Valuing a Startup with Negative EBITDA

Buying a company deep in losses involves high stakes. So, going through all the steps such as startup valuation, EBITDA calculation, finding a company with negative earnings or revenue, etc., becomes extremely crucial before signing the deal.

But even after you’ve ticked off all the things on your to-do list, investing in a company with negative EBITDA could be quite dicey. Either it could be a once-in-a-lifetime opportunity or a big miss. The chances of finding a middle ground are pretty slim.

Investors mostly are on the lookout for such opportunities to score big. These high-reward, high-risk propositions go on to become significant cash-generators in the future. Once an investor spots a company that is full of promises but is on sale for running in losses, they consider the risk well worth investing in.

While it is true that hundreds of such companies go through losses one quarter after the other, a few of them make it big in the industry. The success mantra of well-established investors is to identify the company, invest in its resources, and give it the fuel it needs to reach the pinnacle of its glory.

The worth of a startup is evaluated through EBITDA, a startup valuation tool that stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Apart from measuring the profitability of a company, the metric also has two advantages:

This evaluation tool comes in handy especially when business owners are about to sell off their companies or are looking for investors. Also, the metric helps business owners gauge the financial health of their companies or calculate their enterprise’s total valuation.

Once the components in EBITDA (tax, interest, depreciation, and amortization) are determined, you can easily find your startup’s valuation with the following formula:

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Negative earnings can result from short or mid-term factors (temporary) or long-term issues (permanent).

Short or medium-term factors usually affect a handful of companies or just one organization at a time. A single organization undergoes temporary loss periods due to internal functional disruption, such as in plants or primary production facilities. Temporary losses can also grip an entire industrial sector, such that of the 2008 housing collapse in the United States of America that deeply affected the lumber companies.

On the other hand, permanent loss in company earnings occurs when there is a profound shift in demand due to evolving consumer preferences. A prime example of such an incident is the dying popularity of Nokia and Blackberry in the smartphone market. 

Another cause of longer-term negative earnings value is the evolution of technology that could result in a company or a sector being rendered obsolete. For example, disc and floppy makers completely ran out of business in the first decade of the 2000s due to the emergence of pen drives and portable hard disks.

If a company is going through a temporary loss period, then investors are generally patient with it because often such companies show recovery from their losses. EBITDA valuations for such organizations depend on the gravity of the temporary issue and how prolonged they might be. 

In the case of companies undergoing long-term issues, investors are mostly unforgiving. The base valuation of the companies with permanent problems calls for their intervention as its very survival then becomes uncertain. 

Enterprise Value (EV) measures a firm’s value. The term is coined by financial analysts and it depicts the aggregate startup valuation rather than its current market capitalization. This metric clearly indicates how much money the investors would need to invest in buying a specific company.

Since the metric ‘Earnings Before Interest, Taxes, Depreciation, and Amortization’ indicates a company’s overall financial health and EV measures the firm’s value in its entirety, EV/EBITDA is a trusted evaluation metric among investors. The ratio helps them provide a comprehensive picture to compare companies while making a call to invest. As EV is a firm’s assessed worth and EBITDA measures a firm’s financial profitability, the lower the ratio value will be, the lesser the startup valuation. 

Investors generally look for buying opportunities in companies that have both the EV/EBITDA and P/E (Price to Earnings) ratios in the low with good dividend growth. Generally, when the value of the former is less than ten, it is perceived to be healthy. However, the safe value of the ratio changes from sector to sector. So, it is wise to compare businesses within the same industry sector to understand their proper valuation.

Earnings Before Interest, Taxes, Depreciation, and Amortization is an indication of earnings without the expenses. So, a positive value means that the company is selling its products higher than their cost prices. In contrast, a negative value indicates that the company is failing to operate within a profit margin. 

To sum it up, its negative values mean negative earnings or revenue for a firm which further indicates the managerial or operational difficulties it is going through. A negative EBITDA growth suggests the failure of a company to maintain a regular cash generation.

To understand EBITDA more, let us look at each of the constituting components closely:

Earnings are the figures that the company rakes up over a specific period. To determine what the company is earning, subtract the operating expense from the company’s total revenue.

Interest refers to the cost of servicing the debt of a firm. It could also mean the interest earned by the company. In the EBITDA calculation metric, the expenses related to interest are not subtracted from the company earnings.

EBITDA measures a company’s earnings before its taxes. It is an essential component in the EBIT metric which stands for Earnings Before Interest and Taxes. EBIT is at times referred to as the ‘operating profit’ of a company.

Depreciation refers to the loss in the worth of a company’s tangible assets, which are generally worn out over time, like machines, parts, or vehicles. Amortization costs are the expenses linked to the expiry of intangible assets, like company patents. As mentioned in the formula above,  Earnings before Taxes, Interest, Depreciation, and Amortization is calculated by adding depreciation and amortization back to the EBIT or operating profit’.

Firms running on meager earnings create issues for analysts who are attempting to find out their valuation. From the startup valuation standpoint, they create the following problems:

Growth rates or earnings cannot be calculated and applied to current earnings with a negative value from Earnings Before Taxes, Interest, Depreciation, and Amortization calculation. So, future growth rates or earnings cannot be determined because negative current earnings will make future earnings appear more negative. Also, a rough estimation becomes hectic in the case of negative calculated values, irrespective of whether analysts use projections, fundamentals, or historical growth data.

For tax determination, the standard procedure is the application of the marginal tax rate upon the operating income to deduce the after-tax operating income. To illustrate it in a working formula:

According to this formula, tax liabilities are a result of earnings in the current period. Thus analysts working with negative startup valuations have to pay extra attention to keep track of the total operating losses and remember to use them to protect income from taxes in future periods.

The last problem associated with negative startup valuations is the possibility of companies going bankrupt due to negative earnings. If a firm’s negative earning or revenue remains so for a considerable period, the assumption of lives depending on the terminal value estimation may not influence these cases.

For instance, a bakery company is going through a rough patch through the pandemic, recording a net income of -$25,000 when the owner filed their taxes in 2021. The tax return file also reported $5,000 of taxes paid, $3000 in interest expense, and a depreciation of $300 of the blender the owner bought a year ago.

So, the EBITDA value of the bakery is:

Taxes + Interest Expense + Depreciation expense + Amortization + Total income

$5000 + $3000 + $300 + $0 + (-$25000) = -$16,700

So, the bakery company has a negative growth of $16,700.

Investing in firms with negative startup valuations could involve high risks. So, the general practice involves undertaking a diverse portfolio approach while investing in negative earning companies. This balances out the risk in investing in such companies as success stories of other companies could offset the failures of the other holdings. Not putting all your cards in companies such as these, no matter how lucrative they might appear, is the right approach in buying such firms.

With the right resources, you will be able to assess management capability, evaluate risk-to-reward chances, and use a portfolio approach to make investments in startups with negative EBITDA growth a rewarding opportunity.