How to specify valuations of African startups? We’ve seen a number of contributions on the VC4Africa blog go into this question. Is valuation more of an art than a science? In the VC4Africa Crash Course on writing a financial plan we suggested looking at future expected profits and losses. And Jason Njoku suggested using some rules of thumb, and watching out for ‘sharks’.
What do members of the VC4Africa Investors Network think? Below investor and VC4Africa Pro Account user Jerome Kisting of Baobab Capital discusses some valuation approaches that can be used for startups in Africa. He has concluded not to use the VC method, Discounted Cash Flow or Relative valuation, but the ‘Aswath Damodaran approach’. Watch out for more info on this approach in a second post coming Friday!
VC firms mostly use the VC method, similar to the Net Present Value method (see below), to determine how much equity they need for the investment to meet the return requirements they’ve set over the term of the investment. When going into a valuation scenario you have to understand what it is that motivates you – your ultimate goal will determine what you negotiate for, and how important certain things are to you, e.g. equity, strategy, operations, etc. Are you motivated by an exit (big payday), opportunity to build something, a salary, or something else?
Capital almost always ‘wins’, because – especially in Africa – there aren’t many funds active at the start up stage and, therefore, those that are can have their pick.
My advice to entrepreneurs: Know your business and know it well. Really, you should know everything about your business and the industry it is in, as this is the only way that you can assure investors (like VC’s) that you can be trusted to execute. When you have earned trust, you can usually negotiate a little harder.
There are many different approaches to valuation. Below are some examples.
1. VC Method
The VC Method is similar to the Net Present Value (NPV) method, i.e. you invest if the expected return (at exit) is greater than the initial investment (with the expected return adjusted for duration and the probability of achieving the expected return).
2. Discounted Cash Flow
The Discounted Cash Flow method is most applicable for post revenue startups and can be quite subjective, as it is based on the valuator’s risk assessment.
3. Relative valuation
This method uses multiples like Price to Earnings ratio or Earnings before Interest, Tax, Depreciation, and Amortization (EBITDA) – these are not relevant to most start ups as most are operating at a loss. Identifying comparables and using these to value your start up is difficult but possible and usually involves discounting your value to accommodate the differences in characteristics. However, the risk, cash flow and growth characteristics will be different and in most cases impossible to adjust for completely, thus making the valuation less credible.
4. The Aswath Damodaran approach
The Aswath Damodaran approach to valuation of start ups and growth companies is the approach used by Baobab Capital in its valuation and to promote understanding of the companies it chooses to invest in. (See Aswath Damodaran’s paper “Valuing Young, Start-up and Growth Companies”).
This Friday, Jerome Kisting will go deeper into the Aswath Damodaran approach for startup valuation. Please share your questions, comments and experiences related to valuation in the comments below!
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