Determining the value of a crypto business: 3 approaches

BDC Consulting’s most important mission is to help clients optimize the value of their business. The question then becomes: how do you assess a company’s value correctly? In this article, we will talk about the key valuation methods and the main mistakes
that startup founders make when using them.

Introduction

An accurate valuation of a business helps founders and investors make sound financial decisions: for example, whether to sell a share in a project, or to completely exit it, or whether to acquire a company. Regulators, too, need it to assess the risks; and
financial forensic experts, to calculate the collateral value.

Crypto startups mainly use business valuation when negotiating with potential backers. Apart from a quality blockchain product, a company needs a financial model that will work under different market scenarios and can serve as a base for decision-making.

In addition to traditional equity fundraising, the crypto industry provides a unique opportunity to invest in tokens, whose legal status is still not clearly defined in many countries. This article centers on the former aspect — valuation for investments
in equity. We will leave the topic of investment in tokens for a subsequent review.

Valuation Methods

There are three main methods of asset valuation: income-based, comparative, and cost-based. The name of each method reflects how the assessment works. Further, several secondary valuation methods have been derived from these three to refine the results.

The Discounted Cash Flow Analysis Method (DCF)

The DCF valuation method is based on the company’s future cash flows, bringing them to the current time using discounting. This is the most popular business valuation methodology because it considers the money the company will earn in the future, even if
the project isn’t making a profit currently. We won’t discuss how to calculate discount rates in order so as not to overcomplicate the matter.

A valuer who uses DCF views a company as existing forever — and, therefore, forever producing cash flows. At the same time, the evaluation period is divided into forecast and terminal, with the risks increasing as one moves away from the current moment.

Throughout the forecast period, the company can foresee its future and can plan a business with a high degree of confidence in the market and its product. For a classic business, the forecast period is between 8 and 15 years.

By contrast, the terminal period is the period beyond the forecast, which can stretch into infinity. To assess the terminal cash flow, a valuer uses the discounted sum of the cash flows for all the years beyond 8–15 years. The terminal growth rate of the
company is also important — that is, the rate at which the cash flows will increase annually.

For example, let’s take a business that generates a constant cash flow of $100 annually for the next 7 years. Then, at a discount rate of 10% and a terminal growth rate of 3%, the value of the business in the forecast period will be $487.

The discounted terminal value is $733:

The overall cash flow is $1220, which can be considered a fair valuation of the business in question.

The DCF approach, being a subtype of the income method, represents a company’s value as a sum of the two cash flows, forecast (that is, the amount of money the company plans to earn in the coming years) and terminal (the residual value of the company).

The Relative Valuation Method

This method ranks a company against others in the industry based on comparable criteria, such as the number of active users, connected wallets, unique visitors, etc. Similar businesses can be selected by analyzing funding deals that have already taken place
or public companies in the industry.

When working with these criteria, valuers use multipliers — such as EV/Subscribers, where EV stands for Enterprise Value (the company’s fair value), and Subscribers stands for the number of paying product users.

Let’s assume we need to calculate the value of a streaming service. Knowing the cost of an analogous company, the number of subscribers of our service, and the audience of the analogous service, we can determine the value of our company.

If our competitor’s service has 300 subscribers, and its value is estimated at $900, then the value of our business with 500 subscribers will be $1500.

This method is often used as a control method to confirm the results obtained under the DCF approach. On a large sample of analogous startups and when using several methods, the correct estimate should fit into the range of valuations obtained through each
of the methodologies.

The Cost Approach

The cost valuation method reflects the amount of money spent creating a business. The most common approach is called the net asset method. It considers a company’s value as the difference between the value of the assets and liabilities of the business. Since
this method is not widely used in evaluating startups and developing companies, we will leave its analysis outside the scope of this article.

Comparing the three methods

It is much easier to give a correct valuation using different approaches at the same time. More and more often, when analyzing the value of crypto companies, a combined method of visual estimates called “football field” is used. For example, it can be found
in pitch decks and fairness opinion reports.

The chart above compares the valuation ranges obtained by the DCF Valuation, comparative methods (Precedent Valuation, Comparables Valuation), and the shareholder value of the company over the past 52 weeks (52-Week Trading Range). Given the current project
valuation of just below 4 units, an investor may decide to purchase a stake, as the business has the potential to increase in value.

Valuation Errors

One way or another, crypto business owners are faced with the need to evaluate their company — but often, they do it wrong. In our experience, founders most often make mistakes with their financial inputs and future growth rates.

Input data

To create a DCF business valuation model, it is crucial to correctly interpret the input data: market size, user base growth, revenue growth rate, etc. These data’s validity and logical presentation play a critical role, as they can overly positively or,
conversely, negatively represent the forecast values.

To avoid such mistakes, we recommend introducing multiple scenarios into DCF financial models, each with its own future values.

Growth Rates

There are also often misconceptions about the terminal growth rates of companies. If you overestimate or underestimate this indicator, the error can reach dozens of percentage points. We recommend to base the model on the company’s conservative growth rates,
even for blockchain startups, unless the company has sufficient grounds to assume otherwise.

Conclusion

DCF is the most popular method for estimating the value of a crypto business. Financial models based on DCF take into account both potential opportunities and risks. The main danger when using DCF is incorrectly evaluating the terminal growth rate or input
data.

The relative valuation method provides useful values to check the DCF results against. The main difficulties, in this case, are finding relevant information, comparability of the startups under assessment, and selection of relevant companies for comparison.

Understanding the business valuation process helps crypto companies reasonably negotiate to buy or sell shares and raise capital investments at different stages.

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