Volatile capital markets – agitated by crisis-related corrections – also affect transactions involving early-stage companies. Alongside general market risks, start- up-specific risks should be considered in any early-stage company valuation. Failing to appreciate a start-up’s specific risk profile can lead to inaccurate assessment of its full value potential in an exit scenario unless there is sufficient transparency of existing risks and opportunities to promote robust price negotiations. How can this be considered in the valuation approach? Do the special characteristics of start-ups require unique valuation procedures? We examine these questions, discuss the archetypical evolution of a start-up’s risk profile and explore how this can be reflected in valuations through a dynamic valuation approach.
Start-ups – a somewhat traditional asset class
From an economic viewpoint, start-ups are investments involving an upfront payment today – eg founders’ labor and intellectual property, the contribution of business ideas or financial resources – with the expectation of receiving (higher) financial resources at a later date, e.g. upon (private or public) sale. How high expected future cash flows should be depends on the perceived level of risk of the founders and investor. It is hardly surprising that the respective parties may have vastly differing opinions as to the future development and financial outcome of an early- stage company. Founders and investors may have greatly diverging views on what should be contributed by each party, and what share in the start-up each participant should receive. Many start-ups already had numerous financing rounds and changes in ownership behind them, especially at the beginning, meaning that issues around proper distribution of value (ie. financial performance and risk) between the participants are more common than in deals with established companies. Insufficient information makes it difficult to get expectations right and find alignment. With future operational performance still to be proven, the various stakeholders are most likely to disagree on value expectations. With this in mind, utmost transparency is critical in making valuation assumptions.
Regardless of the valuation purpose, a company’s value is always based on the expectation of future uncertain payments – usually in the form of distributions or exit proceeds. Founders and investors expect adequate future remuneration for their invested capital, and start-ups are no exception. Forecasting future financial returns therefore plays a central role in the valuation of start-ups. The time frame (usually the exit time of a participant), absolute expected amount (reflecting the performance) and expected range (reflecting the risk) of possible returns are all relevant. In this respect, start-ups are no different from any other investment. Taking an investment-oriented view, forward- looking valuation methods based on future cash flows, ie a discounted cash flow (DCF) method, should be the preferred valuation method for start-ups.
When considering the peculiarities of start-ups (eg absence of revenue, unknown interest of customers in the new product or service, evolving operating model, etc), the traditional application of the DCF method may not appropriately reflect the risk-return profile of start-ups at first glance. This may suggest established cash flow- oriented valuation methods may be difficult in practice. Therefore “alternative” valuation methods are often applied to start-ups.
Market multiples as an alternative valuation method
For early-stage companies there are, without doubt, challenges associated with forecasting future cash flows, correctly reflecting the risks (specific and systematic) as well as capturing the evolving risk-return profile over time. Start-ups typically face a high number of valuation events, eg development milestones reached as well as transactions due to investor changes. Alternative valuation methods, typically based on the market approach and comparison of specific price multiples, are therefore frequently used. These alternative valuation methods, however, typically do not offer a solution to the problem, but abstract from the problem itself by greatly simplifying it. As a result, they sometimes result in a high degree of uncertainty of the value conclusion, lack transparency, or mix up long-term company values with short-term achievable company prices due to initially rather short-term investment horizons. In particular, methods that are strongly oriented toward purely operational key figures (e.g. number of customers, click rates, etc.) attempt to compensate for the lack of information or even readiness regarding the start- up’s operational business model (organizational and cost structures).
Methods based on financial key figures (eg sales) are intended to circumvent the problem of negative earnings in the initial loss-making phase. These multiple-based methods, which focus on operational or financial KPIs, assume that key figures obtained from – somewhat – comparable companies can be transferred to a start-up for pricing purposes. They are technically quick to apply, replace the subjective price perceptions of the participants with the alleged objectivity of the market, and can appear to save time and costs. Ultimately, however, they provide an initial, very rough price (but not value!) estimate. While multiple-based methods play an important role in determining an initial rough price estimate based on limited information, the result cannot be compared to the detail of a more intrinsic, future-oriented valuation based on expected returns specific to the valuation target.
Start-up valuations are complicated by the fact that the multiples typically observed for other companies cannot be applied due to the limited empirical basis available for new business models. In other words, the innovation brought by a specific start-up cannot be captured through the application of price multiples observed for other companies as their business models are different.
The disadvantage of missing or insufficient financial information for start-ups is often put into perspective, since the initial focus on the operational value drivers requires a thorough assessment of the business and operating model. Every sound valuation assessment should consider the operational value drivers of the business model and not only on the resulting financial KPIs. This is often neglected when valuing established companies or is justified by the (implicit) assumption that established business models can be reflected in a consistent future financial performance. Since financial KPIs are merely the result of a transformation process from operational value drivers into financial figures, unsupported financial KPIs should not be considered as isolated value drivers. Only a transparent transformation of the operational value drivers into forecasts of the operational performance and, then, forecasts of the financial KPIs provide a solid basis for a valuation analysis. This method results in more transparency and trust than a simple multiple-based approach. It also paves the way for a robust DCF valuation.
Finally, the question of a “pre-money” and “post-money” valuation, which considers the value before and after the injection of new funds, can only be disclosed consistently by performing a future cashflow-based analysis – and not with a multiple-based pricing estimate.
Transparency on return and risk
The addressee of a valuation should always be aware of the purpose of the valuation and the level of scrutiny it is intended to withstand. To speak for the development of a specific early-stage company’s business and operating model – and the associated value development – it is essential to show the transformation of the expected operational value drivers into financial models. This is initially simple but gradually becomes more complex.
Transparent transformation also enables consistent communication regarding the expected development of the company’s performance and risks. While performance can generally be measured by financial KPIs, the question arises – especially for start-ups – of how to measure risks appropriately. Not doing so makes it difficult to allocate risks appropriately to all stakeholders.
This brings us back to the special feature of early-stage company valuation described above: views can diverge greatly when it comes to determining the contribution of founders versus investors, and the entitlement of individual stakeholders to shares in the early-stage company. Missing, insufficient or inadequately transparent information not only makes it difficult to form the right expectations regarding future performance, it also hinders any fundamental assessment of assumed risk. This is precisely where the multiple-based valuation method fails. For start-ups, this is critical as the financial contribution of an investor often represents the urgently needed financing of the business. If the founders cannot transparently demonstrate the risks of their business, investors may only be willing to invest if they can pay less than the fair price (given the difficulty to assess risks) or are promised more than the fair future return for the amount invested.
If one group of stakeholders receives more return than they should considering their risk position, this is inevitably at the expense of the other stakeholders: founders in the case of start-ups. They pay the price for the risks such that, due to lack of risk transparency, they must assume more of the overall risk than would be allocated to them in relation to their expected return. This often comes down to a lack of transparency and consistency, not only with regard to how the start-up’s performance will develop, but also its risk profile. For a start-up valuation to be a reliable basis for an appropriate distribution of stakeholder shares, it must answer the two key questions clearly and coherently: What’s in for me? What risks am I taking? These questions reflect the risk/return profile underlying every investment decision. With the right approach, this can be fully depicted using established valuation methods, even for start-ups.
The probability-weighted DCF approach
In order to reflect the risks and uncertainties specific to the earlystage company being valued, we recommend to develop various business plan scenarios. Typically, these scenarios are structured around a “management case”, which reflects the expected scenario for the start-up by their founders. Variations then reflect any additional upside potential (“best case”) or specific risks such as delayed market entry, change in pricing assumptions, etc. (“worst case”). In practice, as many as four or five different scenarios could be established – each with a consistent set of correlating assumptions – including a scenario where the company fails. Given the very high growth rates typically expected at first for early-stage companies, forecasting periods for each of the scenarios may be extended to include a slow-down phase. From this point onwards, cash flow growth decelerates progressively to reach a steady state where cash flow increase in line with market growth and currency inflation. All scenarios provide different possible outcomes to the “What’s in for me?” question.