Valuation is the sum of the value of stocks and debt, and stocks are what investors usually care to evaluate. But since startups are new ventures and have no track record, evaluating startups is more an art than a science. Nevertheless, several approaches can be applied to frame evaluation efforts in a widely accepted and rationalized framework of analysis.

 

Valuation is based on existing assets

 

Perhaps the simplest way to evaluate a company's stock is the asset-based concept. The latter is closer to the accounting method, as the equity of the company is equal to the total asset value from the balance sheet minus the total debt.

 

But when it comes to startups, this approach generally results in the lowest estimates, because many startups do not have enough assets to justify the high numbers.

 

On the other hand, startups should look to the future reward based on private intellectual property, market prospects, and even more. In terms of accounting, this difference between the actual assets (net debt) and the underlying promise is due to good faith, a factor that justifies the introduction of a specific economic multiplier on the result of the book value difference between assets and debts.

 

The economic multiplier is a qualitative number that reflects this combination of future promise, market trends, the right of investors to make decisions, transparent negotiations, inflation, and the time factor, in which competitors are trying to invest with the same amounts of money to recreate similar offers.

 

It is worth noting that the method of computing the value based on assets along with the multiplier is sometimes referred to as the cost to reproduce valuation method.

 

Discounted cash flow

 

Another quantitative method is Discounted Cash Flow. This concept involves listing the company's past costs and revenues, and then projecting them over the next three to five years.

 

 Although this concept is mostly suitable for companies that have a record of costs and returns, it can be a useful tool for evaluating a startup because of the in-depth thinking and research it needs to link future expectations with strategic plans, as well as appropriate market analysis to forecast expected revenue numbers.

 

The constant in the DCF process is the interest rate, the latter being used to discount future cash flows: Weighted Average Cost of Capital.

 

The WACC is a calculation based on corporate finance theory, as market conditions and risks associated with the project itself lead to the estimated cost of investing money in the startup. In the MENA region, the weighted average cost of capital is in the orbit of 30% and above.

 

Thus, with the expected future cash flows deducted from the value of the average cost of capital, a simple calculation can show the present value of the company.

 

Comparability in the market

 

One of the more qualitative methods is market comparability, and it involves researching the value and debt of similar companies' shares.

 

 For startups that have not yet started earning revenues, this analysis can be simple, whereby a number of companies operating in the same field are selected and then determine or estimate the value of their shares, before comparing them to the emerging company by taking the average or the average as an example.

 

For companies that have already started earning revenues, the comparison can be more accurate by relying on equalizing the ratio of valuation of shares in similar companies to sales figures (as defined by the 'EBITDA', or net revenue).

 

PRCOS method

 

There are other methods of evaluating startups, such as the Dave Berkus method, which is useful for early stage startups and before they generate revenues.

 

This method of valuation is linked to a certain value of the dollar depending on a standard such as the idea itself, that is, if the startup has developed its prototype, or the quality of the management team, and the extent of popularity in the market in terms of strategic partnerships and sales numbers.

The PRCOS method offers the advantage of a popular calculation process, but it has a maximum of $ 2.5 million. This limit may not be sufficient for projects that promise a lot, and that means companies that are working hard to develop their concept and that are in the stage of fundraising before marketing and generating revenues.

Chicago's first method

 

There is a broader method for evaluating startups that can consist of the methods mentioned above, by weighting the results of the different valuation methods.

 

This method is called the "Weighted or First Chicago Method", and it is associated with a certain percentage with three evaluation results, for example, one for the last of the series (such as the evaluation result based on assets), one for the middle, and one for the highest.

 

Findings for the middle and top sides can relate to estimates that are reasonably optimistic and very optimistic, using methods such as discounted cash flows and market comparability.

 

No hard rules

 

Whatever method is used, it is important to emphasize that the final figure agreed upon with the investors and stakeholders is generally more related to the negotiations than to the outcome of the calculation. Some investors may have their own principles for evaluating startups, based on various factors such as the target sector, the geographic location of the company, and the biography of the founders.

 

Also, when the investment result is combined with the desired share after the investment, we can reach a realistic assessment (also known as the Venture Capital Valuation Method).

 

A simple example of this is that when an investor is willing to pump $ 1 million in exchange for a 15% stake after the investment, this automatically reflects the pre-money valuation of $ 5.6 million, based on the following calculation: The amount of one million $ 15% of the value after obtaining the money, which means that the value after money is $ 6.6 million, which implies a $ 1 million less valuation before obtaining the money, meaning $ 5.6 million.

 

How do you value your stocks?

 

This calculation raises some questions: How does the valuation relate to equity ownership; How do investors decide what percentage they want; And what should founders keep in mind when negotiating the company's value?

 

The first question requires an understanding that the ownership percentage is the ratio of the shares owned out of the total share.

 

The number, which indicates the valuation, gives itself the calculated value of the stock price value before the company gets the money: If the total share before the investment is 500 shares, and the value after getting the money is $ 5.6 million, then the share price will be $ 11,200. This means that the investor who pays $ 1 million is actually buying 89 shares (approximately).

 

And so that after the investment, 89 new shares will be issued, and the total share will be 589, and thus the investor will own 15%.

 

Accordingly, too, the ownership of founders will shrink as well: this is called "inflating the number of shares with new issues" dilution. If we assume that the founders own all 500 shares before investing (the share of shares is 100%), then after the investment they will have 500 shares out of 589, which is equivalent to 85%.

 

Adding the internal return equivalent to the calculation

 

The investors ’decision to obtain a hypothetical stake after the company gets the money is often related to the internal rate of return that the investors want. Looking at estimates of how much the company could sell for after a few years, the percentage share allows for a certain amount of cash to be spent.

 

Relating this amount to the current investment gives us the internal rate of return (IRR). The value at which a company can be sold is usually calculated based on the projected annual revenue, multiplied by a specified multiple of the sector.

 

In the example above, investors pay $ 1 million. If the expected revenues of five years amount to 10 million dollars, and the revenue multiplier for the evaluation at that moment is 5, then the future value of the company after five years will be 50 million dollars. Thus, if investors seek to reach an internal rate of return of 50% on their $ 1 million investment, they will have to pump about $ 7.6 million at the exit, which means 15% of the 50 million.

 

It is also important to remember that this investment round is not likely to be the last, at least not before the company is profitable and able to finance its future growth.

 

As a result, business owners must try to retain sufficient ownership in order to maintain room for maneuver when stock values fall due to new issues in the future, something that will undoubtedly happen in subsequent financing rounds. On the other hand, voting rights related to newly issued shares are also very important, because ownership lies not only in the ability to benefit from future profits or capital gains, but also in maintaining sufficient decision-making power over the fate of the company. .

 

In conclusion, entrepreneurship is not only about achieving great success, but is also about transforming the vision and idea into reality, and this may be with reasonable or more valuable results for any entrepreneur.