The True Cost of Raising Funds
A startup is considered to be successful when it is able to raise money. The fact that a startup was able to convince potential investors to open their wallets is considered to be proof that the business model is stable. The fundraising aspect can be considered to be quite thrilling and even glamorous. However, it […]
How Does The Failure of Silicon Valley Bank Affect Stakeholders
The fall of the Silicon Valley Bank happened very suddenly. The bank had gone from a healthy functioning bank to near bankruptcy within 48 hours! As a result, the credibility of the entire American banking system has been brought into question. This is because commercial banks are not like regular organizations. In most cases, they […]
Going From Financial Goals to a Financial Plan
The process of financial planning is a bit more organized compared to the traditional saving and investing approach. During financial planning, a comprehensive plan is created in such a way that the needs and goals of the individual are met at each stage. Hence, the financial plan of every individual is unique since it is […]
Hedge Funds and Leverage
Leverage is one of the defining features of any hedge fund. Therefore hedge funds have gained expertise in the creation and utilization of leverage. Not only do they use traditional means like equity and fixed income leverage but they also use create leverage with the help of futures, options and swaps. In this article, we […]
Why are Professional Sports Franchises Increasing in Value?
The sports business has traditionally not been a very lucrative one. It was common for the valuation of sports franchises to stay stagnant for a large number of years or even drop down as the years progressed. However, all this has changed drastically now. It is now common for sports team franchises to drastically go […]
Valuation of any company can be a very complex task. However, when it comes to pre-revenue companies, this complexity is magnified. This is because of the fact that valuation is generally the discounted value of the future cash flows which are likely to arise in the future. The current cash flows are used as a base to project future cash flows. However, when it comes to pre-revenue companies, there is no current cash flow. Hence, the projection of future cash flows can be considered to be speculative in nature.
The business of startup financing requires investors to routinely invest in pre-revenue companies. It is for this reason that investors have come up with several methodologies which are used in such valuations. Some of the commonly used methodologies have been listed below:
Hence, the valuation is done by simply compounding the investment at an agreed-upon rate. However, the valuation of startups is almost never so straightforward. Investors invest in startup companies because there is a high prospect of growth in the near future.
However, a high prospect of growth also means that the company will have to raise funds from external sources. Since dilution is equity is almost imminent for any reasonable startup, this method is not considered to be appropriate for valuing them. However, this can form a theoretical basis to demonstrate a hypothetical base case scenario.
For instance, if the revenue of a firm in the final year of investment is $100 million, we can use industry averages to make an approximate guess of what the net profit will be for that particular firm. If the industry average is 20% net profit, then we can assume that the firm will make $20 million in profits. Now, the price-to-earnings ratio can be used to value the firm. If it is common for firms in that industry to have a price-to-earnings ratio of ten, then the firm can be valued at $200 million based on the $20 million which the firm has in the form of profits.
For instance, if the terminal value of the firm is estimated to be $200 million and the investors want to earn a 20× return on their investment, then the post-money valuation of the firm has to be $10 million.
Hence, 20× is the anticipated return on investment which is used in conjunction with the terminal value in order to derive the post-money valuation. Now, a 20× return may seem to be predatory. However, it is common in the startup financing universe. This is because startups are inherently very risky. About 50% of the startups that investors back end up losing all or part of the money. The investors have to recover the losses from the ones which actually do make money.
It also needs to be understood that if the value of the firm is going to increase by 20×, then the value of equity may or may not increase by the same amount. Dilution of equity is common and hence the investors may actually realize a much lower rate of return when they actually exit the business.
For instance, investors might find that for a certain type of business, the value of the firm is 10× the asset base. Investors may find it challenging to ascertain the future revenue of a company. However, they may find it relatively easy to ascertain how much money the company is likely to have tied up in assets. This number can then be multiplied with the industry multiple in order to obtain the valuation of the firm. This method does not provide very accurate results. However, it is often used when it is not possible to use the other methods for one reason or another.
Investors commonly use one or more of the methods which have been explained above. It is also common for investors to have a totally different methodology which they have developed using trial and error over many years.
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