The ultimate goal for just about every startup is to be acquired. A successful exit justifies the eighty hour work weeks, tense product launches, and financial sacrifices made by the startup team. Of course, acquisitions involve a number of steps that end with a signed deal. However these only represent the final sequence of events. The whole process takes even longer when accounting for all the analysis and pre-work involved before an acquiring company even sits at the table to negotiate.
When a startup begins its journey towards an exit, one of the very first steps is understanding how much a startup is worth. A challenge here is that there is no single widely-accepted method for valuing a company. Different experts (i.e. accountants, investors, banks, consultants) will have their own formulas and variables they prefer to use in their calculations. To give founders an starting point, can use three different perspectives as a starting point when evaluating the value of their venture.
For clarity purposes, this article will refer to “company” as the acquiring entity (i.e. the company doing the purchasing), and “startup” as the acquired entity (i.e. the company being purchased).
Book Value/Replication Value
When acquiring a startup, the company is acquiring all the assets held by the corporation. These assets include a wide variety of physical items, such as equipment, inventory, and buildings, as well as intangible assets, such as intellectual property, brands, and trademarks. The value of all these assets is the book value of the venture, and is one of the simplest valuation techniques to calculate. Book value is the value of all assets in the enterprise minus depreciation. It seeks to establish a fair market value for all assets in the startup.
Another perspective on book value is that it represents replication value. Instead of acquiring a startup, suppose a company instead chose to create its own version of the startup as a business unit within its enterprise. The company must then purchase all the equipment, materials, and technology needed to manufacture a similar product or service as the startup. The company must also establish and market a brand to customers in order to generate revenue. In this case, the company is replicating the business model of the startup.
Calculating book value involves summing the market value of all elements of the business. This includes replicating all the pieces necessary to operate the business to generate cash, including staff, machinery, materials, etc.. If the company is public, much of this information can be found in the published balance sheet. If not, some informed estimation and assumptions for certain values are required.
One challenge with this method is that it is extremely difficult to make informed estimates about intangible assets. Although an established brand of an acquiring company holds a lot of value, time and cost is required to generate awareness, interest, and confidence in new products or services. Estimating the value of such things as patents, trademarks, brands, and goodwill is incredibly difficult, especially when they form part of the competitive advantage for the startup.
The book/replication value technique is used frequently by companies evaluating others for purchase. It not only helps determine a fair value for the startup, but also to determines if it would be more economical to develop its own competing business internally rather than completing the acquisition.
Valuation of Cash Flows
At its core, a business is an entity that generates cash profit (or at least a successful one does). By operating the business, the owner chooses to receive that profit in increments over the life of the business. If an owner chooses to sell that business, they elect to receive the current value of that cash in one lump sum rather than spread over months and years in the future. The current value of future cash flow of a business is known as the valuation of cash flows, and represents a single dollar amount today of all future cash generated by the business.
The valuation of cash flows is calculated by adding together all the forecast annual profits for the number of years the business is expected to operate. A challenge here is establishing the assumptions about future cash flow. It would be incorrect to assume that the amount of cash flow generated today is the same as it will be in five years. The future is unpredictable and different market factors, changes to customer segments, and new competitive products will affect how much cash a business generates in the future. This can be addressed by documenting the specific and reasonable assumptions used to calculation the cash flow value.
Keep in mind that the value of cash erodes over time. Due to inflation, one dollar today is worth more than a dollar tomorrow, and worth less than a dollar yesterday. Since the business value calculated previously included estimates about cash generated in future years, those values must be adjusted/reduced to represent what they would be worth today. This method is called Discount Cash Flow also known as DCF. This article will not discuss the specific techniques or inputs to calculating this value, but Investopedia has a great article on discount cash flows with an example.
In some cases, particularly in the technology space, a startup can be significantly more valuable to an acquirer than its book value or cash flow value. This is known as a strategic acquisition as acquiring the startup becomes a crucial element for a company’s larger business strategy.
A strategic acquisition is when the acquiring company purchases the startup based on an understanding that the startup enables the company to earn significantly more revenue in the future. This can be accomplished through creating market-transforming products or services
The technology or business model developed and validated by the startup strongly matches the strategic direction of the company. The acquirer believes that their current core competencies complement the offering from the startup. The merger of knowledge and resources of both organizations will create even more value, however that value would be extremely difficult, if not impossible, for either venture to capture independently.
Strategic acquisitions can also be used to eliminate competition. If multiple entities are competitng in the same market with similar offerings, an acquisition is one way for the acquiring company to rapidly increase market share. Thinking in a strategic mindset, acquiring a competitor also allows a company to serve customers in one of their existing markets that they would normally not be their customers. Through purchasing a company that sells products at different quality, performance, and price levels, the acquiring company will be able to serve multiple different customers segments in a market, even if the criteria that separates those segments is very specific.
There is no single technique that is more valued than others. Different acquirers will use different valuation techniques for your company. The method chosen will depend on the type of industry in which the startup operates, and the acquirer’s specific reason for purchasing the startup.
However, it is advantageous for founders to have a cursory understanding of their venture’s value using all three techniques. Understanding the variation between valuations calculated from different techniques can provide guidance on how to market the startup to potential acquirers. It can also be used as a metric for evaluating offers to purchase, as well as be used to negotiate for a more favorable price. An acquirer that bids low based on cash flow valuation may be convinced of the additional strategic value that the startup will provide to the acquirer and their customers, thus justifying a higher purchase price.
Most important, knowing valuations from each perspective provides insight on who to pursue for acquisition and for what reasons. Founders can prioritize specific companies to approach for acquisition potential. A potential purchaser needs to be in acquisition mode (meaning they are actively looking for deals) and have sufficient cash to do so. No benefit can be gained from pursuing an acquirer that is cash-strapped or not conducting any M&A activity. A potential acquirer must be looking to expand, either in number of customers or higher margin through better economies of scale. Or the acquirer might be thinking out-of-the-box and looking to create a whole new product category to engage in a competitor-free blue-ocean strategy.
I want to thank my mentor Kevin Franco for enlightening me with his wisdom on this topic.