Primer on Valuation Methods (Photo by Visual Stories || Micheile on Unsplash)

Primer on Valuation Methods used by VCs Globally

Valuing a company or a business, be it a start-up or an established enterprise, is both an art and a science. But whether you’re raising investment, issuing ESOPs, or even involved in day-to-day operations, it’s critical to understand what your company is worth. It’s important that the company valuation considers all relevant factors such as the business model, market opportunity, goodwill, competitor performance, team capabilities, etc. Angel investors and venture capitalists (VCs) use multiple valuation methods to derive the value at which they should invest and hence their ownership in the company. In this primer on valuation methods, we try to break down the complex world of company valuation by talking about the 3 most commonly used valuation methods by angel investors & VCs globally.

We at AND have supported 100+ start-ups raise capital by helping them understand their value and better negotiate the terms of investment. Our clients span across geographies and industries including agri-tech, food-tech, logistics, edu-tech, health-tech, and energy. While there are several other methods to arrive at a company’s value, our experience tells us that a combination of these 3 key methods gives both the company and potential investors a very clear understanding of what the company is worth.

Valuation Method #1 – Discounted Cash Flow Method (DCF Method)

This method is used to estimate the value of an investment today, based on expected future cash flows. In this method, we take the forecasted future cash flows and then apply a discount rate. The higher the discount rate, the riskier the investment, and the better the cash flows need to be.

It is the most detailed of valuation methods as it requires the maximum number of estimates and assumptions to be made. But, a well-researched and robust DCF can ultimately result in a more accurate valuation. However, one major limitation is that it primarily relies on the estimation of future cash flows, which could be inaccurate based on the assumptions considered and the discount rate used.

Discount rates are generally calculated using the Capital Asset Pricing Model (CAPM) method.

Valuation Method #2 – The Multiples Approach

The multiples approach is a comparative analysis method that values a target company using financial ratios (or multiples) of similar companies. The most common multiples include Enterprise Value / Revenue and EV / EBITDA, Price / Sales, etc. These ratios are easily available for public listed companies (from a quick Google search or on sites like Yahoo! Finance). Sometimes, this data is available for private unlisted companies (from news articles or company filings) when they raise a funding round or have been involved in an M&A transaction.

The basic idea is to take available ratios from these companies and apply it to the Revenue or EBITDA of the target company to arrive at the Enterprise Value of the target company. This is a great source of comprehensive geography-wise sectoral multiples (some of this data can also be used in the CAPM method discussed above).

The simplicity of this model allows investors to make a quick computation to assess a company’s value. However, this method has an inherent disadvantage because it simplifies complex information into a single multiple or a few multiples. While obtaining good multiples for private companies can be challenging (and expensive), some multiples also disregard the future potential of the company as they focus on past performance.

Valuation Method #3 – Venture Capital Method 

The VC method is generally used to value early-stage, pre-revenue companies that don’t have a track record or historical data. This method calculates the terminal value at a future date using the multiples talked about above such as EV/Revenue and EV/EBITDA. The future date is when the investor assumes that there will be an opportunity to exit the investment, i.e. sell their shares and move on. Based on the return the investor expects (say 10x), the company’s present value is calculated from the terminal value. The disadvantage of this method is that it focuses only on the assumptions of the venture investor and not on the company’s performance and characteristics.

While each method has its pros and cons, they complement each other well and are still fairly more robust than the other valuation methods that exist today. Which is why the focus is on them in this primer on valuation methods. We typically use a weighted average of these 3 methods to overcome the inherent shortcomings of each method. Most angel investors and VCs consider this a solid estimate from where to start the negotiation.

Hope this primer on valuation methods simplifies the complex subject of company valuations for you. We at AND have a lot of experience helping companies figure out how much they’re worth and what other terms need to be keep in mind when approaching investors. If you need any assistance, do reach out to us at [email protected].

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