The value of a startup
Why investors sometimes pay millions for a starting company
Imagine someone has started their own business with an invention or a good idea. Often, at some point, the question arises: "What is the value of my business?". Although this is a seemingly simple question, determining the value of a business in general, and that of a startup in particular, turns out to be quite challenging. It's a bit like asking: "How long is a piece of string?" It's a nonsensical question because the answer can be anything. This seems to hold true for the valuation of a business as well. However, a valuation is relevant, and being able to provide a good estimate of the business value is crucial for inventors, startup owners, and those interested in investing in the young company.
This site focuses on establishing a startup based on an invention or a good idea. Of great importance in this process is the ability to calculate the value of the startup (or the invention alone). In several pages on this site, we will discuss techniques used to calculate the value of a business and which ones are suitable for determining the value of a startup. We will do this using an invention we've conjured up called the iCic. Additionally, we will illustrate with this example some hurdles you might encounter on the challenging journey from idea to product. We will also show that valuation not only aims to put a nice price tag on your invention but that an assigned value to the company is crucial during the negotiation phase for financing by investors. Let's first explore the methods commonly used to determine the value of a business.
Methods to Determine the Value of a Business
We can categorize the valuation methods for businesses, including startups, for practical reasons into several types.
0. Quick calculation methods based on the financial statements: These methods are intended as an initial indication and never as an official guideline or valuation. You can use them only as a starting point for further analysis and research.
I. Cost methods: These are based on the costs incurred before and after an investment. In English, these are called pre-money and post-money valuations. Pre- and post-money valuation are often used terms in the venture capital world and play a crucial role during the negotiation phase; we will delve into this later. For now, it suffices to say that pre-money refers to the value before the investment, and post-money refers to the value after the investment;
II. Valuation based on a predicted future value: Here, we make a prediction of the company's value over x number of years. We make this prediction using forecasted variables in the future, such as, for example, revenue, costs, market share, and the calculated cash flows and profit derived from them. From this, we attempt to calculate the expected profit that a potential investment offers. There are several types of valuations based on a predicted future value:
- Market comparison methods based on comparable values in the market. In English, this is called Comparables Analysis;
- Economic valuation methods. These can be divided into:
- Income method: method based on projected cash flows
- Time: DCF methods that consider the "time value of money"
- Uncertainty: DCF methods that take into account the risk of projected cash flows
- Valuation methods based on flexibility. Again, three types:
- DCF-based "Decision Tree Analysis" methods
- Monte Carlo simulation
- Real Option valuation
- Changing risk. These are methods based on "Option Pricing Theory," including:
- Discrete distribution: Binomial models
- Continuous distribution: Black-Scholes option model
The aforementioned methods are not the only ones. There are methods that use Net Capital + Goodwill in valuation or the price/earnings (P/E) ratio. However, we will not discuss these methods because they can only be used for companies with a financial history, and such history is absent in the case of a startup.
In this introduction to startup valuation, we discuss various methods to determine the value of a business. Here's what we'll do: we'll start with five simple valuation methods based on a company's financial statements. However, these methods provide only a rough indication of the business's value, and besides, startups usually do not have financial statements based on long-term income. Therefore, we introduce more advanced valuation methods, also suitable for startups, starting with the cost method.
To further elaborate on the valuation of a startup, we first need to delve into the future value of money and the discount rate. Here, we also introduce the Capital Asset Pricing Model (CAPM) and the DCF method (Discounted Cash Flow).
Next, we'll explore the concept of return and its definitions, and discuss the concepts of Net Present Value, and explain what cash flow is and how to calculate it.
Then, we'll look into the concept of comparable value and demonstrate, through a concrete example, how to actually determine the value of your tech startup with the comparables analysis method.
Finally, we'll address what always comes at the end but is actually the most crucial part of the entire investment process and what it's all about: how are shares distributed within a startup, and how does this relate to Goodwill and Business Valuation? What we aim to achieve is that you begin to get an understanding of what an investor looks at and how they perceive the value of your startup in the future. After all this we will give a brief introduction to one of the more sophisticated startup valuation methods: the monte carlo simulation.
But before we proceed, a warning for the language purists among us. As you may have noticed, we will use a lot of financial terms in English. The reason for this is twofold. Firstly, English is the international language in the financial world, and we assume that your invention or idea will gain international recognition, thus the likelihood of negotiating in English. Secondly, it will be easier to search for more information on financial analysis later in literature or on the internet using English terms.
This text is intended as an introduction and by no means as a scientifically sound academic paper. It is clear that our goal is not to turn you into a financial expert through this website. However, we hope to shed some light and help you be better prepared for a meeting with a potential financier or buyer of your invention. Using the presented example of valuing a startup, we will also cover some commonly used financial methods. This includes concepts like cash flow, net present value, and the future value of money.
If you wish to delve further into this matter, the book "Principles of Corporate Finance" by Brealey & Myers is highly recommended.
Value creation: the three pillars of a successful invention
Determining the value of a startup with an innovative invention is no easy task. It involves not only calculating the costs of developing the invention and figuring out its future potential but also understanding the economic laws that apply to its marketing. Startups must not only have a valuable invention but also a solid plan to bring it to the market and make a profit. This requires careful considerations and a good understanding of market laws. Below, we delve into some important principles. To be a successful inventor, meaning you know how to create value with your invention, it must ultimately meet at least three conditions:
- The invention must work.
- There must be a market for it.
- There should be no legal or regulatory obstacles to applying your invention. And, of course, it must be safe.
1. The invention must work
We all have good ideas from time to time, but has your idea been developed, and can you show a Proof of Concept or a working prototype? Can you truly demonstrate that it all works? If not, you'll need to continue developing and testing, and that costs money.
2. Nice to Have versus Need to Have
Okay, it works, but who will buy it, and what are they willing to pay for it? Is it something nice to have for a limited number of people, or is it something everyone rushes to get? This is not known beforehand, and answering such crucial questions falls into the realm of marketing. It's also important to realize that the terms "Nice" and "Need" are highly subjective. For some, owning a car in Grolloo or Los Angeles may be a "Need to have," while in the center of Amsterdam, owning a car might be a burden. In any case, it's essential to understand that an invention considered a "Need to have" by buyers will likely bring in more for you as an inventor than a "nice to have" invention. Large companies often go to great lengths to turn a "Nice to have" into a "Need to have" through significant marketing campaigns.
3. Safety, legislation, and legal aspects
This can not only be a serious problem but an absolute showstopper, which often occurs in the pharmaceutical industry, for example. Inventors must not only demonstrate that the invented therapy works but also that there are no serious side effects. If authorities deem your invention unsafe for the general public, its value will decrease significantly. However, it doesn't have to be entirely worthless, as some parts of the invention may be applicable to other products or technologies. Remember the saying, "Someone's Trash is Someone else's Treasure." Giving it away is always an option...
Below, this is further elaborated using a very familiar example: The lessons of Bill Gates and Microsoft.
In the business world, all stories about the failures of a company are more or less the same because entrepreneurs repeatedly make similar mistakes. Success stories, on the other hand, often have something unique, and they are not only enjoyable to read but also offer learning opportunities. Let's take the story of Bill Gates and Microsoft as an example of a success story about the value of an invention — why not? It remains a beautiful story. To do this, let's go back to the early '80s when the world was on the verge of witnessing the birth of the PC.
The Bluff of Bill Gates
About the beginning of Microsoft and how Bill Gates founded and shaped his business, many stories circulate, but there is a particular anecdote that remains very persistent. The story goes like this. The computer giant IBM was about to decide whether or not to manufacture an IBM Personal Computer (PC). A requirement was that there should be an operating system (OS) available for the PC. Gates bought another OS for $50,000 (the creator knew nothing about the impending deal with IBM), made some necessary changes to the software, walked back into IBM, and sealed a global deal. Read on another page more details about this inspiring deal of Bill Gates with IBM.
The value of Bill Gates' invention (or rather, the product): the assessment
Regarding a startup with an invention, we stated that an invention seeking significant success must meet three conditions. These were (1) the invention must work, (2) it must be a "Need to have," and (3) there must be no legal obstacles or safety issues for large-scale sales. Now, if we assess Bill Gate's OS against the three pillars of an invention, we can easily say that the reason Bill Gates — then an insignificant dropout — could enforce a licensing agreement from the world's largest computer producer was that the OS (the invention) worked; the OS was not a Nice to have for IBM but an absolute Need to have; there was no risk of authorities disapproving the invention; Voila! Microsoft was in business.
Let's continue with the example and define some principles for the valuation of a company. Afterward, we will determine the value of a sample invention, which is the key asset of a startup.
Investing and Risk: "De Cost Gaet Voor de Baet Uyt"
If you visit Amsterdam, the capital of the Netherlands, and arrive at the central station, you can walk through "Damrak" to the central square called "de Dam" with the Royal Palace. This building, designed to showcase the power and wealth of Amsterdam in the 17th century, is now the official reception palace of King Willem-Alexander.
If you are interested in business, startups, and investments, there is another interesting historical building you can find during your walk from the station to "de Dam." After a few hundred meters, you will see, on your left, behind the canal boats, the above building with the Dutch text "De Cost Gaet Voor de Baet Uyt."
Trade has always been important for the Netherlands. The Amsterdam Stock Exchange (established in 1611) is considered the oldest stock exchange in the world. The building with the old Dutch text at the front dates back to the late 18th century and used to be an office for trade information. It is now a nice restaurant for tourists and locals.
This old text means more than just a historical sentence. It means something like "Costs must be incurred before benefits can be earned." The text perfectly illustrates the basic principle of finance. One must take a risk before money can be earned. And the more risk an investor takes, the more they want to earn from the investment! It is the basic principle of finance, economic growth, and the banking system - and the cause of many sleepless nights for many entrepreneurs and investors.
Today, we would say that there must be an investment first before we can share in the profit. The reason we state the obvious is that we want to focus on those who invest and under what circumstances the investment(s) are made.
As a first principle, we assume that you are the first financier, meaning you are the first to have invested time and money in your own idea so that you can now show the first result. With this model or prototype, you hope to convince others to invest as well. As a second principle, we assume that you haven't recently won the jackpot in the lottery or have millions in your bank account. If you did, it wouldn't affect the valuation of the invention, but it would change a few of our chosen assumptions during the process. It would undoubtedly influence your decision when you can take two hundred thousand Euros from your millions of bank accounts or when you have to increase the mortgage on your house by that amount. This difference in risk profile will significantly influence your decision pattern. So, we assume that the chances are high that you will need to attract co-financiers. Co-financing is not only a matter of money but also of risk distribution. Finding a co-financier means, besides obtaining financial resources to proceed, that you don't have to put all your savings into it, thus significantly reducing the risk for yourself.
Of course, this doesn't come for free, and there is a price to pay. The co-investor will also share in the profit at the expense of your returns. About this phenomenon, reducing your risk resulting in decreasing your profit, the concept of risk and return, much has been published and discussed. Nobel prizes have also been won. You understand, we won't go into this further, but we assume that you will eventually seek co-financiers.
Company Valuation: The Example of the iCic
The next assumption is your invention. Let's imagine something as an example and assume that you are working on what you call the iCic, or the I Cinema in Car — you're not entirely satisfied with the name yet, but that will come later.
The iCic is a device that projects moving images on the inside of a car's windshield and adjusts the projection so that the image is not distorted by the curvature of the glass. Also, the driver can continue to look at the road calmly while driving because the images, although of superior (HD) quality, are transparent. The driver can enjoy a fantastic movie in Dolby Surround 9.1, watch the news, or stay updated on financial markets in real-time with the iCic during the car journey, along with the passengers. You are quite far with the iCic; it doesn't work perfectly yet, but you have a prototype that works in your garage at home, and you've already congratulated yourself, and the champagne is ordered. In the next part of our series on valuation, we will test the iCic against the three pillars of a successful invention and introduce different methods for the valuation of a company whose key asset is an invention.
Determining the value of the company is often a challenging and common problem for inventors with a startup. Often, there is an invention that doesn't work at all or works a little. There is still much to be done to create a real working prototype or at least to show that it works in principle. But to do this, you don't have enough financial resources. You need financing, and to raise money successfully, you first need an idea of what your invention, and thus your company, could be worth.
Methods for the Valuation of a Company
First, we need to determine what and how exactly will be evaluated. Will we evaluate the iCic on its own, or only the existing patents, or both? To simplify the discussion, we will combine the patents with the invention since they are usually linked to each other, and we are at the beginning of commercialization. We assume that there are no producers who have taken a license for your patent and are producing the iCic at this stage.
In the following pages, we will further explain the aforementioned valuation methods. We start with the most straightforward way of valuation, the quick calculation methods based on the financial statements.
