Within the landscape of small and medium-sized companies, start-ups have their own specificity that must also be reflected in the way they are evaluated.
Since it is difficult to leave the comfort zone of companies with solid profits and a predictable future, the underlying temptation is to try to apply traditional evaluation metrics to start-ups as well. This approach, however, can cause many problems.
How to evaluate a start-up
Let's assume that the ability to value a start-up depends on the entrepreneurs' chances of funding the company on the one hand, and the lenders' return on investment on the other.
The fact that start-ups have a limited history, depend on future growth and are particularly prone to failure, makes their valuation using traditional methods very complicated.
To reduce the possibility of error, we propose an approach based on the following points:
1. Start with revenues
The valuation of a start-up necessarily starts with the estimation of revenues and future growth. There is no one-size-fits-all approach to making this estimate; however, one usually begins by determining the size of the overall market in which the company operates, and then goes on to determine the "conquerable" market share. In making these assessments, one has to think deeply about the quality of the management, the company's knowledge of the product and service offered, and how it compares with current and potential competitors.
2. Estimating operating margins over time
Growing revenues are not enough, a start-up is only assessable if it is able to generate positive economic results in the future. In order to estimate the evolution of the operating result over time, it is necessary to separate the valuation process into two parts. Firstly, it is necessary to estimate, looking at the largest and most established companies in the sector, the target operating margin that the company will be able to generate, once it has overcome its growth problems. Secondly, it is necessary to carefully evaluate the actions that will have to be put in place to achieve the target margin, taking into account, as far as possible, fixed costs and the nature of competition in the sector.
3. Assessing reinvestment to sustain growth
To improve business performance, a start-up is required to make significant investments to generate the expected growth. These investments need to be carefully determined and their impact on cash flow assessed. One of the dangers of estimating revenues, margins and reinvestment separately is that one can fall into the trap of making unrealistic assumptions, underestimating the capital required to support growth.
4. Estimating the cost of equity and capital over time
Rather than trying to estimate the cost of capital from the start-up's historical data, we recommend using industry averages for risk parameters (beta, cost of debt and debt/equity ratio), taking care to consider the riskiest and smallest companies in the industry for the initial high-growth phase and mature companies for the later stable phase. In fact, a start-up cannot and should not be valued with a cost of capital that remains unchanged over time. High growth in operating revenues and losses in the early years will turn into limited growth in turnover but with operating profits in the later years, which means that a different cost of risk and debt capital will have to correspond.
5. Terminal value estimation
The application of DCF requires the determination of the terminal value, which in turn presupposes the identification of the period in which the company will become mature. In making this analysis, it must be considered that only a few companies are able to sustain high growth for long periods.
In conclusion, the valuation process, especially for early-stage start-ups, is not so much a science as an art, where the sensitivity to qualitative aspects of the evaluator has a strong influence.
The best approach is to consider different methods so as not to overlook factors relevant to the success of the start-up that cannot always be captured by the mere analysis of purely financial data.
In order to obtain an objective assessment, it is advisable to rely on a financial advisor specialised in extraordinary finance transactions.