Investing in Potential

Investing in Potential

When established companies are purchased, finding the value of the business is particularly easy. The buyer can use the historical cash flow of the business to determine what the total value of the business is on a yearly scale. From there, this number is factored against the total amount of assets subtract liabilities. While this sum may change greatly depending on how many years of cash flow are considered, and how many projected years are factored: this base number is considered by many to be a starting number when approaching divesting scenarios. This method of creating a valuation is called the comparable transaction method.

Valuing a Startup

The problem arises when using the comparable transaction valuation method on startups. In many cases, the startup in question has little to no revenue. Therefore, using the comparable transaction method is not ideal in these circumstances. The majority of investors use a Discounted Cash Flow (DCF) method valuing with startups. While this method can work well, it does not follow the traditional framework of a valuation based on the company’s assets, liabilities or past profits. Instead, the startup’s valuation is based on their potential for success using metrics such as growth, active user base and possible profits. In essence, the DCF valuation model uses the concept of time value of money. Typically, future cash flows are factored to the company’s projections of at least three years. These cash flows are then discounted by using cost of capital to give the factoring party a present valuation of the company.

Five23 | Investing in Potential

Adding Potential

The largest take away from the typically DCF valuation method for a startup is the need to prove potential. Without potential, the valuation of the venture in question will be quite low. Though having revenue may increase the valuation and the likelihood of receiving investment, the growth potential for future profits is what will drive the investment. A few key growth factors which may be considered by startups to show their potential growth could be:

  • Active User Base
  • Lifetime Value of Client
  • Total Addressable Market
  • Organic Traffic

 

Currently, there are over 50 valuation methods used by investors globally. Although the majority of investors use a DCF method, all of the methods used focus on potential. Therefore defining your venture’s potential in a myriad of areas will give a clearer picture to future investors; no matter what valuation method is used.