With each round of private equity funding, the issuer, or company raising money, sets a valuation – the perceived monetary market value of the company. For publicly traded companies, the process of calculating valuation is streamlined, multiplying the stock price by outstanding shares. This is typically presented as a company’s market capitalization, or market cap. Because private companies do not report financial statements as frequently as publicly-traded companies, if at all, valuations can be more subjective in the private markets. In this blog, we will look at some methods commonly used to calculate valuation, the importance of valuations, and how to understand the factors that go into and affect valuation.
What is a Valuation?
Simply put, a valuation is the economic value of an entire business or company unit. Valuations are used far more often than just for funding, as they are also calculated to determine the sale value of the company, establishing partner ownership, and determine tax values. Valuations can be calculated for the entire business, or for specific units within the business – like the sales department or a specific product line.
Private companies that reach a valuation of at least $1 billion are considered “unicorns”, originally dubbed so for the rarity of achieving this valuation in the private market. Unicorn companies have become more prevalent in recent years, with over 1,000 unicorns in operation worldwide as of March 2022, according to CB Insights. The term “unicorn” was popularized by Aileen Lee, the founder of Cowboy Ventures, in 2013, and has expanded to include “decacorns” – companies that have reached a valuation greater than or equal to $10 billion and “hectocorns” for valuations reaching $100 billion. Globally, CB Insights recognized around 50 decacorns and 3 hectocorns as of March 2022.
So, how are these valuations calculated and determined?
How Valuations are Calculated
Ideally, a valuation calculation is completed by a neutral third party using objective measures to determine the current worth of the company. Both tangible and intangible factors can be considered to determine valuation, such as a company’s management team, capital structure, future earnings prospects as well as financial statements, cash flow models, shares outstanding, and other sources of data. Calculating valuation is typically seen as both an art and a science; there is no “one size fits all” methodology. We’ll take a closer look at five valuation calculation methods below.
DCF Analysis Method
The DCF Analysis Method calculates today’s value of expected future cash flows using a discounted cash flow (DCF) analysis. This attempts to estimate the value of an estimate today using projections of how much money it’s expected to generate in the future. If the DCF value is greater than the current cost of the investment, the opportunity could have positive results. The downfall of the DCF Analysis Method is that it is based off assumptions of future values, which can prove inaccurate to actual results.
Multiples Analysis Method
A multiple is a ratio calculated by dividing one financial metric by another financial metric of a comparable private company (or companies). Operating under the idea that similar assets sell at similar prices, the Multiples Analysis Method calculates the value of a company using multiples. For example, a Multiples Analysis Method could divide the value of Tech Company A by its revenue and use the revenue of Tech Company B to find Company B’s value. A challenge of using this method is finding comparable companies with publicly available financial statements. If a comparable company is not found to complete the calculation, the scope of search can be broadened to include less comparable companies, but this could provide less accurate data than a more comparable company.
Net Book Value Method
The Net Book Value Method is primarily considered for companies that have lots of tangible and intangible assets. The Net Book Value includes the value of tangible assets such as land, equipment, building, and intangible assets such as patents, brand guide, and reputation. However, this method may not accurately capture true market value, which could result in lower valuations when utilizing this method.
Scorecard Valuation Method
The Scorecard Valuation Method compares a company to an existing funded startup that operates within the same industry, region, or company stage. Factors considered in this method include the team, the product or service, sales and marketing, and if they will need additional financing.
First, this method finds the average valuations of comparable companies. Then, investors apply weights to various factors, resulting in a weighted average based on the individual investors’ preference. Then, the investor will assign a score to their selected categories where percentages greater than 100% equating to the business outperforming in that category. Multiplying the assigned score (the range) by their weight (target company) produces factors, which are summed up to provide the ratio of the valuation. Once multiplied by the average pre-revenue valuation of the comparable companies, that value will provide the Scorecard Valuation.
For example, a company assigned a 1.07 ratio of the valuation and the average pre-revenue valuation of comparable companies is $2M, the company featured in the table above would have a Scorecard Valuation of $2.14M.
Venture Capital Method
The Venture Capital Method calculates the post-revenue valuation to determine the pre-revenue valuation. Multiplying the projected revenue with the projected margin and the industry price-to-earnings (P/E) ratio, or other relevant multiples, provides the future value of the asset.
For example, a company expects $10M in revenue in 10 years with a 20% profit margin, and the industry P/E ratio is 15. Multiplying the revenue by the profit margin and the P/E ratio provides the future value of the business as $10M * 20% * 15 = $30M. To calculate pre-revenue valuation, the investor needs to account for return on investment (ROI) and investment amount. If the investor wants a 20x return on a $1M investment, the future value will be divided by the ROI and after subtracting the original investment, the Venture Capital Method reaches ($30M / 20) – $1M = $500K as the pre-revenue valuation.
In the private markets, additional equity information can be collected to provide a more accurate valuation, including price-to-earnings, price-to-sales, price-to-book, and price-to-free cash flow.
Impacts to Valuations
Company valuations are not an exact science, as they are based off series of assumptions, best guess estimates, and industry averages. While valuations can be set by the company itself, it is best to have an independent auditor to reduce bias in reporting. There are multiple other factors that can impact valuation including public perception, recent media press, management staff, the company’s reputation, industry demand, market size. While company valuations should not be interpreted as 100% accurate, they can provide a glimpse of the potential stability and financial future of a business.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.