Business valuation dramatically reduces investment uncertainty. It is still a science under development as markets change and more information becomes available. Since valuations are forward-looking, the practice still involves a high degree of judgement.
Startup valuation is based on leading practices rather than set standards. Most early-stage valuation decisions take place during negotiations, nevertheless they are still based on implicit valuation know-how.
Early-stage businesses can be very different from one another. Startups are typically defined as companies with a scalable business model, focusing on a fast growth rather than profits, often technology-based. Another effective way to define them is through their financing story: startups rely on multiple rounds of funding to grow, aiming at a high and short-term exit or IPO. In fact, the transaction defines the valuation methods to be used. Whether a company fits into this description will depend on the startup story.
MUST STARTUP VALUATIONS BE DIFFERENT?
Startups have little to no past financials to account for to predict the future, and the failure rate is high, but this applies to normal businesses during the early phases as well. There are many more reasons why valuations in these circumstances need a different approach.
Added uncertainty of startups:
- New business models have no reliable data on possible future exits and likely fundraising paths
- Very successful startups may even create new markets that disrupt older business models, therefore changing underlying market assumptions
- Exit timing and multiples are fast changing as technology trends change fast in the startup market.
The practice of startup negotiations, financing and portfolios:
- There is a gap in expectations between what founders may promise or think they can achieve, and the probability that these expectations will materialise, and this gap in expectations is usually known and accepted by the investor
- The portfolio strategy and structure of VC funds, which invest early and rely on long-term exits, requires large winners to achieve a satisfactory return on the fund, as the very high risk afflicting the majority of early-stage companies needs to be balanced with a very high return, making normal businesses unsuitable for VC funding and leading many founders to overinflate their possibilities to fit into this model, or to create a strategy that purposely fits into this model
- Multiple rounds of funding lead to a high dilution of early investors
- These fundraising transactions often have very particular rights and clauses attached, sometimes with different rights held among different investors, which are not reflected in the valuation
- The only liquidity event, from which an investor can earn a return, is an exit, and therefore no return is earned from dividends in the typical shareholding contract
- Since an exit is a must, the conditions to enable a successful exit are usually planned from early-on, including a favourable shareholding structure
- The valuation scope, as it relates to a venture capital or similar round of funding, are different from other transactions, as multiple rounds, sometimes very close to one another, are expected. Also, the VC investor has a strong role in facilitating future rounds of funding, by introducing the startup to industry experts, and pushing for a fast growth and exit, which differ sometimes from the typical practices of private equity investors.
Budgets and asymmetric information:
- At the same time, available budgets to outsource valuations to experts are low, and a strong weight is placed on negotiations, which often also see the founders as having little negotiating power during the early-stages
- This links up to the fact that founders without extensive entrepreneurship experience may be unaware or not take into consideration how someone may turn a complex fast-growing company into a profitable one, or how investors achieve returns in startup companies, with more asymmetric information held by the two main negotiating parties.
DIFFERENT VALUATION ASSUMPTIONS
Valuers should apply different assumptions to startup valuations. For example, the disconnect between expectations and reality results in the valuer relying more on judgement and experience, than science and valuation techniques. Expert opinions and standards to rely on for startup valuations are lacking or almost non-existent, whereas only volatile prevalent practices are followed.
Additionally, mathematical models used in traditional valuation methods were created and became more sophisticated thanks to the availability of stock market data and observable market risks, which do not apply well to the illiquid and intransparent startup market.
In case the company fails, there are no assets to be recovered (or almost none, as the IP often does not have significant value that can be recovered) and therefore the liquidation value might be zero. The premise of value is going concern.
The Standard of Value (fair value, market value, investment value, etc.) depend on the role and rights of the investor, and on the transaction in questions (called Bases of Value in the International Valuations Standards – IVS). Investment Value (or possibly equitable value) with entity-specific factors (according to the IVS definition) would be the suitable standards of value for many startup valuations done during a round of funding. The reasons for this is that only specific investors can extract the value indicated during a startup funding transaction, and it would not apply to any market participant without startup expertise and market power. The reason why I also take Equitable Value into consideration, even though it is not often used in valuation, is that the valuation decided in negotiations also aims at satisfying the interests of founders, such as the need to keep control over the company until exit and to pursue their chosen strategy under certain conditions and to keep the motivation high.
When we are valuing an existing startup portfolio asset, fair value or market value can apply, depending on the circumstances and liquidity of the asset. In fact, The International Private Equity and Venture Capital Valuation (IPEV) Guidelines, which set out best practices to value funds and their holdings, refers to Fair Value and the standard of value to use for such assets within a portfolio. The value of a startup at exit, instead, is likely a synergistic value or market value.
As for the valuation report that can be prepared for startups, the valuer can prepare a Calculation Engagement according to the standards they follow (e.g. NACVA), but a Valuation Engagement is not recommended for early-stage startups due to the high risk of error and lack of verifiable data.
The investment marketability can be high or low, sometimes very high for the latest technology trends, but the liquidity of the investment is very low, sometimes having to wait for over 10 years to cash out on early-stage investments. However, we do not add discounts or premiums to reflect this. The higher marketability, when present, is reflected in rules of thumb methods or in a lower discount rate, whereas the lower liquidity is typically reflected in a higher expected return on investment or in the term sheet and clauses surrounding the investment.
HOW DO MAINSTREAM VALUATION METHODS APPLY TO STARTUPS?
The income approach, the market approach and the cost approach are the three methods for valuing a business.
The capital structure of startups is usually absent of debts, taxes are low, and convertible instruments are assumed to convert into equity, simplifying income valuation methods.
Using a typical Discounted Cash Flow methods is possible, but cash flows are unlikely to be relevant before the liquidity event, and the aim here is to reinvest cash to maximise the exit. A terminal value is difficult to calculate as projections need to be calculated until the company displays a sustainable growth. In the case of startups, the exit replaces the terminal value: however, calculating a terminal value can help for comparison purposes and for new emerging industries with no data.
Since securing an investment for startups involves illustrating a best-case scenario, carrying out a valuation for startups involves producing additional scenarios, or using high discount rates not consistent with CAPM (Capital Asset Pricing Model). Even when using a base-case scenarios and the Modified CAPM, startup cash flows are subject to typical startup risks that SMEs are not subject to: this subjective cost of capital is then replaced by the fund’s expected return on investment.
Considering that the exit replaces the terminal value, combined income and market methods are common for startups. The market method is in fact used to calculate a future rather than a current possible exit. Another market method used for startups is a rule of thumb method, and involves the analysis of similar stage rounds of funding with subjective adjustments. The lack of financial data for early-stage companies leads us to consider different types of transactions or companies, and to include sector-specific multiples and other adjustments in the market method.
The cost approach, instead, for startups is unsuitable for financing transactions, but it can be used for other purposes and for startups comparison.
Many are against using advanced financial techniques for early-stage startups. Some say that it is not possible to create reliable financial projections: however, when considering qualitative financial plans, we have enough information available to decrease uncertainty, and to learn from deviations in the financial plan. Some investors interpret a complex financial plan by a startup team as the lack of a hands-on approach, whereas the financial plan should be used for goal and strategy setting, rather than as a substitute for a hands-on approach by either the investor or the founder. Whereas it is crucial to assess the founders’ reliability when significant milestones have not been achieved, the team in not the only thing that matters, and therefore the financial plan helps to justify and clarify the investment decisions made. Financial plans and valuations provide important information about the market, strategy and financing possibilities: they do not provide a sure way to recognise investments that will fail, but they can classify the type of investments and avoid overfunding companies with little market potential. Using advanced financial techniques is therefore recommended for all companies that fit under the ‘startup’ definition, whereas they do not provide the same value to those early-stage companies that do not fit this description.