Getting the valuation of a start-up enterprise right, to ensure investment and potential return are correctly assessed, is a complex combination of science and art, according to experts at Grant Thornton.

The international accounting and audit company has issued guidance on how to achieve that balance, based on the experience and knowledge of experts across its global network.

Martin Kneale, a director of Grant Thornton in the Isle of Man, said determining the value of a start-up can be a challenge, but the advice from Grant Thornton’s specialists is a useful guide to the process.

He explained: ‘Entrepreneurs need to establish how much to give away in return for investment, and investors need to evaluate their next venture. Typically, the valuation of any new economic asset is based on expected future cash flow, discounted at a rate that reflects the inherent risk facing the business. 

‘Most start-up entities share the same characteristics; they are innovative, they are based on an idea (which is likely to create disruption in the market), and they are grounded in cutting-edge technology. Additionally, there is a substantial reliance on the entrepreneur, who strives to make their big idea a reality. Relentless energy and agility is required in order to keep up with dynamic changes in the market.

‘This combination of innovation and entrepreneurialism presents significant uncertainties in determining the cash flow of the business.’

Mr Kneale continued: ‘All these variables make the process of a start-up valuation very challenging, not only due to the lack of historical financial data but also the difficulty in assessing a product or service that implies a new way of doing things. In addition, the business is likely to be running at a loss in early phases.

‘Grant Thornton’s specialists advise that, usually, the determinants of discount rates are based on market data. Even when valuations are made based on comparable transactions or multiples, the concept of a cash return to investors in the business is implicit.

‘This is not to say that the valuation of a start-up company should be disconnected from basic or traditional economics, but a start-up valuator must understand that the key assets of the company are likely to be intangibles. These intangibles could be disruptive ideas, normally supported by a technological platform. Equally, they could be the creativity of the entrepreneur, their capacity to endure the difficulties of initiating a business, and the continual development of ideas.’

Grant Thornton’s advises that in an innovative and forward-thinking business environment, traditional valuation tools, such as discounted cash flow or multiples, may not be the right way to fully understand the value of a start-up. Specialists question whether an alternative, more artistic valuation approach should be applied, adding that both investor (buyer) and entrepreneur (seller) can consider qualitative information to help evaluate the business, although much subjective judgement is involved. This includes:

• entrepreneur’s ability to implement the idea
• entrepreneur’s market profile
• compatibility of the relationship between buyer and seller
• the entrepreneur’s capacity to build on the product - and capture the market opportunities (current and future)
• stage of business maturity
• the risks of technology
• scalability
• likelihood of a lucrative exit

Mr Kneale continued: ‘Today, along with the traditional methods of discounted cash flow and multiples, there are different methodologies to evaluate a start-up. Two commonly used are the Berkus methodology, a simple rule of thumb that bases its valuation on qualitative aspects of the business, and risk summation methodology, which compares 12 characteristics of the start-up company, from the business stage until potential lucrative exit.

‘Start-up companies pose a challenge for accurate valuations. However, using a combination of methodologies can result in a more accurate value.’

For more advice on start-up enterprises, contact Mr Kneale or any other director at Grant Thornton on 639494.

Photo - Martin Kneale.