow estimate. Since most analysts only develop a proforma income statement, the DCF analysis is most commonly done with income statement information.
You first have to get an estimate of cash flows by adding back depreciation, after tax interest expenses and changes in operating assets to your net income estimates. From here, you also need to reduce that cash flow by planned capital expenditures, the amount spent each year on R&D and property, plant and equipment (PP&E) necessary to keep the company operating. This will give you an estimate of the free cash flow over the next few years.
Again, that future cash isn’t worth as much as a dollar today so you have to find the present value. To estimate the WACC, you multiply the cost of debt and equity by its percentage within the capital structure.
First calculate the after-tax cost of debt by multiplying the interest rate by (1-tax rate). Since the company can write off bond interest as an expense then debt doesn’t really cost the full interest rate because it helps save on taxes. If the company pays 5% on its debt and a 35% tax rate then the real cost of debt is 3.25% or 10%*(1-0.35).
If the company has raised 30% of its funding from that debt then the debt portion of WACC is 1.0% or (0.0325 times 0.30).
The cost of equity more subjective because it is the return investors require to fund the company. For mature companies with stock, the cost of equity can be assumed as the return on the stock market. For early-stage companies, the required return is going to be much higher because the investment risk is much higher. I usually use 20% as the cost of equity for startup deals.
If the company raised 70% of its funding from investors then the equity portion of WACC would be 14% or (0.20 times 0.70).
Combining the debt and equity portions gives you a 15% weighted average cost of capital. Any financial calculator or Excel spreadsheet can calculate a net present value given your WACC and each year’s estimate for cash flows. In the example above, we find that the five years of free cash flows are worth a present value of just over $2.4 million.
To estimate the value of the business after our forecast period, we have to find a terminal value based on a perpetual growth rate. The terminal value is the free cash flow of the last forecasted year divided by the difference between the cost of capital and the growth rate.
In our example above, it would be $2.5 million divided by 10% which is the difference of the WACC (15%) minus the 5% growth rate. Since this terminal value is five years into the future in our example, we need to get a present value by discounting it by the WACC. In our example above, that gives us an estimate of just over $13 million for our terminal value in today’s dollars.
Add both the present value of cash flows and terminal value together and you’ve got an estimate of the enterprise value. This will be enough for many startup investing deals since most startup companies will have very little cash or debt.
If the company has debt then you subtract it from the enterprise value and add back any cash to get the value of equity (stock). Dividing this by the number of shares will give you a present value estimate for each share of stock.
After all that, I’ve got to tell you that I don’t like the DCF method very much as a valuation tool. It is a good check on the other two methods and can help to get more certainty on your estimate but there are a lot of drawbacks to DCF.
DCF valuation is completely dependent on your estimates…and there are a lot of them. From estimating cash flows to the growth rate and discount rate, there are a lot of opportunities to be way off in your final value.
The final value is also highly dependent on the terminal value, more than 84% of the valuation estimate in the example above. Estimates for cash flows are more uncertain as they get further into the future and the terminal value is about as uncertain as it comes.
I still try to do a DCF analysis just to give myself one more look at a company’s potential value. If there is not enough financial statement information provided from the company to estimate earnings, I don’t sweat it too much. You can still do the other two valuation methods with an estimate of sales.
Using M&A Analysis for Startup Investing Valuation
The mergers & acquisition (M&A) method of valuation is probably the most applicable for equity crowdfunding deals and early-stage companies. Most investor exits are going to be through an acquisition by another company so you better know how much companies are willing to pay.
Fortunately, M&A analysis is also fairly easy to do and involves fewer estimates than does the DCF analysis.
You can get information on acquisition deals through a simple Google search. Search for a few different keywords including the specific industry or sector and M&A or acquisition deals. It will take some research but you should be able to build a table with the date of the deal, target company, buyer, transaction value and any multiples.
It’s these multiples that are important. You want to find how much the company is paying per each dollar of sales or some other metric. Most common multiples are transaction value relative to sales and earnings before interest, taxes, depreciation and amortization (EBITDA). Searching through the Google results may be able to uncover the actual multiples but you may also need to look through the acquisition target’s financial statements or press releases to find sales and EBITDA information.
The table below is an M&A analysis I did for the Pinterest equity crowdfunding deal, a social media sharing site. Notice I measured the transaction value of deals relative to users on each platform, one of the most followed metrics for social media. Through your market research, you should be able to uncover the most important valuation metrics for an industry. It’s usually sales and EBITDA but may be something else specific to the industry.
Once you’ve got a good list of prior acquisitions, you need to look through any high or low outliers. The $150 Microsoft paid for each user on Yammer in 2012 is obviously high considering the rest of the deals and probably doesn’t reflect a good estimate for future deals.
Looking through the deals, you will pick a multiple with which to value your target company. You don’t necessarily have to go with the average every time or have to pick the same multiple for both metrics. For the Pinterest valuation, I went with the most recent multiples on the LinkedIn deal. The LinkedIn valuation based on users also happened to be the average of prior deals. The valuation based on sales was the lowest in the list so could be a good conservative estimate.
Whichever multiple you choose, just be able to back it up with reasoning. How does the size and maturity of prior targets compare with the company you are trying to value? What about market share and any intellectual property that might make one company more valuable to an acquirer than the next? There are so many unknowns with equity crowdfunding, choosing a conservative multiple is always best to give you a safe estimate.
Once you have your multiples, you can use projections for your startup investing company to arrive at an acquisition value sometime in the future. While it may take years for an early-stage company to become an acquisition target, it’s best to base a valuation on no more than three or five years out.
Using Public Comparables for Equity Crowdfunding Valuation
The final valuation method for startup investing deals is comparing your target company against similar companies with publicly-traded shares. The M&A valuation method may be the most applicable to startup investing but public comparables is likely the easiest.
You start by looking for companies within the same industry that trade on the stock exchanges. Most online investing platforms will display the sector and industry for each stock so it usually isn’t too hard to find a list of companies in any particular group.
If your target company is developing a new market or doesn’t quite fit with an established industry, you may need to put together a list of companies from different industries to make a better comparison. For example, when valuing a startup that sold a bumper attachment for cop cars that deployed stop sticks I used comparison companies from auto parts and from personal security to get a better idea of valuation.
The table below is one I used to value one of the funding rounds Pinterest.
Just as with the M&A valuation method, the idea is to take the current market value of the company against a metric like sales or EBITDA. Monthly active users (MAU) is a commonly used metric to value social media platforms so was more appropriate for valuing Pinterest.
To get the price multiples, just take the market capitalization or the enterprise value of the company against your chosen metric. The market capitalization is the value of all shares issued. Enterprise value is the market cap minus cash and adding back any debt.
You’ll need to do some of the same research and inspection with public comparables that you did in the M&A analysis.
- How comparable are other companies with your target in size, market share and business model?
- The market multiple for companies will differ, mostly on growth in sales and earnings. Startups may be able to get a higher multiple in the market due to faster growth.
- Are there any outliers that shouldn’t be included?
Pinterest benefits from several factors that could make it more valuable than some of the other social networks though it’s not likely to get the same valuation as shares of Facebook. I decided to use the average multiple of the group which made for a good trade-off between the multiples on the other networks and the runaway Facebook valuation.
Using the Blended Approach for Startup Investing Valuation
Combining the three valuation methods is another exercise in analysis. While it’s always a good idea to use multiple methods to value an startup investing deal, there may be one of the methods that are more appropriate for the specific deal.
Since the most frequent investor exit for startup investing is through an acquisition, the M&A method is usually the most appropriate. Because Pinterest is a late-stage startup and already has a valuation of nearly $11 billion, an initial public offer (IPO) of shares is a more likely exit and the public comparables valuation was deemed most appropriate.
Putting the valuation estimates in a graphic helps to see where they overlap as well as the range in valuation.
If the different methods provide fairly similar valuation for the company, you may just want to take an average. If there is an outlier method that provides a much higher or lower estimate than the others, you may want to discount that valuation or throw it out entirely.
In the end, it’s all about finding a realistic estimate for the company over the next few years. Again, it’s usually best to go with a conservative estimate. By using conservative estimates, you’ll only invest in deals that are most likely to be successful. You may miss out on some deals that do alright but will also avoid many of the losers.
You can also build estimates around different scenarios for sales and earnings. Use management guidance as a best-case scenario, your own expectations for the base case and then estimate a worst-case scenario on lower expectations for market share or growth. This will help give you a range of estimates for valuation. If even the lowest valuations provide for an acceptable annual return, you might just have a slam-dunk investment.
Remember that you need a high potential rate of return on the startup investing deals in which you invest. If you are going to be averaging an annual return of 20% or higher on your portfolio with up to half of the deals returning nothing, then the startups in which you invest must have the potential to return 38% or more to even everything out.
So while the potential for a return of 15% or 20% a year on a traditional stock investment may sound great, it isn’t enough when you’re selecting startup investing deals.
Valuing startup investing deals or other startup investments isn’t an easy process but no investment with the potential to double your money is going to be easy. You’re never going to be exact in your estimates but using multiple valuation methods will help you better understand the potential for different investor exits and draw a narrower range for an eventual payoff to your investment.