Methods for evaluating a startup

Startups are a trend that is popular not only in the IT environment ... For more than 10 years, there has been a boom of startups that is not declining, despite the riskiness of this type of investment.
The authors of the projects, however, like a number of investors, sometimes do not have elementary economic and managerial knowledge, the lack of which hampers the normal Startup-Investor dialogue.
We would like to share our experience in investing and mentoring startups in a series of analytical articles designed to help assess the economic potential of a startup, as well as its target audience.
A series of articles - an unusual experience of collective work of people familiar in absentia, but interested in this topic.
This article is only a small part of what a startup has to know about the financial evaluation of his startup.

What is the assessment of a startup.

The issue of a monetary valuation of a startup concerns both sides of the venture financing process. The author of the project, as well as the investor, it is important to estimate the current cost of the project and its expected market price and the capitalization of the project.
The cost of the idea itself (if it is not registered intellectual property in the form of a patent, copyright certificate, license, etc.) is assumed to be zero. Only the creative potential of the author / team and entrepreneurial initiative are subject to evaluation.
It is more important for authors and investors to evaluate the intermediate (at the stages of connecting to the project of the next investment stage) and the final cost of the project, that is, when investors leave the project at the current stage and investors enter the next one.
This note is written about this.

Methods for evaluating traditional business.

Market approach (market approach) - (BSV-VI standard)
A general method of determining the value of an enterprise and / or its equity capital, in which one or more methods are used, based on comparing the given enterprise with similar investments already sold.

Income approach (income approach) - (BSV-VII)
A general way to determine the value of an enterprise and / or its equity capital, in which one or more methods are used, based on the recalculation of expected revenues.
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Asset based approach - (BSV-IV)
A general method of determining the value of an enterprise and / or its equity capital, in which one or more methods are used, based directly on the calculation of the value of the assets of an enterprise less liabilities.

Unfortunately, none of these approaches provides an objective assessment of the effectiveness of investments in start-ups. The fundamental difference between a stable business and a startup is that while the profitability of a stable business tends to the ultimate profitability, the profitability of a startup tends to fantastic values ​​for a stable business. When evaluating a startup, the fundamental point is not an assessment of the current financial condition of the project, but an assessment of its future state, at the next stage, taking into account the risks of project development.

Evaluation of a startup from the point of view of a venture investor.

At the startup stage, i.e. at the idea stage (Pree-seed), the most adequate estimate of the current value is calculated using the restoration method.

The rationale for the high rate of return venture capital investment in startups
The task of any investment activity is to generate income on the invested money. In principle, money doesn’t matter where to work (for someone the principle “Money does not smell” is valid, for someone moral aspects of making profit are important - this does not change the essence). Money is important to earn income. Naturally, any investor wants to get a return on their invested funds not lower than usual.
What is “usually”? This rate is a little risky investment of money: bank deposits, bonds of blue chips, etc. (Note - we do not consider conditionally risk-free investments - government securities, etc.)
Any increase in profitability is accompanied by an increased risk of investment. There is no linear dependence here, which attracts investors to the field of risky (venture) investments. The usual conservative income for Russia currently gives up to 10% per annum. (For Europe - while 3%). If we take the established statistics on the success of startups - 10% of those who started, take into account the risk payment, the investor’s share in the project and take the average time for a startup to reach the next funding stage of 3 years, we will get the desired return on investment - 200 - 500 %% per annum, which means The expected increase in the cost of the project is 6 to 15 times.

Calculation example: Conservative rate (10%) * Risk charge (30%) * Success rate (10%) / Investor's share (50%) = ((1 + 0.1) * (1 + 0.3) * ( 1 + 0.1)) * 100 / 0.5 = 315%

The main factors that determine the attractiveness of a startup for an investor.
When making a decision on participation in a project, the investor estimates it by the following parameters:

1. The rationality and relevance of the project, its target audience (target audience)
2. Project risks, the possibility of minimizing them
3. Ability to monitor the progress of the project
4. Estimated project profit margin
5. Depth of analysis of forecasts for financial and marketing parameters of the project
6. The growth stability of the business area that the project is aimed at
7. Ability to exit the project (liquidity of a successful project, minimizing losses in case of failure)

The depth of the study and the accuracy of the answers to the above questions strongly depends on the stage at which the project is located. Obviously, a project at the idea stage cannot boast of a deep market analysis, and it is also obvious that a project at the growth stage must be accompanied by a sane BP (Business Plan).

To be continued

Suppose you have already found out what attracts an investor in a startup.
Next you will need:

1. define the startup stage
2. calculate financial attractiveness by various methods
3. make a portrait of the target audience
4. and much more

These questions will be discussed shortly in the continuation of this article. In the second part of the article, assessment methods will be described: “Brooks Method”, “Profit Rate Method”, “Multiplier Estimation Method”, etc.

Remember, the sooner you estimate the financial attractiveness of your startup, the more effective your communication with the investor will be!

Author: Dmitry Chernyak (business angel, info@findstartup.ru)
Collaborators:

1. Roman Bobkov (investor, rbobkov@gmail.com)
2. Zhuravlev Ivan (business angel, info@findstartup.ru)
3. Ratunin Oleg (creator of the project www.napartner.ru , okolovas1@gmail.com)

PS Continuation of the series “Methods for evaluating a startup. Continuation " , " Startup time to market "