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Home > Mergers and Acquisitions Best Practice > Valuing Start-Ups

Mergers and Acquisitions Best Practice

Valuing Start-Ups

by Aswath Damodaran

Executive Summary

  • Young and start-up companies pose the most problems in valuation, for a variety of reasons.

  • Start-ups have a limited history, are generally not publicly traded, and often don’t survive to become successful commercial enterprises.

  • Faced with daunting estimation challenges, analysts often fall back on simplistic forecasts of revenues and earnings, coupled with high discount rates, to capture the high failure rate.

  • In this article I suggest that traditional valuation models can be used to yield better estimates of the value of these firms.

Introduction

Although the fundamentals of valuation are straightforward, the challenges in valuing companies shift as they move through their life cycle: from the initial idea and start-up business, often privately owned, to young growth companies, either public or on the verge of going public, to mature companies with diverse products and serving different markets, and finally to companies in decline, marking time until they disappear. At each stage we may be called on to estimate the same inputs—cash flows, growth rates, and discount rates—but with varying amounts of information and different degrees of precision.

Determinants of Value

If we accept the premise that the value of a business is the present value of the expected cash flows from its assets, there are four broad questions that we need to answer in order to value any business:

1. What are the cash flows generated by existing assets?

If a firm has significant investments that it has already made, the first inputs into valuation are the cash flows from these existing assets. In practical terms, this requires estimates of: how much the firm generated in earnings and cash flows from these assets in the most recent period; how much growth (if any) is expected in these earnings/cash flows over time; and how long the assets will continue to generate cash flows.

2. How much value will be added by future investments?

For some companies, the bulk of the value will be derived from investments they are expected to make in the future. To estimate the value added by these investments, you have to make judgments on both the magnitude of these new investments relative to the earnings from existing assets; and the quality of the new investments, measured in terms of excess returns, i.e. the returns the firm makes on the investments over and above the cost of funding them.

3. How risky are the cash flows, and what are the consequences for discount rates?

Neither the cash flows from existing assets nor the cash flows from growth investments are guaranteed. When valuing these cash flows, we have to consider risk somewhere, and the discount rate is usually the vehicle we use. Higher discount rates are used to discount riskier cash flows, and thus give them a lower value than more predictable cash flows.

4. When will the firm become mature?

The question of when a firm is mature (i.e. when the growth in earnings/cash flows is sustainable forever) is relevant because it determines the length of the high-growth period and the value we attach to the firm at the end of the period (the terminal value). It is a question that may be easy to answer for a few firms, including larger and more stable firms that are either already mature businesses or close to it, and firms that derive their growth from a single competitive advantage with an expiration date (for instance, a patent).

A framework for valuing any business that takes into account these four considerations is shown in Figure 1.

Although these questions may not change as we value individual firms, the ease with which we can answer them may change, not only as we look across firms at a point in time, but also across time—even for the same firm.

Valuing Young Companies

Every business starts with an idea stimulated by a market need that an entrepreneur sees (or thinks that he or she sees) and a way of filling that need. Although many ideas go nowhere, some individuals take the next step of investing in the idea.

The capital to finance the project usually comes from personal funds (from savings, friends, and family), and if things work out as planned the result is a commercial product or service. If the product or service finds a ready market, the business will usually need more capital, and the providers of this are often venture capitalists, who provide funds in return for a share of the equity in the business. Building on the most optimistic assumptions, success for the investors in the business may ultimately be manifested as a public offering to the market or sale to a larger entity.

Estimation Issues

At each stage in the process we need estimates of value. At the idea stage, the value may never be put down on paper, but it is the potential of realizing this value that induces the entrepreneur to invest time and money in developing the idea. At subsequent stages of the capital-raising process, valuations become more important because they determine what share of ownership the entrepreneur will have to give up in return for external funding. At the time of the public offering, the valuation is key to determining the offering price.

From the template for valuation that we developed in the last section, it is easy to see why young companies also pose the most daunting challenges. There are few or no existing assets, and almost all of the value is based on the expectations of future growth. The current financial statements of the firm provide no clues about the potential margins and returns that may be generated in the future, and there are few historical data that can be used to develop risk measures.

To complete our consideration of estimation problems, we should remember that many young firms do not make it to the stable growth stage. Estimating when this will happen for firms that do survive is difficult. In addition, these firms are often dependent on one or a few key people for their success, and losing them can have a significant effect on value.

Figure 2 summarizes these valuation challenges.

Given these problems, it is not surprising that analysts often fall back on simplistic measures of value, guesstimates, or on rules of thumb to value young companies. In the process, though, they risk making serious valuation errors.

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Further reading

Books:

  • Damodaran, Aswath. The Dark Side of Valuation; Valuing Old Tech, New Tech, and New Economy Companies. Upper Saddle River, NJ: Prentice Hall, 2001.
  • Gompers, Paul, and Josh Lerner. The Venture Capital Cycle. 2nd ed. Cambridge, MA: MIT Press, 2006.
  • Metrick, Andrew. Venture Capital and the Finance of Innovation. Hoboken, NJ: Wiley, 2007.

Guidelines:

  • Multiple authors. “International private equity and venture capital valuation guidelines.” October 2006. Online from: www.privateequityvaluation.com

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