Most emerging or startup companies - technology, in particular, go through three main stages; each stage has its characteristics, risks and challenges.
Unfortunately, some perish in their early stages, some in the second stage, and a small part succeeds in reaching the third stage and achieving growth and spread. Through the follow-up of many startups, the company's life can be divided into the pre-sales stage, the search for the appropriate business model, and the growth stage. Of course, these stages often overlap, and the company may not experience some, but this is not the scope of our research in this article. Instead, what interests us in this article is how we value startups in each of these stages.
Typical appraisers mostly use the "Discounted Cash Flow" DSF to evaluate a company based on a future expectation of the company's financial performance.
1) The first stage: is the pre-sales stage.
The company starts with an idea, and the founder or founders decide to implement it. At this stage, the focus is on developing the product's infrastructure, specifically, the technology used, whether a website, platform or application. In addition, the entrepreneurial team will develop an action plan that includes the target customer segment, sales channels, and pricing. What distinguishes this stage is the following: There are no sales, but there are many assumptions about the market viability of the product they offer in terms of price and added value. Also, the founding team is the cornerstone of this stage, as the company is only a team and a product that has not been tested.
At this point, using any of the above methods is futile, in our opinion. Companies at this stage have no value because they have not yet become economic entities. Therefore the term "valuation" does not apply to them in the first place. In addition, using the Discounted Cash Flow method requires an operational history that the investor or resident can build upon, which is unavailable in the pre-sales stage. So how does the investor determine the value of his stake in the company? No precise formula determines the amount of stake versus investment at this stage. But we believe that any amount invested in the company should not get the investor (or the investors together) a share that exceeds 15-20%, provided that the amount is sufficient to move the company to the next stage and if it is not enough, then even these percentages will be many.
The justification that we offer here is that the amounts that the company needs at this stage are often small to complete the product or service design. Therefore, taking a large share at the beginning for small amounts is not logical, as the company is on the verge of larger investment rounds, and the founders will lose more shares. The investor must consider the founders' ownership percentage, especially at this stage. It is not wise to take large shares in the early days of the company's life, as it might cause damage not only to the company and the founders but the investment.
2) The second stage: searching for a business model
After everything seems clear, the company enters this stage, and the plan is solid and ready for implementation, so the team decides to go to the market and start selling. But the company discovers that sales are less than expected. Your search for the reason and talk to customers, only to find that many of them did not like the price, another part did not need the product, and a third group needed it, but not in its current form. Here the team faces the challenge of redesigning the business model, so they re-price the product and perhaps its production and sales methods. What distinguishes this stage is that the team's hypotheses in the first stage are tested. The market's opinion may differ from the startup company's assumptions. At this stage, the features of the operating model begin to appear, and the load increases on the founding team to develop a product that satisfies customers.
We believe the evaluation here can be built by assessing similar companies in the stage or sector, considering the founders' shares. Investors usually evaluate companies at the same stage with a similar operating model - but not necessarily the same industry - and then take these assessments and make them a basis for negotiation. Primarily, the valuation at this point is based on sales multiples. Of course, the company will be losing. Still, it has sales, so the valuation is, for example, five or 7 multiplied, meaning that a company whose sales are one million dirhams is valued at five million or seven million, and so on. But, once again, the founders' shares must be considered. Their interest in the company should not be weakened at this stage because it relies on them extensively and needs future investments to eat up its remaining shares. So we don't think it's appropriate for the founders to lose more than an additional 20-25% stake.
What if the valuation is low, leading to a loss of more shares? Here we have one of three solutions: reduce the invested amount, raise the valuation or both. This is mainly resolved through negotiation. An experienced investor often pays attention to this and does not push the founders to lose large shares. Also, we assume that the investment will help the company reach a business model and product suitable for the market and prepare it for the following growth and expansion stage.
What cannot be applied here is the discounted cash flow method because this method requires a clear vision of prices and the number of units sold in addition to the cost structure, which is what the company lacks at this particular stage.
3) The third stage: the growth stage
After a set of modifications and experimentation and the company's success in reaching a product or service with a price and quality acceptable to most customers, the company moves to the third stage, the growth stage. At this stage, the company conducts an intensive marketing process and sells large quantities. The company's arrival at this stage means that it needs to pump significant investments to meet the demand resulting from marketing operations. What distinguishes this stage is the clarity of the business model, as the company repeats the same work procedures but in larger volumes. A decline in the importance of the founders and an increase in the importance of the second line of leadership also characterize it.
The valuation at this stage can be based on the discounted cash flow method. The price is clear, the market has accepted it, and the cost structure has settled on certain margins. Therefore, the company can technically build a financial model for the coming years until it reaches profitability, even if losing money. Also, the market comparison method can be used, and in most cases, the evaluator applies both ways and then reaches a fair evaluation of the company. The company will be evaluated regardless of the founders' shares. This is because it has become an economic entity and is supposed to operate even in its absence. In any case, this matter is up to the investor's discretion, so if they see that the company is still based on people, this must be considered.
So these are the stages that, in our view, most Startup Valuation go through before they turn into mature companies that grow at standard rates. The investor needs to know what stage the company they want to invest in has reached. This will facilitate evaluating risks and returns and, in light of that, knowing the best method for assessing the company before investing. As we have seen, the evaluation differs at each stage according to the importance of the founding team and the business model or stability and growth. These elements are not often found in large and stable companies, so investors have no problem applying well-known technical methods. As for emerging companies - especially technological ones - these entities have distinguishing characteristics; therefore, the evaluation must consider these characteristics.
Best-in-class Business Valuation Services
Proper business valuation is a necessary part of every startup business. This determines whether you are equipped for the industry or if the idea passes the economic value standard that goes into every company.
At Credence & Co., we unravel startup value using a 5 in 1 business valuation method:
Qualitative Methods: Developed by prominent American business angels to value the elements that guarantee future success in pre-revenues, early-stage companies.
1) Scorecard Method
2) Checklist Method
Future Cashflow Methods: The standard and most traditional methods according to which a company is worth the cash it will generate.
3) DCF with Long Term Growth
4) DCF with Multiple
and
5) Investors Return Method or Venture Capital Method
This method considers the returns investors expect to earn upon exit to have a profitable portfolio.
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