Table of contents
Introduction
The valuation of a start-up is almost always the most critical step in the path to the capital market, often representing the main stumbling block in the dialogue between founders and investors.
How to evaluate a company without a long history and a substantial track record, often characterised by financial results that are not yet positive?
This question incorporates the complexity of a highly articulated process, which can make the financing of the start-up particularly difficult to the point of inhibiting it.
The evaluative peculiarities of start-ups
The valuation process of a start-up differs markedly from that of traditional companies. Young innovative companies are characterised by a substantial absence of debt in the early phase, with EBIT tending to coincide with net income. Operating cash flows are often negative in the first years, while uncertainty about future results is particularly high.
To summarise, the vast majority of start-ups are characterised in their early stages of development by the following indicators: very limited if any value of production, rising costs, significant plant investments, negative profitability, insignificant net financial position.
When applying traditional income and/or equity and/or mixed valuation methodologies, the result of the valuation calculation almost always shows a negative figure.
The motivation is always related to the failure to value the business idea, the entrepreneurial project, the qualities of the founders, the market space tapped, in short, the possibility of developing a profitable and lasting business project.
Methodological approaches to evaluation
In the landscape of valuation methodologies, the 3-stage DCF method has proven to be particularly suitable for start-ups. This approach recognises the existence of distinct phases in the company’s development: an initial phase characterised by typically negative cash flows, a consolidation phase in which financial equilibrium is achieved, and a maturity phase with the stabilisation of positive flows.
The Venture Capital Method, on the other hand, focuses on estimating the expected terminal value and calculating the expected ROI by incorporating various exit scenarios. This method is particularly useful when evaluating late-stage start-ups.
A particularly interesting approach is the Berkus Method, named after its inventor, Professor Berkus, which places a concrete value on the typical risks that a start-up faces. The method assesses five key areas: product risk (how successful the business idea is), technological risk (validity of prototypes), execution risk (quality of the team), market and competitive risk (strategic choices) and production risk. Each risk area is assigned a value of up to EUR 500,000, for a maximum pre-money valuation of EUR 2.5 million.
It is evidently a very simplified and empirical evaluation method. Although it was used massively in the early period of start-up development, it is now used much less, and often only as a control method.
The Risk Adjusted Net Present Value (RNPV) approach introduces a further element of sophistication through the probabilistic weighting of cash flows, allowing for a more granular assessment of the risks specific to each stage of development.
There are further valuation methods, but these have the same shortcomings as described above, in that the start-up, inherently, in its early development phase and until it receives confirmation from the market with growing sales volumes, positive income margins and also positive net cash flows, does not offer the valuer the typical and fundamental metrics to make an estimate.
The search for evaluative balance
The key to a balanced evaluation lies in the ability to simultaneously analyse market traction, the quality of the management team and the sustainability of the business model. The validation of market traction through concrete growth metrics, coupled with the assessment of the skills and motivation of the founders and the team and the scalability of the business, makes it possible to build a more solid, albeit still empirical, basis for evaluation.
A pragmatic solution: The SAFE
Given the complexity and subjectivity inherent in the startup valuation process, a tool has become popular in recent years that allows the valuation moment to be postponed: the Simple Agreement for Future Equity (SAFE). This hybrid tool, which we have written about here, allows investors to finance the start-up without the need to immediately determine a valuation, postponing this critical step to a later time, when the company has reached greater maturity and can count on more concrete data to support the valuation process.
Conclusions
The evaluation of a start-up requires a balanced approach that balances growth potential with financial viability. The complexity and subjectivity of this process have led to the development of tools such as SAFE, which overcome the valuation impasse in the early stages. This pragmatic approach allows start-ups to access the capital necessary for their development, postponing the definition of value to a time when it will be possible to base evaluations on more concrete and measurable elements. In this way, the risks of over- or under-valuation that could jeopardise the future development of the entrepreneurial initiative are reduced. ( photo by Slidebean on Unsplash)
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