Valuing a Company

Early-stage company valuation is by no means a science; a great deal of judgment is involved on the part of the valuer, and different methods yield different valuations. A recent BVCA report listed seven methods for valuing venture capital investments of which four are of use to start-ups. These are:

1. Revenue Multiple
2. Discounted Cash Flow Or Earnings Of The Underlying Business
3. Price of Recent Investment
4. Industry Valuation Benchmarks

Revenue Multiple
This method simply multiplies the revenue (sales) of a company by a certain number, to give a value for the firm as a whole. Very often, the multiple is the price to sales ratio. This ratio is simply the price per share divided by revenue per share.

While this is an easy calculation, we have to ask two fundamental questions for the derived value to be of any use at all.

• Are we using a reasonable price to sales ratio?
• Are we using a reasonable earnings figure?

As a broad rule of thumb different classes or types of revenue attract different multiples. Generally speaking consulting type revenue typically obtain a revenue multiple of 0.5x to 1.0x. On the other hand revenues derived from IP owned by that company will attract anything from 2x to 5x revenue. As said above this is not a science and a great deal of intuition goes into this.

What revenue multiple a company can expect depends on a host of factors including:

• How far is the company away from break-even (the closer the higher the multiple)
• The quality of the existing or target customers (the better the quality the higher the multiple)
• The length of the sales cycle (the longer the lower the multiple)
• The predicted rate of sales growth going forwards (a high rate of growth gets a higher multiple)

At the end of the day you should use this multiple as a rough guide. If you are predicting £100,000 of sales in year 1 and £90,000 in year 2 with difficult target customers and a long sales cycle you will be very unlikely to secure a valuation of £1m without substantial mitigating circumstances.

Always bear in mind the key questions – are my revenue assumptions fair, reasonable and defendable? If not, do not try to. Experienced investors have developed antennae that can spot these coming.

Discounted Cash Flow Or Earnings Of The Underlying Business
The discounted cash flow, or DCF technique can be used instead of, or a compliment to, the revenue multiple technique. While the full technique can be quite complex the basic technique is fairly straightforward and involves only a few steps. You should note that the resulting valuation is very sensitive to the estimates you make for cash flow and discount rate, and that the latter is a subjective judgement. This method should be used with caution.

• Forecast your cash flows for the next five years. You can use a different time period, but 5 years should do for most cases.
• Forecast your cash flows thereafter, that is, from the fifth year to infinity.

We can use the following formula: FV5 = C/(I-G)
Where FV5 means future value 5 years ahead, C means cash flow, I is your required rate of return and G is the growth rate of the cash flows.

Convert both types of forecasts to today’s money.
To do this, we take the cash flows from each future period and convert to today’s money (by dividing them by the ‘discount rate’), then add them all together.

Discount rate is the interest rate for the investment – the greater the risk, the higher the interest rate. PV means present value – today’s value – and is calculated by dividing the future cash flow by the discount rate

Price of recent investment
A recent investment is likely to provide a good indication of the fair market value of a company. However, this method suffers from a number of downsides:

• This method only works after the fact of an investment.
• One has to ask if existing or new investors made the recent investment. If new investors were not involved, this is likely to reduce the value of the start-up since existing investors would rather diversify their portfolio of investments.
• The investor may have secured particular rights when making the investment. This would indicate that they are willing to pay more for a certain share of the firm. This would indicate that the share of the firm, in and of itself is worth less than what was paid for it.
• An investor may have strategic considerations. They may wish to fill a particular niche in their portfolio for example, or there may be synergies with their other investments. Other investors in the market are unlikely to be subject to the same conditions, thus reducing the fair market value of the firm
• If the share of the company was sold to an investor as a matter of urgency, say a forced sale or a rescue package, this is likely to have driven the value of the firm artificially low.
• If the actual amount invested is very small, this is likely to be a bad indicator of the overall value of the firm, because investors will understandably take less care valuing very small investments.

Industry Valuation Benchmarks
In industries where long-term contracts are a key feature, such as subscribers for cable television, there are often simple multiples of revenues as a benchmark.This technique is simple, but limited to those industries in which profitability is not very variable.