Startup Valuation

What is startup valuation?

First, we must define the concept of a Startup, A startup or also known as emerging companies, are recently created companies, commonly established by one or several entrepreneurs, based on a technological, innovative idea, and with a high capacity for rapid growth. Rapid growth is what is expected of a startup. , although this is not a rule.

The valuation of a startup currently presents a challenge because in many cases they do not generate economic benefits or in some cases the cash flow is nonexistent. In this type of valuation, it is more important to evaluate the entrepreneurial team, the potential clients, existing agreements and contracts and the degree of technological innovation being used.

The valuation of Startups is basically focused on the value of the going concern, the Going Business refers to the economic unit that is presumed to be in continuous existence and that will continue in operation in the foreseeable future, the commercial unit or economic unit is located in operation and generates economic benefits, this definition is based on the basic postulate of the NIF A-2 (Financial Reporting Standards). 

The business may be valued using widely used valuation approaches, such as the comparative market approach, the cost-based approach and the income approach; an entity shall use valuation methods consistent with one or more of those approaches to measure fair value ( IFRS Foundation, 2019).

Factors to Consider When Valuing a Startup

When carrying out the valuation of a company, both internal and external factors must be considered, since the company is affected by the environment that surrounds it, the factors to consider that can affect the value of a company, Whether positively or negatively, they are the following: 

Internal Factors

• Evolution of the economy of the country where the company is located.
• Evolution of the economy of the countries where the company works.
• Evolution of the economy of the sector to which the company belongs.

External factors

• History of the company.
• Environment in which it operates.
• commercial factors. 
• technical factors.
• Human factors.
• Financial Factors.
• Other factors (legal, administrative, etc.)

What is the value composition of a Startup?

The business is an entity with economic activity that is constituted by a set of fixed assets linked to intangible assets and integrated according to a set of technologies that allow it to produce goods or provide services. 

It is important to recognize that these types of assets are important to carry out the valuation of a company, where it should be noted that the real value of tangible and intangible assets comes from their ability to generate future economic benefits.

The value of a company is determined by:

What makes up the appraisal of a business or startup?

It is considered a “business in progress” to one that will continue to operate for the foreseeable future. 

This type of study allows the businessman to have a clear and concise idea about his financial situation that allows him to measure the profitability and liquidity of his business.

This type of valuation must consider the internal and external factors in which the company is located that influence its socio-economic context before the valued objectives.

One of the main characteristics that the startup must fulfill is to verify to the appraisal agency that it is, indeed, able to continue operating; the company must do so by preparing its financial statements under the going concern assumption. 

Introduction to valuation methods for Startups

It is important to precisely identify which valuation techniques or methods are most appropriate to the circumstances, on which there is sufficient information and data available to measure the fair market value of a Startup, we, as appraisers, we must maximize the use of more observable and relevant input data.

The objective of using a valuation method is to estimate the fair market value at which an orderly transaction of sale of the asset between market participants would take place on the measurement date under present market conditions, equally, for any other purpose, The appraiser will identify the most appropriate method.

The IFRS identifies three widely used valuation methods: Market approach, the cost approach and the income approach. It also states that an entity will use valuation methods consistent with one or more of those approaches to measure fair value.

It is necessary to use judgment to establish if the fair value of the company can be determined with sufficient reliability with each of the mentioned methods. 

For example, when there is an observable market of purchase and sale transactions of comparable economic units, we can use the market approach; however, when this data set is poorly observable and there is not enough comparable data within the market, it will be necessary to consider the other two approaches, the same will happen for the income and cost approach, for the income approach, it will be very important to count the financial statements of the business, and apply the most assertive valuation methods.

In this way, as a valuation unit, the most accepted valuation criteria and methods will be applied for the circumstances in which said economic unit is found.

IFRS Foundation. (2019). IFRS 13 Fair Value Measurement. 2020, by IFRS Foundation Website: www2.deloitte.com/content/dam/Deloitte/cr/Documents/audit/documentos/niif-2019/NIIF13-MedicindelValorRazonable.pdf

What are the valuation methods?

COST APPROACH

This method estimates the value of a property or economic unit that considers the possibility, as a replacement for it, could be built and put into operation with an equivalent utility.

The result obtained from this approach is the replacement value, the replacement value is equal to the cost of acquiring a company with the same production and profit generation capacity as the company that is being valued, The replacement value is based on current market prices and takes into account the use of the goods and their corresponding wear and tear. The value requires an estimate of the fair market value of all the components that make up the company.

MARKET FOCUS

This method estimates the value of the company, taking as a reference some indicators and financial ratios related to the sale price at which a recent transaction was carried out whose object was a similar company and from the same sector.

This method is based on comparing the assets of both economic units in terms of installed capacity, geographic location, sales time, level of financing and sales conditions, as well as operational and financial indicators. The comparison of these indicators will help us to carry out a value homologation between companies and in this way the fair market value of the business is determined, this comparative analysis will only be possible in those sectors whose nature determines homogeneous companies. 

This method, by requiring an investigation of supply and demand, and comparable business transactions in an open market, which depending on the sector, turns out to have a high degree of complexity due to the lack of information that exists, especially in Latin America. .

INCOME FOCUS

This valuation method establishes that the value of the company is the result of the sum of the present values of future free cash flows (Free Cash Flow – FCF). Thus, the projected cash flows of the company are brought to present value discounted at a discount rate relative to the company, this rate is called WACC (Weighted Average Cost of Capital).

The FCF (Free Cash Flow) method is the most widely used valuation method and recognized for its efficiency in estimating going concern value, which is why it constitutes the basis on which the concept of creating value is developed. worth.

This method even makes it possible to carry out asset valuations and also to estimate the value of strategic and operational alternatives for companies. This method provides us with complementary information such as knowing the risk and the rate of return for the shareholder, the effect that financial indicators have on the value of the company and the effect that macroeconomic variables have on the value of the business in march, and in general for a great variety of decision-making. 

Within the Free Cash Flow method there is the FCFF (Free Cash Flow to Firm) and the FCFE (Free Cash Flow to Equity), but what is the difference between these two concepts? 

Some most used models:

Free Cash Flow: It is the firm's measure of value that calculates the cash flow that is generated after deducting all expenses, taxes, and changes in net working capital. And on the other hand, the FCFE (Free Cash Flow for Capital) is the value that is distributed among the shareholders of any business after deducting expenses, taxes, changes in net working capital and additionally the payment of the debt. .

Comparison rating: The valuation is based on comparison to recent or comparable merger and acquisition agreements or also risky investments. This method is often the most common way founders and investors look at startup valuation at startup. This methodology is a fair way to value a company at its start. 

Pre-money valuation: It is the estimated value that the company will have at the end of the period.

Post-money valuation: It is the value that the company had at the end of the start-up period.

Dilution: It is the extra money that the company requires to finish the period. It is not recommended to go beyond 20% per round.

Financial rounds: They are the established goals, where time, productivity and cash flow are variables to determine the future of the company.

Why is it necessary to carry out a startup appraisal?

Finding more appropriate ways to identify, measure and manage the risk/return relationship will provide companies with a clear competitive advantage, as they will give them better tools to diagnose problems, find solutions and anticipate consequences. 

The valuation of companies or startups is a method that makes it possible to identify, measure and manage this risk/return relationship, in addition to being a fundamental process in all acquisition, sale, merger, investment analysis, capital placement on the stock market, and in many cases, to evaluate and remunerate managers.