Valuation of startups and early-stage businesseshas become a more prevalent topic globally as investors and business owners have increasingly focused on the importance of the valuation of such businesses/ investments (and of course, monetisation!).
The startup and early-stage businesses ecosystem in Malaysia has grown rapidly particularly since 2010, with a significant increase in the number of startups and investors in the country. As per Startup Genome’s 2020 Global Startup Ecosystem Report, Kuala Lumpur ranked as the 70th best startup ecosystem globally, and the 3rd best in Southeast Asia, after Singapore and Jakarta.
There are challenges including lack of capital in the country and the difficulty in scaling up. A lot of startups and early-stage businesses fail due mainly due to these reasons amongst others. There is a growing culture of innovation and entrepreneurship in Malaysia, with many young people starting their own businesses instead of pursuing corporate/ traditional career paths.
As such, the valuation of startups and early-stage businesses in Malaysia whether it is for funding, M&A, strategic partnerships, shareholder purposes, is gaining importance.
Let’s look at some of the typical characteristics of a startup business:
- Limited history and track record – i.e., limited company history and inexperience business owners/ management.
- Lack of business, industry, and financial information – i.e., product or service offered that are unique and therefore its business model is untested and uncertain.
- Reliance on fundings, typically for growing market share, marketing/ advertisement, talent acquisition.
- A focus on growth, rather than profitability.
- Most of the time – a complex capital structure.
An example in the Fintech funding and valuation characteristics by stage of growth is noted below:
In general, there are three (3) approaches to valuation – market approach, income approach and cost approach. Typically the cost approach is not used in valuing a startup or early-stage business unless it is under a process of liquidation or having a going concern issue or it is pre-revenue but significant funds may have been deployed to developed a product or service or a technology related platform or software, etc. The valuation of startups and early-stage businesses for transaction negotiations can be arrived at depending on factors, including but not limited to:
- The number of current and potential users/ customers.
- Total current and potential revenues.
- Revenue growth trajectory.
- The business model.
- Uniqueness of product/ service.
- The market niche.
- The technology/ Intellectual Property (IP) value.
It also reflects the relative negotiating power of each party involved.
An overview of expected rates of return by Venture Capitalists (VCs) based on four studies are noted below:
Source: KPMG Quarterly brief, Q2, 2021
Some of the methods for early-stage or startups company valuation include:
Scorecard Valuation – Method
In most industries/ sectors, in general, pre-revenue start-ups pre-money valuation does not vary too significantly from one industry/ sector to another given the limited information and uncertainties involved. This method compares the subject company to broadly similar angel-funded startups and adjusts the average valuation of recently funded companies in the relevant industry/ sector to establish a pre-money valuation. However, comparisons can only be made for companies at the same stage of development.
This method was invented in the 1990s by Dave Berkus, a well-known US angel investor and venture capitalist. According to him – fewer than one in a thousand startups meet or exceed their projected revenue in the projected period and as such at that stage, key strength and weakness factors which are highly subjective, provide a good guide for valuation.
This is a basic and convenient rule of thumb or framework to estimate the value of a pre-revenue start-up for entrepreneurs and early-stage investors based on risk factors as financial projections at that stage are highly uncertain or not that meaningful. Just because it’s basic and simple, doesn’t mean that detailed fact-finding or comprehensive due diligence should not be done.
Comparable Transactions Valuation – Method
This is one the most popular start-up valuation methods as it’s built on precedent. What one is trying to answer, “How much were similar start-ups acquired for?”
This method is part of the multiples analysis and is also known as multiples relative valuation, transaction multiples valuation, etc. Where financial indicators may not be available, other indicators can be used.
It provides an indicator of value which will be a proxy for the value of an early-stage company. This indicator can be specific to the industry/ sector: which could be: Monthly transactions (e-commerce), Monthly recurring revenues (SaaS), Asset Under Management (Wealth Management), Patents filed (Biotech), Number of outlets (retail). Most of the time, one can just take the key financial matrix from P&L: revenue, gross margin, EBIT/ EBITDA, etc.
First Chicago Valuation – Method
The First Chicago method is used either in the Venture Capital method or the DCF method.
Once the method is chosen, it considers the worst-case, average/ base-case, and best-case valuation outcomes under that method.
By combining the 3 scenarios with realistic probabilities of each of the 3 scenarios, a weighted average valuation can be arrived at.
Venture Capital Method
It is used in the case of pre-revenue company valuation for pre-money valuations.
It provides another option to consider for pre-revenue valuation. It also reflects the mindset of VC investors who are considering exiting a business after making the required return within a certain timeframe.
Back solved Method
This method is more commonly used for startups who have successfully completed a fundraising exercise (usually through issuance of shares other than the common shares). When an exit event is not imminent, the appropriate models to measure the fair value of a company with a complex capital structure are:
- the Probability Weighted Expected Return Method (PWERM)
- the Option Pricing Method (OPM)
While the choice of the model(s) is often dictated by facts and circumstances – for example, the company’s stage of development, visibility into exit avenues, etc. – using either the PWERM or the OPM requires several key assumptions that may be difficult to source or support for pre-public, often pre-profitable, companies.
This method is particularly useful for startup companies granting equity-based compensation which require valuation for financial reporting purposes.
Ultimately, any business valuation and more so, startups and early-stage businesses valuation, is an art and not a science. It requires significant experience, judgement and deep qualitative and quantitative analysis to arrive at a reasonable and defensible valuation. The Malaysian startup and early-stage businesses ecosystem will benefit from experienced professional valuers to be part of that ecosystem.