Startups: A value conundrum

Startups are unlike other businesses. They have limited operating histories but promise investors enormous growth. Most have never turned a profit. In fact, some early-stage startups are based solely on an undeveloped concept or idea.

Statistically, most startups fail. These high-risk ventures face numerous unknown variables, including untested products, unknown cost structures, uncertain market acceptance and inexperienced management. Clearly, valuing these fledgling companies presents a particularly challenging valuation conundrum.

Reasons to value startups - Despite their limited budgets, entrepreneurs frequently seek valuation expertise. And for good reason — valuators can help those entrepreneurs interested in selling their business concepts or later-stage endeavors. Alternatively, they can prepare valuation reports for entrepreneurs seeking to transfer shares of their startups before they appreciate in value.

When valuing a startup, appraisers consider the same three basic approaches that they use for established companies. But they modify their methods slightly to capture the nuances of entrepreneurial businesses.

The cost (or asset-based) approach - Under the cost approach, a company’s value is the difference between its debt and the combined fair market value of its assets. Investors prefer the cost approach for startups, because it’s comparatively objective and conservative. Conversely, entrepreneurs disdain its disregard for their “sweat equity.”

Startups usually have few hard assets and, instead, rely on intangible assets. Because the cost approach excludes intangibles, it generally underestimates a startup’s value. Although this approach provides a meaningful test for the reasonableness of other value indicators, it usually best serves as a “floor” for the company’s value.

The exception to this rule is startups with excess cash from a recent round of financing. In this case, valuators sometimes use the cost approach (or consider a separate add-back to other value indicators). Extra cash on hand functions somewhat like a non-operating asset — a common valuation adjustment.

The market approach - The market approach derives a company’s value from pricing multiples obtained from similar public stock prices or private company transactions.

Because most startups aren’t yet profitable, price-to-revenues multiples are generally the most relevant pricing multiple. But some valuators prefer to use price-to-earnings before depreciation, interest, taxes, and research and development costs (EBDITR) multiples.

In practice, it’s extremely difficult to apply the market approach to startups. Some have never reported revenues or positive EBDITR. In addition, it’s virtually impossible to find meaningful comparables in the same industry that are also at the same stage of development.

Nonetheless, the market approach shouldn’t be blindly dismissed. If nothing else, industry-pricing multiples obtained from the market approach can provide useful sanity checks for valuators’ final conclusions.

The income approach - Because startups focus on the future, the income approach is normally the most viable valuation method. But new ventures usually require valuators to use complex discounted cash flow (DCF) analyses.

Although valuators usually rely on management to project future income streams, they view an entrepreneur’s projections with professional skepticism. And because projections can vary significantly as startups evolve, DCF analyses can quickly become outdated. Therefore, startup valuations should be updated frequently.

What’s more, startups face numerous risks and uncertainties. Thus, the discount rates valuators use in their DCF analyses should be commensurate with the subject company’s risk. In general, their discount rates are higher than those of more established businesses — especially in the early years of development.

Credibility leaders - As disinterested third parties, valuators lend credibility to entrepreneurs’ business plans and financial projections. They can also help bridge the expectations gap between emotional, optimistic entrepreneurs and the skeptical investors they’re trying to persuade to buy into their new ventures.