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Today, the central resource that creates wealth in many industries is intellectual property.

Wirtz, 2012

The landscape

A business valuation is a process of determining the economic value of a company (Beal, 2020). Determining a fair value is important for several reasons, including mergers/acquisitions, partner ownerships, share distributions, and taxation. The process includes analysing earnings prospects, capital structure, or market value of assets (Hayes, 2021). In times past, the important assets that a company had were tangibles, e.g. plant and equipment. Today, the central resource that creates wealth in many industries is intellectual property (Wirtz, 2012). Intellectual property (IP) includes patents, trademarks, copyrights and 'know-how' and often is the most valuable asset for startup businesses. It also constitutes a significant consideration for investors (Adekunbi, 2020).

There are several ways to put a value on a company. The simplest methods used start from the market capitalisation, multiple of earnings before interest, taxes, depreciation, and amortisation (EBITDA), through revenue method, P/E ratio, discounted cash flows to book value and liquidation value methods (Hayes, 2021); (Reilley & Schweihs, 1998); (Smith & Parr, 2005).

Due to the IP being different from other tangible assets, traditional valuation methods for startups are often not practical and present challenges across the finance community. What needs to be considered alongside the 'traditional' valuation methods are the 'soft skills', including the teams skillsets, reputation in running businesses, the ambition of the business and the milestones to achieve it and managing for founder dilution (Quirk, 2020).

Dreamlaunch developed the below valuable summary on the key factors that determine startup value: (Startup Valuation Methods: Everything You Need to Know, 2020):

Positive Factors

Negative Factors
  • Traction – One of the biggest factors of proving a valuation is to show that your company has customers. If you have 100,000 customers you have a good shot at raising $1 million.
  • Poor Industry – If a startup is in an industry that has recently shown poor performance, or maybe dying off.
  • Reputation – If a startup owner has a track record of coming up with good ideas or running successful businesses, or the product, procedure or service already has a good reputation a startup is more likely to get a higher valuation, even if there isn't traction.
  • Low Margins – Some startups will be in industries or sell products that have low-margins, making an investment less desirable.
  • Prototype – Any prototype that a business may have that displays the product/service will help.
  • Competition – Some industry sectors have a lot of competition or other business that has cornered the market. A startup that might be competing in this situation is likely to put off investors.
  • Revenues – More important to a business to business startups rather than consumer startups but revenue streams like charging users will make a company easier to value.
  • Management Not Up To Scratch – If the management team of a startup has no track record or reputation, or key positions are missing.
  • Supply and Demand – If there are more business owners seeking money than investors willing to invest, this could affect your business valuation. This also includes a business owner's desperation to secure an investment, and an investors willingness to pay a premium.
  • Product – If the product doesn't work, or has no traction and doesn't seem to be popular or a good idea.
  • Distribution Channel – Where a startup sells its product is important if you get a good distribution channel the value of a startup will be more likely to be higher.
  • Desperation – If the business owner is seeking investment because they are close to running out of cash.
  • Hotness of Industry – If a particular industry is booming or popular (like mobile gaming) investors are more likely to pay a premium, meaning your startup will be worth more if it falls in the right industry.

Snapshot of different valuation methods

The below provides a snapshot of different types of valuation methods, including considerations of pros and cons associated with each.

There are three basic valuation methodologies: cost-based, market-based, and income-based (Smith & Parr, 2005). Wirtz (2012) summarised each approach and submethods in the below diagram.

Figure 1 Valuation Approaches and Methods

Figure 1. Valuation Approaches and Methods:

Other valuation methods:

Valuation Method

Pros

Cons

Cost to Duplicate

The basic assumption of this approach is that the cost to build or buy new property equals the value of its ownership.

Rarely used in practice. They are used as a check of values calculated by other methods.
  • A simple approach to come up with a "lowball" estimate of company value
  • Applicable with partially completed IP that does not generate any revenue
  • It does not really appraise the future benefits arising from the asset
  • The underlying assumption that costs create value is very problematic in this context
  • Ignores intangible assets, like brand value, that the venture might possess even at an early stage of development

Market Approach

  • Based on paid prices as an indicator for the value of an asset.
  • Wirtz (2012) explains that this method requires an active market for the good, which means that the traded assets have to be homogenous, willing buyers and sellers can be found at any time, and prices are publicly known.
  • For example, you are considering purchasing an apartment in the city. Using the 'Market Approach,' you would compare prices paid across transactions of similar size apartments before making an offer accordingly.
  • Good for homogenous assets traded in an active market.
  • An example of a homogenous asset is gold, for which there is an active market (many sellers and buyers).
  • Limited use for startups and IP assets since the transaction object is unique and the number of transactions is very limited (Wirtz, 2012)

Market Multiple

  • This is another way of applying the Market Approach method, but it is based on the recent acquisition of similar companies in the market and using revenue/sale price ratio as indicative valuation price.
  • For startups, extensive forecasts must be determined to assess the potential sales and earnings of the business when it reaches a mature stage of operation.
  • Providers of capital will often provide funds to businesses when they believe in the product and business model of the firm, even before it is generating earnings (McClure, 2020).
  • The market multiple approach delivers value estimates that comes closer to what investors are willing to pay.
  • Suitable for mature companies that generate revenue and have ongoing operations in place.
  • Comparable market transactions can be very hard to find. It is not always easy to find companies that are close comparisons, especially in the startup market (McClure, 2020).

Discounted Cash Flow (DCF)

  • DCF involves forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth (McClure, 2020).
  • A higher discount rate is typically applied to startups, as there is a high risk that the company will inevitably fail to generate sustainable cashflows.
  • For example: Looking at the initial purchase price (cash outlay) and future revenue benefits (cash in) to calculate NPV
  • The license fees approach can be used directly as cash flows in the valuation calculation. They can be quantified relatively quickly and with high reliability for the near future (Wirtz, 2012)
  • The quality of the DCF depends on the analyst's ability to forecast future market conditions and make good assumptions about long-term growth rates (McClure, 2020)
  • It becomes a guessing game to project sales and earnings beyond a few years.

Valuation by Stage

  • This method is often used by angel investors and venture capital firms to arrive at a rough range of company value (Kulkarni, n.d.).
  • Values are typically set by the investors, depending on the venture's stage of commercial development.
  • The further the company has progressed along the development pathway, the lower its risk and the higher its value.
  • While the initial round of funding is usually for employee salaries to develop a product, future funding rounds can also include funding to mass-produce and market the invention.
  • One of the few methods used for the valuation of startups.
  • Simple
  • This method can be subjective depending on the type of investors

Example - Valuation by Stage

The below table lists stages and estimated values that investors often use when considering investing in startups. Ultimately, it is the future potential of a business idea that drives the investment, and this table plays an important part in the process.

Stage of Commercial Development Example

Estimated value ($)

Stage of Development

Your Progress

250k – 500k

Exciting business idea or business plan

Yes

500k – 1 mil

Strong management team in place to execute the plan

Yes

1 mil – 2 mil

Has a final product or technology prototype

Yes

2 mil – 5 mil

Has strategic alliances or partners, or sign of a customer base

Yes

5 mil +

Has clear signs of revenue growth and an obvious pathway to profitability

Yes

To find an acquired startup and for how much is difficult to do. This is because if this happens, the purchase is done by a private company and the information is not required to be reported. However, let’s look at one transaction in the US that highlights what a small investment can turn into.

It is 2007, and a new start-up Heroku is born. Heroku is a cloud platform that lets companies build, deliver, monitor and scale apps (Heroku Official Site, 2021). In January 2008, $20k was invested into the business as a seed round investment. In May 2008 Investors poured $3 mil into the business. An additional $10m was poured in in 2010 (Heroku, 2021).

By the end of 2010, Heroku had just over 100,000 social and mobile applications with an extensive community and internet companies such as Twitter, Groupon and Hulu using the development language to power its applications. That was the time when Salesforce.com, a global cloud computing company that develops CRM solutions and provides business software on a subscription basis, approached and acquire Heroku for staggering $212 mil cash, and around $30 mil in share options for Heroku employees (Salesforce.com Buys Heroku For $212 Million In Cash, 2010).

Heroku valuation fits the last Stage of Development, where there is a steady growing revenue and great potential, what needs to be remembered is that their idea was executed by a strong team that had technical and business expertise, proven experience and commitment.

Case Study - Market Multiple

In March 2021, Airtasker, launched on the ASX. As part of this process, Airtasker released IPO documentation supporting their operations that contained important financial information.

In May 2021, Airtasker acquired US-based company Zaarly to gain better access to the US market (Sunarto, 2021). Zaarly is a platform that is very similar to what Airtasker offers.

Zaarly annual revenue is around $0.9mil, which comes from 600,000 users. The company has operated since 2011, and the start of the company was supported by an $18mil cash injection from investors.

The acquisition price that Airtasker paid was $3.4m, which represents 3.7x the amount of revenue Zaarly generates.

Airtasker's value when it launched on the ASX was $83 million. It has been operating for nine years with annual revenue of $24.5mil. The market capitalisation of $83mil represents about 3.4x the amount of revenue.

A similar company that recently launched on the ASX was Hipages (in 2020). It had a market capitalisation of around $286 mil with a revenue projection of $53mil. The market capitalisation of $286mil represents approximately 5.4x the amount of revenue.

The $3.4 mil question is, did Airtasker got a good deal? Considering that the same week they also went to the market to raise additional $20.7 mil (Mickleboro, 2021), I see this as investors having confidence in the way Airtasker is moving forward to get the big piece of the US market.

Summary of Market Multiple Calculations

Company

Market Capitalisation

Revenue

Market Multiple

Zaarly

$3.4 mil

$0.9 mil

3.7

Airtasker

$83 mil

$24.5 mil

3.4

HiPages

$286 mil

$53 mil

5.4

In conclusion

Valuation methods that are used to estimate company values can be complicated. The complication intensifies when we include startup companies and IP assets where limited validated financial information is available.

The cost approach is relatively easy to process but has a conceptual weakness. It does not appraise the benefits of the IP but its cost. The market approach has the problem that comparable transactions are difficult to find. The market multiplier or income approach appears to be the most appropriate approach for many appraisal situations where companies generate revenue and have ongoing operations.

The valuation process becomes murkier for startups valuations. Investors do not use traditional valuation methods, but use methods such as valuation by stage, scoreboard valuation and comparables method approach, which helps establish the value of businesses and confidence for investors. While there is no guarantee of a startup valuation there is evidence that you, as a business owner will do everything you can to make the business work. And that is why investors will often put more value on the people rather than the business idea.

References

Adekunbi, A. A. (2020, Dec 19). Entrepreneur Asia Pacific. Retrieved from How and Why Startups Must Protect Their Intellectual Property at All Costs: https://www.entrepreneur.com/a...

Beal, S. (2020, Feb 12). Business Valuation – What Is It? Retrieved from Beal Business Brokers: https://www.bealbusinessbroker...

Hayes, A. (2021, April 25). How to Value a Company. Retrieved from Investopedia: https://www.investopedia.com/t...

Heroku. (2021). Retrieved from Crunchbase: https://www.crunchbase.com/org...

Heroku Official Site. (2021). Retrieved from Heroku: https://www.heroku.com/what

Kidness, D. (2021, May 26). Investopedia. Retrieved from How to Value a Company: https://www.investopedia.com/t...

Kulkarni, A. (n.d.). Valuation for Starups. Retrieved from Cev Group: https://cevnews.in/2020/08/val...

McClure, B. (2020, May 15). Valuing Startup Ventures. Retrieved from investopedia: https://www.investopedia.com/a...

Mickleboro, J. (2021, May 21). Airtasker (ASX:ART) share price halted to raise funds for US expansion. Retrieved from The Motley Fool: https://www.fool.com.au/2021/0...

Quirk, C. (2020, Aug 18). Rampersand. Retrieved from How to Value a Pre-Seed Startup?: https://medium.com/rampersand/...

Reilley, R., & Schweihs, R. (1998). Valuing Intangible Assets. Boston, MA: McGraw-Hill.

Salesforce.com Buys Heroku For $212 Million In Cash. (2010, Dec 08). Retrieved from Techcrunch: https://techcrunch.com/2010/12...

Smith, G., & Parr, R. (2005). Intellectual Property. Hoboken/N.J: Wiley.

Startup Valuation Methods: Everything You Need to Know. (2020, March 4). Retrieved from Dreamlaunch: https://www.dreamlaunch.com.au...

Sunarto, E. (2021, May 24). Stockhead. Retrieved from Airtasker acquires Zaarly, gets foot inside the US$500 billion local services market: https://stockhead.com.au/tech/...

Wirtz, H. (2012, May). Valuation of Intellectual Property: A Review of Approaches and Methods. International Journal of Business and Management, 7(9). Retrieved June 7, 2021