It is difficult to predict the future. This is especially evident in the context of startup companies who have modest or no income at the present but have high hopes for growth in the future. Investors who wish to invest in such companies must compare the risk present with the hope of financial gain before putting their funds at stake. In this process a valuation is essential.
Valuation is in many cases a prediction of the future. Often this involves an educated estimate of the future cash flow of the company based on its business plan discounted by the appropriate discount rate based on the risk involved. The result of the valuation, the price of the equity of the company is the real entry point for the investor. For that sake, it is difficult to overemphasize the importance of a company´s valuation.
A valuation is especially important during times of change where there is a strong need for clear decisionmaking, this is also the case for growing companies that are launching products and hiring additional staff. The methods of valuating a company are numerous and diverse. It is important to choose an appropriate valuation method or methods to ensure both the quality and the precision of the valuation.
When a well-established company is concerned with stable operations a valuation is generally based on discounted cash flow methods. Among the benefits of such methods is the consideration for the time value of money.
When valuating a growth company however is becomes especially important to select valuation methods carefully due to among other things the diversity of such companies. The valuation of growth companies generally is based on discounted cash flow on one hand and a comparison with comparable growth companies (comparables) on the other hand.
Valuation methods based on comparables like the name suggests are methods where companies are compared with comparable companies. In this case, a company is estimated by key quantitative factors that affect the value of the company like the experience of the management team, the strength of the intellectual property protection, the financial strength of the companies investors and the stage of development and competition with each factor having a set level of weight in the overall valuation. The company is then compared to an average company in the same industry based on these key indicators. These methods are especially useful for companies that are in the development stage or have a short operating history with venture capital funds looking at these indicators especially in the case of estimating young companies.
Utilizing more than one valuation method in the case of growth companies and taking a weighted average of both discounted cash flow and comparables gives a more accurate valuation than if a valuation is only based on either discounted cash flow or comparable methods. Is this the case as the longer the operating history of the company is the more accurate a discounted cash flow analysis becomes and because utilizing more than one method makes the final valuation less sensitive to a single factor. In the case of the weighted average between discounted cash flow and comparable methods, it is dictated by the development stage of the company in the case of growth companies.
It is important however to note that the most important part of valuating a company is the quality of the data the valuation is based on. It is therefore important for the valuating party to have experience in the analysis of projections and experience of comparable operations in the case of discounted cash flow methods and having access to a large amount of data on comparable companies in the case of valuation based on comparables.
A high-quality valuation with this in mind creates circumstances for effective investment and it prevents a loss for the entrepreneur due to a valuation that is too low resulting in the wrong decisions that lead to excessive dilution of the entrepreneur’s shares or a long and drawn out financing process that does yield results.