Valuing start-ups: Bordering between rational and irrational



    The past years have been characterized by outrageous technology start-up valuations.

    As of January 2017, there were about 185 so-called “unicorns” – companies whose valuations are at least $1.0 billion. Take for instance, UBER’s latest valuation at $70 billion. That’s very close to AT&T’s market capitalization of $71.0 billion. UBER was founded in 2009; AT&T in 1885. So what’s driving the value of these start-ups over the roof? How are these start-ups being valued?

    These staggering valuations seem to defy logic and conventional wisdom. One would think that given these incredulous valuations, that there is a precise science behind it. But unlike valuing traditional cash-generating and profit-making businesses, there is no standard in valuing start-ups. With little or no historical financial performance, valuing a start-up is largely based on potential rather than historical results.

    While no standard approach is established, globally acceptable methodologies in estimating the value of start-ups exist, one of which is the Venture Capital (VC) method. As the name suggests, this method looks at start-up valuation from the point of view of the venture capitalist.

    It indicates the value of pre-money ventures by following the process that VCs go through, where they exit an investment within three to seven years. It estimates the expected exit price of a similar mature business venture and discounts it back to present value considering the risks involved. To illustrate, it follows these steps:

    Step 1: Forecast the financial performance of the venture in three to seven years, the anticipated investment
    horizon of a VC. Consider the size of the target market, expected share and profitability of the venture by then. Identify reasonable milestones particularly for market roll-out and acceptance.

    Step 2: Look for comparables to determine the multiples paid by investors for a similar business. Do they pay 30X earnings, 3X revenues or other comparable metrics?

    Step 3: Calculate the exit value by taking the product of the net income (or another base) and the multiple of a similar business.

    Step 4: Discount the exit value using the appropriate rate. Unlike typical financial investors in a mature and stable business that usually seek to double or triple their investment, a VC often expects to get 10X or more of its investment upon exit. While it seems exorbitant, one needs to understand the business model of a VC and the risks it takes to invest in a business at a very early stage. Oftentimes, a VC will only have one or two successful ventures out of its 10 investments.

    Step 5: Consider the amount of investment required to arrive at pre-money valuation. Use different approaches to perform a sanity check on the resulting values.

    This method uses a lot of assumptions and estimates but should be grounded by the valuer’s understanding of the industry, the market and the business venture itself. That said, there is no exact science in these valuations. These are often driven by the investor’s desire to pioneer the new venture with the hope that they’ve discovered the next unicorn, matched by the founder’s willingness to fund his venture in exchange for a part of his company.

    Valuation is important because it determines how much ownership the founder is giving up to the investor, but it should not be the end-all and be-all goal of the start-up. In assessing with whom to partner, the founder should also consider what other value the investor is bringing to the table apart from funding. The investor’s experience in similar ventures, understanding of the market, network and management capability are likewise important considerations in choosing the right investor.

    Going through the exercise of valuation helps the founder assess his goals and current circumstances. If his current valuation does not stack up to his expectations, then he needs to look back and assess how he can improve the value.

    From the point of view of the investor, and as what we have illustrated in the VC method, the factors contributing to better valuation include:

    Traction – How many users or customers does the start-up have? Are these paying customers? What’s the fall-out rate? How fast has the number of users grown?

    In today’s world, developing an “app” is no longer expensive. There are many developers who can code and replicate a mobile or web-based application at a low cost. However, having a huge following, attracting people to continually use your app or product and pay for its use, is the difficult, yet valuable, aspect of the start-up.

    If the founder is able to demonstrate that his product has gained good traction in his target market, then that reduces market acceptability risk and, therefore, improves the valuation.

    Market size – How big is your target market? Are you able to scale and expand the size of possible users? Are you looking at a local rollout, or can this be replicated globally? What is your competitive advantage over current and future market players? Is your product or technology unique and disruptive?

    The bigger the market size, the more unique the product, and ultimately, the more attractive the founder’s proposition: the better the value.

    Management team – Do you have the right team to execute your plans? Will they remain loyal to the business? How are you keeping your team engaged and motivated? Do they work well together?

    Given that start-ups lack the track record yet, investors place huge importance on the passion and talent behind the management team: the founder is key to all that. Valuation is about assessing the risks and rewards of an enterprise. Having a great management team reduces the execution risk of the business and thus, improves start-up valuation.

    Being the next Facebook, Snapchat or Alibaba takes a lot of work. A good valuation is a mere start. Staying on track means longevity and better shareholder value. After all, no one wants to be a fleeting shooting star that will light up the sky for a brief moment only to disappear and be forgotten forever.

    Mary Jade Roxas-Divinagracia is the Deals and Corporate Finance Managing Partner of Isla Lipana & Co./PwC Philippines. The firm launched VentureHub@PwCPhilippines in March 2017 to help promising start-ups and entrepreneurs execute their ideas, improve their valuation and find the right partners. Email your comments and questions to markets@ph.pwc.com. This content is for general information purposes only, and should not be used as substitute for consultation with professional advisors.


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