Did this idea come across your mind how investors value your startup? Perhaps, not. As an entrepreneur, you are supposed to tack actions, make plans etc. to make your startup successful and financially viable. For this, you need fund and, thus, approach investors.
If you now how investors do their homework and draw a valuation of your company, you may have the upper-hand and better bargain over them. Discounted Cash Flow (DCF) valuation and The Venture Capital method are the ones investors prefer while making company valuation.
Let’s know them in detail!
a) Discounted Cash Flow (DCF) Valuation
DCF model calculates the present value of a company by discounting the expected cash flows, available to its investors without affecting the profitability, to their present value by using the weighted average cost of capital (WACC).
Steps in Conducting DCF Valuation
- Determine the cost of debt and the cost of equity
Cost of debt is usually the borrowing cost whereas cost of equity, in the simplest term, is the return requirement of the investors.
- Calculate the weights of debt and equity
Total value of the company = Value of Debt+ Value of Equity
% of Debt = (Value of Debt /Total value of the company); % of Equity = (Value of Equity /Total value of the company)
- Calculate the Weighted Average Cost of Capital (WACC) or Discount Rate
It’s the single most factor in determining the usefulness of this valuation model. Error in calculating the discount rate can render a seemingly promising business grossly unrewarding to invest.
Discount rate = Interest rate×% of Debt× (1- Tax rate) + cost of Equity ×% of Equity
- Calculate the Terminal Value (TV)
In DCF model, the terminal value accounts for the majority of the future cash flows. It is the value of a company’s expected cash flow beyond its explicit forecast horizon. Two methods, namely perpetual growth and exit multiple, are being used to determine the terminal value. Between these two, the exit multiple is commonly preferred by industry practitioners as it offers the advantage of comparing the value of a business to a metricavailable in the market. Typically, EBIDTA multiple of the respective industry at exit is used in this regard.
- Perpetual Method: TV = [Free Cash Flow x (1 + g)] / (WACC – g); g = perpetual growth rate of Free Cash Flow
- Exit Multiple Method: Financial Metric (i.e., EBITDA) × Trading Multiple (say 10x)
- Calculate fair value of company and its equity
Steps to Follow:
- Free Cash Flow each year= EBIT* (1-Tax rate) + Non-cash Expense- New Capex – New Working Capital Investment
- Value of the Company = Enterprise Value= Present value of forecasted years’ free cash flow + Present Value of Terminal Value
- Value of Equity = Value of the Company – Value of Debt + Non-Operating Asset (i.e., Cash & Marketable Security)
b) The Venture Capital Method
As its name implies, the venture capital method is widely used by venture capitalists to value startups. It’s multiple based approach to valuing companies. The multiple is the based on the return expectation of the investor at exit. The return expectation or ROI either equates to some multiple of the investor’s initial investment or to the risk-based Internal Rate of Return (IRR) requirement.
Value of the company after receiving a round of investment = Terminal Value / ROI expectation
Value of company before receiving external investment = Post-money Valuation – Investment amount
If an investor seeks 20 times (x) ROI over its initial Investment and terminal value stands at USD 20,000, the post-money valuation becomes USD 1,000 and pre-money valuation would become USD 750 for 25% ( or USD 250) ownershipinterest in the company.