Valuation Considerations for Start-Up Businesses
Startup valuation entails more than meets the eye - below we explore the four phases of the start-up life-cycle and what to consider as a growing company.
By Amy Gardi, Senior, Advisory Services
Uber, AirBNB, Waze… These popular start-up businesses seemingly appeared out of nowhere but have managed to become household names. It is fascinating that Uber, for example, can have an initial public offering (“IPO”) valuing the company at $82.4 billion dollars despite never having turned a profit and producing only a small income in 2018 due to non-recurring income from the sale of assets and investments. In 2019, many of these young companies experienced dramatic swings in valuation because investors started demanding more reliable and transparent data from management. And certain companies’ valuations have plummeted overnight, as in the case of WeWork.
At first glance, these start-ups may seem different from the more traditional companies that valuation experts and investors commonly analyze. The key to a successful valuation of a start-up business is to determine the value of the company’s future cash flows. Traditional valuation methods can be utilized. But investors must be aware of the unique characteristics and risks associated with each “phase” of the life cycle, from start up through initial public offering. Specific issues include the company’s growth rate, its life cycle stage, risk, and most importantly, the reliability of information available to investors.
Venture Capital and Rates of Return for Young Companies
| Stage of Development | Plummer (a) | Scherlis and Sahlman (b) | Sahlman and Others (c) | Aswath Damodaran (d) |
|---|---|---|---|---|
| 1. Start-Up (e) | 50% – 70% | 50% – 70% | 50% – 100% | 50% – 70% |
| 2. First Stage or Early Development (f) | 40% – 60% | 40% – 60% | 40% – 60% | 40% – 60% |
| 3. Second Stage or Expansion (g) | 35% – 50% | 30% – 50% | 30% – 40% | 35% – 50% |
| 4. Bridge/Initial Public Offering (h) | 25% – 35% | 20% – 35% | 20% – 30% | 25% – 35% |
Sources: Aswath Damodaran, “Valuing Young Start-up and Growth Companies: Estimation Issues and Valuation Challenges,: 2009, and AICPA, “Valuation of Privately-Held –Company Equity Securities Issued as Compensation,” May 2013.
(a) James L. Phammer, QED Report on Venture Capital Financial Analysis (Palo Alto: QED Research, Inc., 1987).
(b) Daniel R. Scherlis and William A. Sahlman, “A Method for Valuating High-Risk, Long Term, Investments: The Venture Capital Method,” Harvard Business School Teaching Note 9-288-006 (Boston: Harvard Business School Publishing, 1989).
(c) William A. Sahlman and others, Financing Entrepreneurial Ventures, Business Fundamentals (Boston: Harvard Business School of Publishing, 1998).
(d) Aswath Damodaran, Valuing Young Start-up and Growth Companies: Estimations Issues and Valuation Challenges, 2009.
(e) As described in the publications referenced in this table, early development-stage investments are made in enterprises that have developed prototypes that appear viable and for which further technical risk is deemed minimal, although commercial risk may be significant.
(f) As described in the publications referenced in this table, early development-stage investments are made in enterprises that have developed prototypes that appear viable and for which further technical risk is deemed minimal, although commercial risk may be significant.
(g) As described in the publications referenced in this table, enterprises in the expansion stage usually have shipped some products to consumers (including beta versions).
(h) As described in the publications referenced in this table, bridge/IPO-stage financing covers such activities pilot plan construction, production design, and production testing, as well as bridge financing in anticipation of a later IPO.
Phase 1: Start-Up
In the initial stage of a start-up venture, the market for the company’s product or service has not been established. Generally, the company is just beginning its operations. There is no proven history of revenue or cash flow, and there may be few, if any, comparable businesses in the market space.
Investors typically include the founders’ close friends, family members, or other individuals, and the founders retain control. The risk of failure in this early stage ranges from 50% to as high as 70%. From this precarious position, the company develops a business strategy and begins to create a viable product (service).
Generally, start-ups experience significant negative cash flows initially, and nearly all of the inputs to the valuation calculation are based on estimates and projections of future growth. Early earnings reports can be misleading because of initial development costs, unclear projected future cash flows, and lack of a clear market for the goods being offered. These valuations usually change rapidly as new information emerges.
Phase 2: Rapid Expansion
During Phase 2, the company starts to attract customers and establish a market presence. The risk of failure narrows to 40 to 60%. Typically, the company will sell approximately 30% of total shares to more sophisticated external investors such as venture capital (“VC”) firms and private equity (“PE”) firms.
The company begins to attract reliable customers, and if operating in an emerging industry, the space becomes populated with other comparable firms. This was the case for ride sharing companies such as Uber, Lyft, Via, and Gett among others. This phase may be the first time a young company sees a true valuation process applied to its business.
These companies’ valuations continue to change rapidly as many inputs are still entirely based on estimates. If possible, the valuation at this stage will be based on the projected exit value, which is generally reflective of comparable public firms in the market. This subjective data input can lead to serious mis-valuation if the underlying market data is skewed. VC firms usually value businesses by applying a discount rate based on both estimated future cash flows and terminal value. If there are multiple VC firms bidding to purchase interests, the price or bid may change rapidly based on the release of information, good or bad.
Investors at this stage are largely focused on meeting a specific target rate of return. Often, an outside investor will need to purchase high percentages of ownership in order to reach its goal. The business owners may not want to sell substantially all of their ownership interest, so the parties will negotiate on the target rate of return and overall company valuation in order to reach an agreement, and the founders retain an ownership interest.
Phase 3: High Growth and Mature Growth
By now, the company has started to build a more stable track record. Many companies will hire professional management at this stage. Additionally, the product’s market and competitive environment becomes more stable. Overall revenue begins to stabilize, and cash flows begin to increase. The risk of failure drops to 30% to 50%.
Companies at this stage begin searching for more strategic investors, rather than just VC firms. The valuation models become more reliable and focus less on unsupported estimates. Overall, it becomes easier to estimate future cash flows.
Another goal of young companies at this stage is to become acquired by a large existing player in the market space. For example, when Waze was in Phase 3 in late 2013, the company was purchased by Google. Google incorporated Waze’s proprietary technology into its mapping software, and Waze, in turn, got access to Google’s vast resources.
Phase 4: Bridge and Initial Public Offering
The final life stage of a young entity is the bridge or “decline” stage. Here the risk of failure is approximately 20 – 35%, and revenue growth begins to level off. More competitors enter the marketplace, and the space becomes crowded.
It is likely that, at this point, the founders have retained 10 to 20% of ownership in the company. If a business has lasted this long, it will likely offer an IPO in order for the VC and other sophisticated investors to cash out on their investment. The financial activity of the firm is more stable, and the valuation inputs are more reliable.
In 2019, many companies in Phase 4 of the start-up life-cycle experienced issues with valuation, when investors began demanding more transparent information. Companies that had IPOs last year were met with serious price fluctuations, despite an overall upward trend in the stock market. Just weeks before WeWork’s expected IPO in September 2019, for example, the valuation swung between $15 and $47 billion dollars. The higher valuations were based largely on speculation and not on reliable financial information. As investors demanded more transparent information, the value of the company declined, and the IPO was indefinitely postponed.
VC firms generally hold the majority of shares being sold during the IPO, and these firms are interested in inflating the value of the young company just prior to the public offering in order to maximize profits before moving on to their next investment. Many times, support for the financial projections and the methodology behind these valuations are not released. The valuation could also be based on past capital contributed to the company by other investors. Having a stock price based on speculation or previous capital contribution is not considered a reliable indicator of current value for an operating entity. Valuation needs to be based on actual data, and as investors learned in 2019, that data and those methods need to be properly communicated.
Conclusion
The valuation of start-up businesses entails unique challenges. Good input information is key for a valuation at all stages of the start-up life-cycle since the value of a firm is still ultimately the present value of expected future cash flows. Therefore, the greater the transparency, the more reliable the valuation.
