This is part 2 of the series on business valuations. Here's the list of all articles in this series:
Part 1: The Mighty '8x Multiple'
Part 2: Calculating DCF valuation of an early stage start-up (You are here)
Last time we discussed how a quick business valuation can be achieved using the 8x / 5x / 12x multiple. That tool is handy but suffers from a serious drawback: it assumes that the EBITDA has plateaued, and the business will enjoy constant returns year on year, which is almost never the case in real life.
Wait, what? Did I read the last article for nothing?
Don't worry! There are plenty of places you will still see the use of 8x multiple (or the 5x, or the 12x multiple; depending on the industry and risk involved). Although no business achieves constant returns year on year, the 'multiple' methodology is still widely used. Since the future is uncertain, there’s an underlying assumption that the business is operating at the highest efficiency possible under the given capital investment, competitive landscape, people, etc. This is a fair assumption as there is no alternative other than to accurately predict future EBITDA figures, which, by definition, is going to be a prediction or a best guess (and not accurate in all likelihood).
I see that the keyword here is 'mature business,' please continue...
Now that we have revised our learning from the last post, let’s talk about the valuation of an early stage start-up or a high-growth business incurring initial losses.
Imagine you start a bakery by investing $100,000 as capital. You lease a large shop, buy high capacity automatic equipment, hire staff, engaged a lawyer, engaged an accountant, hired a programmer to develop your eCommerce website, etc. Since this is your first year of operations, a few weeks were lost in setting up the equipment, in signing vendor contracts, in hiring and training the staff, in printing the marketing collateral, etc. before you could start selling your baked goods. Moreover, you decided to offer a 60% discount to attract customers away from the existing bakeries in the neighbourhood. Overall, you were able to utilise about 40% of your equipment’s capacity and ended the year with $10,000 in losses.
In year 2, business started gaining traction, you offered lower discounts, and now utilised 60% capacity = $20,000 EBITDA
Year 3, focus on online sales, utilised 100% capacity of current equipment, and offered no discount = $50,000 EBITDA
Year 4, bought new equipment, achieved 2x sales, rented space was already large enough = $120,000 EBITDA ($30,000 investment into new equipment)
Year 5, same operations as previous year but you invested in an identical second bakery which was not operational yet = $120,000 EBIDTA ($130,000 investment into new lease and equipment)
Year 6, second bakery also operating at 100% capacity = $240,000 EBITDA
In the above scenario, imagine you reached out to investors to raise money. Depending on the year when you reach investors, using the 5x multiple they will calculate the following valuation of your bakery:
Year 1: -$20,000 (Negative EBITDA)
Year 2: $20,000 * 5 = $100,000
Year 3: $50,000 * 5 = $250,000
Year 4: $120,000 * 5 = $600,000 (we ignore $30,000 in new equipment for now)
Year 5: $120,000 * 5 = $600,000 (we ignore $130,000 investment for now)
Year 6: $240,000 * 5 = $1,200,000
If I have negative EBITDA in initial years, does that mean that my business has no value?
That’s the whole point of this post, a negative EBITDA in the initial few years does not mean that the business has no value. We see it in real life all the time that start-ups raise millions of dollars even when they haven’t started making any profits. For this, we have valuation experts who create complex (sometimes simple) financial models to forecast business growth over the next few years. And depending on the forecast and the risk involved, a valuation is arrived at the current point in time.
Forecast and the risk involved… absolutely!
The first element we will discuss is forecast. In simple terms, forecast are the outcomes of a detailed financial model. In our bakery model, we have yearly EBITDA and capital expenditure.
A detailed model would take a bottom-up approach to calculation. For example, we would first list all the products we will sell in our bakery. Then we would prepare a chart of how many units of each product we expect to sell every day, week, or month, and at what price. The sum-product of these estimates will give us the revenue we expect to generate every year.
Once the revenue is estimated, we would calculate operating expenses that we would incur to produce and sell the said units of products. In case of the bakery business, some cost items we would consider are raw material, rent, electricity, gas, water, staff salaries, retainers, marketing, insurance, security, subscriptions, etc. Needless to say, the difference between revenue and operating expenses is EBITDA.
Similarly, for capital expenditure, we would prepare a detailed list of capital expenditure and amounts per month or year. Capital expenditure is not only equipment and other physical assets but could also include security deposits, provisions, license fee, brand fee, etc.
Other important outcomes of the financial model are balance sheet and cash flow statement. You can also customise the model to offer information as per your business needs. In our bakery example, the outcomes are simple: capital investment and EBITDA.
The second element we would discuss is the risk involved. Risk involved is the uncertainty associated with forecasts i.e. the probability of achieving the growth rate, estimated sales, EBITDA, cash balance, etc. Uncertainty is a subjective matter. People take big bets all the time because they are certain that the world will turn out a specific way or that they will make the world change a certain way. No matter how certain you are, the bottom line is that every event will have some degree of uncertainty. In finance, we quantify uncertainty as a discounting rate. Higher the risk, higher the discounting rate that is applied to a forecast. I will do a separate post on elements which go into estimating a discounting rate. For simplicity, let’s assume a 20% discounting rate for our bakery example.
Note: Calculating discounting rate deserves a special post of its own. For now, I encourage you to read my previous post here on the 8x multiple for more information on how higher risk commands a higher discounting rate.
It cannot be so simple, what am I missing?
There are just two more concepts to discuss: Free Cash Flows and Terminal Value.
Firstly, free cash flows or FCF. Quite simply,
FCF = EBITDA – CapEx
FCF is the EBITDA left in hand after incurring all operating expenses and providing for capital expenditure to sustain the existing business or to achieve growth initiatives. Going back to our bakery example, we will no longer ignore the capital expenditure that we incurred at three instances:
1) $100,000 at the beginning i.e. year 0
2) $30,000 in year 4
3) $130,000 in year 5
The table below shows the FCF calculation for our bakery business:
Yes, the FCF could be negative as evident above. In this case, the shortfall could be met by previous years accumulated FCF or through additional capital infusion by promoters. Some start-ups go through multiple rounds of funding because they are incurring negative FCF in efforts to rapidly grow and capture market share. Some established businesses may deliver negative FCF even with positive EBITDA at times when growth investments are made.
The last concept that we must discuss for now is the 'terminal value' calculation. In our bakery model, it is safe to assume that if everything remains the same, the bakery will continue to earn $240,000 EBITDA every year. However, the model is limited to 6 years. This is where the mighty ‘x’ multiple kicks in. Since we are using a 20% discounting rate for our bakery business i.e. a 5x multiple, the sum of all FCFs from year 6 to ∞ would be $240,000 * 5 = $1,200,000.
Are we ready to calculate the business valuation yet?
Absolutely! Now we have all the information we need to calculate the valuation of our bakery business. All that’s left to do now is to discount all estimated FCF and terminal value. The sum of all present values thus arrived is the DCF valuation of our business. In this example: $367,419.
Parting words
We need to be cautious of the valuation trap. We haven't even left our homes to go look at lease spaces and we have a business worth over $350,000 in valuation. I have seen people so mesmerised by the valuation of their business idea that they stop focusing on execution. 20% discounting rate is quite high and low at the same time. As the business achieves various milestones, the uncertainty would reduce and investors will gain more confidence in the business, thereby, reducing the discounting rate. At this stage or any stage, the founders should focus on raising the lowest amount possible in exchange for lowest equity possible in business. My part words would be to develop the initial model and define milestones to achieve such as 1) incorporation formalities to be complete by a specific date, 2) product development complete date, 3) go-to-market date, 4) first-sale date, and 5) specific growth milestones. Strive for a balance between valuation and execution.
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