Valuing software and other intangible assets pose many questions for investors since tech start-ups may need 10 to 15 years for stability and growth. The 5 valuation methods include DCF, First Chicago Method, Market and transaction comparables, Book value/Market value, and Liquidation value. Start from the future when valuing high-growth companies to assess what the industry and firm may look like after achieving more stability, and interpolate back to current performance.
1️⃣ Identify Total Addressable Market (TAM): Acts as indicator of the potential business size in the future. Adopt a bottom- up analysis, for instance, selling carpets to 10,000 retailers in a target market, of which 1,000 may convert to sales and retailers will be charged $5000 a month, then the total addressable market is $6million. It helps to assess the potential size of the business.
2️⃣ Comparable Companies Analysis: They need not be in the exact sector, but must have a similar business model to the company you’re building (using IG/ LinkedIn for a networking start-up). Review EBITDA, sales, valuations (or market cap/ enterprise value). Then use the average of the Price/Sales or EV/Sales, and EV/EBITDA ratios for these firms, and attach a discount rate to account for the liquidity risk, market risk and other factors related to the target market.
3️⃣ Valuation Scenarios: Calculate the 5-7 year projections and test performance in at least 3 scenarios (best, worst, base case) to assess investment returns or losses, and mitigate risk. After projections are complete, use the EBITDA and/or sales data and attach the multiple created earlier to devise valuation scenarios. For instance in the GOOD scenario, your company will generate $20m in year 6, and companies similar to yours trade at 5x sales. If you apply a discount rate of 30%, you will have an average ratio of 3.5x sales, and therefore a valuation of $70m.
4️⃣ Factor in the required return: Start-ups at different stages of funding have a different risk to be factored in. Early-stage ones require a higher rate of return for investors since higher risks are involved, like market risk, product risk, growing pains, execution risk and others. We have minimum return profiles for the different stages that also include the holding period of each stage, since earlier investments are held for longer periods.
-Seed stage = > 20x or > 70% IRR (7 year holding period)
-Late Seed = > 10x or > 60% IRR (6 year holding period)
-Series A = > 8x or > 50% IRR (5 year holding period)
-Series B = > 5x or > 40% IRR (4 to 5 year holding period)
-Series C = > 4x or > 30% IRR (3 to 4 year holding period)
Check out the comments section to understand the next stage of capitalisation table and scenario testing to determine fair price calculation
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