(i) Earning/ Cash Flow Approach:
In this approach, estimated cash flows for the foreseeable future are discounted to present value and business is valued accordingly.
(ii) Asset approach:
This approach is generally used when the business is not a going concern viz. during liquidation, untimely losses etc. The assets and liabilities are valued based on their current realisable value and that is considered as value of the business.
(iii) Market approach:
This approach assigns the value of a business based on the value of comparable companies in same/ similar industries, adjusted for their specific parameters. One common feature in the above approaches is that it pre-supposes a business that is established and generates cash flows using its assets.
On the contrary it is difficult to call Start-ups “established” in any sense or assume that their cash flows (if not already spent on marketing) will remain constant. Profitability seems to be a cursed word in the startup investor circles.
Like the valuation of startups is often required for bringing in investments either by equity or debt. However, the most significant differentiating factor in the valuation of a startup is that there is no historical data available based on which future projections can be drawn.
The value rests entirely on its future growth potential, which, in many cases, is based on an untested idea and may not have been based on an adequate sampling of consumer behaviour or anticipated consumer behaviour.
The estimates of future growth are also often based upon assessments of the competence,drive, and self-belief of, at times, very highly qualified and intelligent managers and their capacity to convert a promising idea into commercial success.
The major roadblock with startup valuation is the absence of past performance indicators. There is no ‘past’ track record, only a future whose narrative is controlled based on the founders’ skill.
It can be equated as founders walking in the dark and making the investors believe that they are wearing night vision goggles. While this is exciting and fun for the founders, this is risky for the investors.
This is why valuation of startups becomes critical and the role of a professional comes in – it is a way of definitively helping investors navigate the dark using facts, rather than fairy tales.