1. Introduction

How to value startup firms? The valuation of startup firms is arguably the most fascinating but also the most daunting valuation challenge. Many investors such as business angels, startup funds, and venture capitalists face this challenge when trying to determine whether a new venture promises to be an attractive investment opportunity.

Firm Valuation has covered in many details the standard techniques to value relatively mature companies. The purpose of this section is to understand the specific challenges we face when valuing startup firms and to see how we can adjust the standard valuation techniques to at least roughly assess the potential financial value of a new venture.

Firm valuation is not an exact science. This is especially true when dealing with startup firms. Still, the process of conducting a careful assessment of the financial viability of a startup company will provide us with a better understanding of the business case and hopefully help us identify the key value drivers or success factors managers and investors should focus on.

 

The challenges

When trying to value startup companies, we are typically confronted with a set of additional challenges such as:

  • No historical data: Without a financial history, it is harder to make reasonable assumptions about key value drivers such as growth, efficiency, cost structure, etc.
  • Few, if any, tangible assets: Most of the value of startup firms comes from expected future investment opportunities. There are few, if any, valuable tangible assets in place.
  • No revenues, negative earnings: Without representative revenues and earnings, the standard implementation of relative valuation is meaningless (e.g., the P/E ratio or the EV/EBITDA ratio).
  • Lots of uncertainty in the business model: It is far from clear how the business model will evolve. The company might have a beta version and some test clients in place but still lack a comprehensive sales and marketing plan.
  • High probability of failure: Most startup companies fail. Failure therefore has to be reflected in the valuation.
  • Positive free cash flows are years away: Regardless of the sales and marketing plan, anticipated break even and positive free cash flows are often in the relatively distant future. If it is challenging for young firms to forecast next month’s sources and uses of funds, long-term projections until break even and beyond are an even harder nut to crack.
  • No comparable firms: A startup company with a truly innovative idea will also find it hard to identify publicly traded firms with a similar business model. The absence of such comparable firms complicates the validation of the business plan as well as the estimation of key valuation parameters such a reasonable growth rate of the relevant cost of capital.
  • Additional risks: Often, startups are also exposed to additional “systematic” risks such as technical challenges, funding problems, survival, etc. When estimating the cost of capital with comparable firms, these additional risks are typically not fully captured.
  • Hockey sticks: Revenue forecasts of startup companies typically resemble a hockey stick: Flat for a certain number of years and then steeply increasing thereafter. Unfortunately, most companies don’t make it to the point where revenues start increasing. And when they do, the growth period is often less extreme and shorter than anticipated.
  • Management flexibility: Because most sizeable investments are in the relatively distant future, the management has flexibility when rolling out the business. For example, it could invest less if demand is lower than expected or push a different sales channel if this is where demand comes from. Such management flexibility could reflect valuable real options. However, most traditional valuation approaches struggle to appropriately capture these real options.

These challenges complicate the compilation of a business/financial plan, the estimation of the cost of capital, the use of relative valuation, and the implementation of discounted cash flow methods. In other words: They make company valuation harder.

 

Still, a startup company will need a financial plan if it wants to raise money. In this plan, it will have to document how much money it needs, when the money is needed, when the providers of capital can expect first payments, and when they can expect to exit their investment. This financial plan requires, among other things, pro forma balance sheets, income statements, and cash flow statements. We can use this financial plan as a starting point for the valuation of the company.

The main focus of this module is to discuss the application of standard valuation techniques in the context of startup firms. In particular, we discuss:

  • How to adjust the DCF-approach to get a very rough potential valuation of the company
  • How venture capitalists typically value companies
  • How to get from the potential valuation to the issue price of an equity offering
  • How investors can protect themselves against “dilution” in future rounds of financing
  • How we can (and cannot) use option pricing to incorporate the real option value of startup firms.

 

In order to raise money, the company and the investors will also have to agree on a price. The challenges discussed above imply that doing so will not always be easy. The typical situation is that the entrepreneur is much more optimistic about the prospects of his venture than a potential investor. It will therefore be crucial to find a deal structure that accommodates the differing preferences and expectations of both parties.  The separate module “Deal Structuring” shows in detail how we can find such structures and thereby make deals possible.