Start-up companies are difficult to value for a number of reasons. While young or start-up companies are diverse, they share some common characteristics that can be problematic when valuing the companies. These characteristics include:
- No history. Young companies have little or no history; many have only one or two years of data available on operations and financing.
- Small or no revenues. Revenues are small or non-existent with start-up companies, and the expenses often are associated with getting the business established, rather than generating revenues.
- Dependence on private equity. Young companies are often dependent on equity from private sources, rather than public markets. Venture capitalists become a source of equity capital in return for a share of the ownership in the firm.
- Survival. Many young companies don’t survive. There are studies that back this up, although the failure rates vary from study to study.
- Multiple claims on equity. Repeated attempts to raise equity exposes equity investors who invested earlier in the process to the possibility that their value might be reduced by deals offered to subsequent equity investors.
- Illiquidity of investments. Typically, equity investments in young companies are privately held and are, therefore, more illiquid than their publicly traded counterparts.
The fact that young companies have limited histories, are dependent on funding from private sources, and are especially susceptible to failure, all contribute to making them more difficult to value. Analysts typically run into valuation challenges when doing either an intrinsic valuation (using the discounted cash flow methodology) or a relative valuation (using the guideline public company or guideline private transaction methodologies).
There are four components to valuing young companies intrinsically using the discounted cash flow methodology: 1) the cash flows from existing assets; 2) the expected growth from both new investments and improved efficiency on existing assets; 3) the discount rates based on our assessments of risk in the business and its equity; and 4) the assessment of when the company will become a stable growth company. With al of these measures, there are estimation challenges that trace back to the young companies’ common characteristics listed above.
With a relative valuation (using the market approaches), the analyst looks outside of the young company to similar companies and/or related transactions. The essence of relative valuation is that you value a company based on how much the market is paying for similar companies. Again, this premise is challenging when a company has little to no operating history. Analysts differ in where they go to get comparable data. Some analysts focus on transactions paid for similar private businesses, arguing that these businesses have more in common with the subject start-up company being valued. Other analysts look to publicly traded companies in the same or similar business and attempt to adjust for differences in fundamentals. Both methodologies can be problematic when using them to value young companies.
BIZCOMPS, Pratt Stats, Market Data, and IBA are databases that provide transaction data for privately held business. These databases are used with the guideline transaction methodology, and potential problems exist when using these databases to value start up companies. Problems include non-arm’s-length transactions. Many of the transactions are arm’s length, where the price reflects just the business being sold. However, sometimes they are not, and the price includes other side factors that may be specific to the transaction. Another issue with transactional databases is timing differences. Private transactions are infrequent. Unlike public companies, where the current price can be used to compute the multiples for all firms at the same point in time, private transactions are staggered across time. For example, private transactions from June 2008 and December 2008 are included in the database of private transactions; this is a period of time when public markets lost nearly 45 percent of their value.
Using public multiples obtained when using the guideline public company methodology also has its share of problems, which makes applying the multiples to start up companies challenging. For example, the life cycle of a company affects fundamentals. Generally, public companies will be larger, have less potential for growth and have more established markets than private businesses and these differences will manifest themselves in the multiples investors pay for public companies. Additionally, survival or the probability of failure typically decreases as companies establish their product offering and go public. These public companies have a greater chance of surviving than younger, privately held firms, and therefore, should trade at higher market values for any given variable such as revenue, earnings or book value, holding growth and risk constant.
Both intrinsic and relative valuations of young, start-up companies require the estimation of inputs that are difficult to nail down. They force the analyst to address sources of uncertainty, learn more about them and, as always, use professional judgment in developing the best estimates.
Kristin Coffey is a principal based out of our Rochester, NY office.
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