This is “Valuing Start-Up Businesses”, section 11.5 from the book Creating Services and Products (v. 1.0).
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Businesses that are yet to be undertaken, or are in the early stages of their development, are especially hard to value. Suppose an entrepreneur with a concept for a new business needs capital to launch the business. Because of the high risk of new businesses, traditional capital sources—banks and other institutional lenders, and the public equity markets—are usually not available. Most new businesses begin with capital raised from the founder’s own resources, and perhaps from friends and family. Sometimes, an unrelated investor who believes in the concept, referred to as an “angel,” also provides some seed capital. Angels are especially common in artistic ventures, such as movies or stage shows. As the business begins to develop, VCs often provide the next influx of capital. These investors take short-term ownership stakes in promising new businesses. Business valuations have a role to play in these situations as well as in the financing or purchase of established businesses.For an expanded discussion of valuation of startup companies, see Abrams (2001), especially Chapter 12 "Developing a Business Plan", and Evans and Bishop (2001), especially Chapter 15 "Wrap-Up".
Because a new business has little to no history, and because it may be pursuing innovative products, services, or other business features, uncertainty about its future prospects is especially high. A capitalized earnings approach cannot be used, as new companies frequently report losses in the early years, and their present earnings (losses) may not be indicative of expected earnings. A discounted earnings or discounted cash flow approach is typically most appropriate. Many analysts favor using cash flows rather than earnings, because of the importance of cash management in start-up firms. Many start-ups fail because they quickly run out of cash. During the “dot.com” era, analysts often focused on the rate at which a start-up consumed cash, a phenomenon colorfully known as its burn rateThe rate at which a start-up consumed cash..
When performing a discounted cash flow approach to valuing a new business, the analyst must decide on the estimate of cash flows to use. The entrepreneur’s forecasts are likely to be highly optimistic, reflecting his or her vision of a successful future. When using an entrepreneur’s forecasts, the analyst typically tries to neutralize the entrepreneur’s optimism with a high discount rate. A high rate reflects both the degree of risk involved and the expectations of capital providers for high returns to compensate for the risk. VCs might seek rates of return of 50% or more during the seed capital stage and 30–50% at later stages.
VCs are not long-term investors. They seek to cash out after 3–5 years. Their investments often take the form of specialized equity, such as a preferred stock issue with a high dividend rate and mandatory redemption at a specified future time, either at a high cash price or at a generous conversion into common shares. The latter option is appealing when the VCs anticipate an initial public offering of the start-up’s shares.
Venture capital investing is high risk. First-time start-ups have a 21% chance of succeeding. Even previously successful venture-capital-backed enterprises still only have a 30% chance of succeeding in the next venture.Gompers, Kovner, Lerner, and Scharfstein (2010).
In addition to using high discount rates for start-up companies, valuation analysts may use a multiscenario approach. One multiscenario approach begins by constructing alternative outcomes under different degrees of optimism about the future of the company. The approach next estimates a discounted cash flow value for each outcome, called a conditional valueEstimates a discounted cash flow value for a businesses alternative outcomes., and then weights each outcome according to a probability estimate of its likelihood of occurring. Often referred to as the First Chicago ApproachWeights each outcome of conditional value according to a probability estimate of its likelihood of occurring.,Abrams (2001), pp. 410–413. this methodology frequently creates a table such as the one shown below, using the success percentages cited above:
|Scenario||Conditional value ($)||Probability||Weighted value ($)|