A 22-year-old college dropout stands in front of you asking for $13 million dollars, would you give it to him? This is the exact situation early Snapchat investors faced. The company was making minuscule revenues while losing money along the way.
How are companies valued when there is little to place value on? Looking strictly at income and expenses, most new tech companies appear to be terrible investments. But there are few who don’t wish they had seen the potential of industry giants like Google, Facebook, or Uber before they became masters of the universe.
But there is a lot of risks associated with tech company valuation. Is it a bad idea to invest based on expected growth instead of where the company currently stands? This article will show you how to value a tech startup.
Where to Start in Valuing New Tech Companies
Valuing software and other intangible assets poses many questions for investors. There is a lot on the line when you’re expecting the value of your investment to grow many times over.
How do you know what valuation is low enough for you to make a return while high enough that the company doesn’t feel cheated? These five methods are common ways of pinning down these hard to wrangle investment beasts.
- Discounted Cash Flow (DCF)
- First Chicago Method
- Market and transaction comparables
- Book value/Market value
- Liquidation value
Predicting Future Growth of New Tech Companies
At its heart, DCF is just a way of calculating how much money you’ll get back from your investment. New tech companies’ income can change a lot over a few months. DCF uses the projections analysts make to guess what future income might be. That value of future income sells at a discount to investors ready to put money down now.
Investors are looking to DCF more than ever because of its advantages over P/E ratios as value indicators. Price to earning (P/E) ratios are a way to determine the profitability of a stock. But there is a big problem with using P/E as a benchmark.
How Valuations Get Out of Control
Technology company valuation can get out of control as a result of investor speculation. If average P/E ratios are too high to indicate profitable stocks, they become useless. Using P/E ratios can leave you with an overpriced stock ready to drop in value.
DCF, on the other hand, gives you a real number to base your decision on. You can calculate how fast the company needs to grow to justify the valuation.
The First Chicago Method gives us an idea of what the stock could look like in three situations. A best case, base case, and worst case scenario for the stock are set. This is better than DCF which only shows the best case scenario. This method also calculates the risk and probability of each scenario happening.
Looking at Other Valuations for Help
Tech valuation borrows a method often used in real estate to determine a stock’s price. By looking at comparable past valuations of other companies we can get a better idea of what we should be paying for this stock. Market and transaction comparables fill in the missing piece missed by DCF and the First Chicago Method.
The total value of all a company’s assets creates the book value. Market value is the highest valuation of those assets unless market demand has gone down. Liquidation value is what’s left if a company closed shop and sold everything off.
Pre-Money and Post-Money
Pre-money is the term for a company before taking on an investor’s money. Post-money is the valuation after taking on that investment. Cash multiple is the amount of money an investor walks away with after exiting the investment divided by how much they initially put in.
Because the money you are investing goes on the balance sheets of the company, it affects the percentage you are buying. So if you buy $250,000 worth of company A at a valuation of $1 million, you’ll only own 20%. If the pre-money valuation were at $750,000 instead, your $250,000 would put your stake at 25%.
That 5% could amount to tens or hundreds of millions for a company that experiences explosive growth. Pre-money valuations are where a lot of the tension in valuing new tech companies is. But there is a solution…
Convertible notes are loans that a company can pay back with equity rather than money, and they mature after a certain time period, like a bond. They let companies take on the money they need to grow, without stifling their valuation.
The Question of Valuation Caps
You might be thinking, “won’t the original investors get a smaller cut when new funding comes in?” That’s where valuation caps come in. Valuation caps protect early investors from having their investment diluted.
This means early investors get a much larger slice of the pie then what their money would be able to buy at the next valuation. In return for an ambiguous valuation, early investors are given equity based on a predetermined valuation that is lower than at later funding rounds.
The company can continue to raise money, early investors get their fair share and new investors don’t dilute previous rounds of funding.
The Best Time to Invest for Gains
Snapchat raised over $13 million in their first round of funding. Investors saw comparable businesses, like Instagram, sell for billions before having a plan to make money. They saw the revenue parent company Snap could make once their user base grew.
But finding a unique business, a startup with a valuation of $1 billion or more, is harder than venture capitalists make it look. Aswath Damodaran, the author of The Little Book of Valuation, states, “Einstein was right about relativity, but even he would have had a difficult time applying relative valuation in today’s stock markets.”
We can apply scientific methods to evaluate a new tech companies, but only time will tell how accurate our predictions are.
Contact us to find out how to take your startup to the next level.
