Business Valuation Issues Related to Start-Up Companies
By: Scott D. Levine, CPA, CFA, ASA, Willamette Management Associates
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INTRODUCTION The valuation of start-up companies poses a unique challenge to the business appraiser. The process can often be far from scientific. In addition, the most widely recognized approaches to valuing mature closely held businesses may provide conclusions that are not meaningful when valuing the stock of a start-up company. This article discusses the characteristics of a start-up company, why start-up companies may require valuations of their stock, and the approaches that prove most effective for valuing start-up companies, including the pros and cons related to each valuation approach. WHAT IS A START-UP COMPANY A start-up company can exist simply based upon an idea or a concept. The company may or may not have operations that generate revenue. However, there are certain factors that are consistent throughout all start-up companies: 1. They have limited operating histories; 2. They have never generated a profit; and 3. They project significant growth in revenue and profitability that offers a substantial upside for investors. These factors present specific problems for the appraiser when applying standard business valuation approaches. Some of these problems will be discussed later. REASONS FOR VALUING START-UP COMPANIES It is first necessary to understand why start-up companies may require valuation services. Reasons for estimating a start-up company's fair market value may include: (1) attracting and negotiating with potential investors; (2) planning and providing various forms of equity based incentive compensation;
(3) gift and estate tax planning; (4) litigation support; (5) valuation of intangible assets; and (6) transaction analysis (merger, acquisition and/or disposition). Attracting Potential Investors Start-up companies often suffer from anonymity. Therefore, active marketing to potential lenders and equity investors is critical in order to attract the necessary capital to fund operations. An independent estimate of fair market value is often a valuable tool that assists a start-up company in securing additional financing. Banks and equity investors often rely on the unbiased opinion of an independent appraisal report when considering whether or not to provide financial support to a start-up company. Equity Based Incentive Compensation Many start-up companies attempt to assemble a capable and talented workforce. This process may require the additional investment of company resources. However, limited access to capital may prevent start-up companies from paying market wages to potential employees. Start-up companies often offset lower wages by issuing stock options as a means to attract talented employees. Due to the formative stage of the start-up company (and the typically attendant low-value of the company), stock options are issued at very low strike prices. If a company is able to achieve the projected level of growth, or institute an initial public offering (IPO), the capital appreciation of the stock associated with exercising the stock options significantly offsets below-market wages. Valuing the stock of a start-up company is necessary to estimate the fair market value of the options as of the grant date, providing a supportable basis for comparison in future years. When a start-up company is preparing for a potential IPO, one of the critical issues reviewed by the Securities and Exchange Commission (SEC) is the determination of whether the grant price of stock options issued prior to the IPO is reasonable and not a form of compensation to the employees. "Cheap stock" is the name given to stock options granted with a strike price below the fair market value of the underlying common stock at the time of the option grant. An independent appraisal of a start-up company's stock provides support for the option prices. An appraisal performed at or near the time of an option grant often plays an important role in discussions with the SEC, which often attempts to increase the recorded compensation expense charged against a company's earnings based on this issue. Gift and Estate Tax Planning Start-up companies often require business appraisal services for estate and gift tax planning for the key owners. For example, business appraisers are frequently retained to estimate the fair market value of a minority interest in the common stock of small companies for gift tax purposes in the years preceding an initial public offering. Litigation Support Business appraisers are often retained to provide litigation support and dispute resolution services related to start-up companies, since these companies often become involved in litigation disputes, such as shareholder disputes, intangible asset infringements, contract disputes, and so on. Valuation of Intangible Assets Start-up companies may require appraisal services related to the value of internally developed or tobe-purchased intangible assets, for the purpose of a sale or acquisition.
Transaction Purposes Business appraisers are frequently retained to estimate the value of start-up companies for the purpose of selling all or a portion its equity to another entity. This might be to another company, an angel or venture capitalist. Valuations are also performed in conjunction with setting the price for a stock or cash merger. Frequently valuations are completed along with these transactions for financial and/or tax accounting purposes. The purchaser's objective is usually to expense the acquired assets as quickly as possible for tax purposes while reducing financial accounting earnings as little as possible. The seller's goals are not only to receive as high a price as possible but also to pay the least amount of tax legally permissible. BUSINESS VALUATION APPROACHES USED IN THE ANALYSIS OF START-UP COMPANIES In theory, the generally accepted valuation approaches used to value a closely held business are similar to those used in valuing a start-up company. These approaches are: 1. the market approach; 2. the income approach; and 3. the asset-based approach. The application of each fundamental approach, however, has unique factors related to the valuation of a start-up company that complicate the appraisal process. Market Approach The market approach involves identifying either comparable or guideline companies within the industry of the start-up company that are publicly traded (the guideline publicly traded company method) or that have been acquired within a reasonable period before the valuation date (the guideline merged and acquired company method). Pricing evidence from selected publicly traded companies or transactions are used as guidelines, and market-derived pricing multiples are extracted from various financial fundamentals (e.g., earnings, cash flow, revenues, book value, etc.). The multiples are applied to the subject company's financial fundamentals to estimate an indication of fair market value. Unfortunately, most financial fundamentals provide non-meaningful indications of value for the start-up company because of its limited operating history and negative profitability. The only relevant indication of value using this approach is often based solely on a multiple of revenue. Another method within the market approach is the projected guideline publicly traded company method. This method involves the extraction of market-derived pricing multiples based on the projected earnings of the guideline companies. The selected pricing multiples are applied to the subject company's projected earnings. Unfortunately, many start-up companies do not project positive profitability for many years. Additionally, analysts that cover many of the guideline companies that operate in industries noted for developing start-up companies, such as bio-technology and operations related to the internet, are also not projecting profitability, and, therefore, non-meaningful multiples result. Another difficulty in valuing start-up companies using the market approach is finding appropriate guideline companies for comparison. Most of the companies that are publicly traded have an existing track record, are substantially larger than a start-up company in terms of revenue and asset size, and are more diversified. The projected growth for a start-up company is generally higher than the
guideline companies, making comparisons even more difficult. Each of the above factors make the application of the market approach difficult. However, there still is some benefit to the comparison of a start-up company to public companies that operate in the same industry and that can provide an indication of potential earnings growth. Additionally, industry-wide price/earnings multiples provide meaningful information with regard to third-party investor discount rates and rate of return expectations. When properly applied, the market approach proves to be useful if used in conjunction with other valuation approaches. Income Approach The income approach recognizes future earnings by calculating the present value of projected cash flows at a reasonable present value discount rate. There are two generic applications of the income approach: (1) a single-period method or (2) a multiple-period method. The single-period method includes dividing or multiplying a representative level of recurring economic income (e.g., net income, cash flow, etc.) by a discount rate or a capitalization rate that may or may not be based upon comparable or guideline companies. The multiple-period method consists of estimating economic income for discrete future periods and then discounting these benefits using a present value discount rate. The discounted cash flow method is a common multiple-period method and often is the most relevant method to use when valuing a start-up company. The discounted cash flow method estimates the fair market value of a company as the sum of two components. It first calculates the projected net cash flow over a finite period of time (generally not longer than ten years). A terminal value is calculated as a proxy for value into perpetuity by capitalizing the terminal year projected cash flow (or the last year in the projection period) at the appropriate direct capitalization rate. Both the interim cash flows and terminal value indication have to be discounted at the appropriate present value discount rate, calculated based on market rates of return on equity and debt capital. The advantage of using this approach to value a start-up company is the indication of fair market value is based on the expectations of future company-specific economic performance. However, there is typically a limited basis to support the projections that call for substantial growth over the projection period before stabilizing. The most effective means to account for risk imbedded in the projections is the discount rate. Present value discount rates for start-up companies are much greater than discount rates for old economy companies due to the speculative nature of the start-up projected cash flows. Start-ups seeking seed money may have a cost of capital between 50 to 100 percent; early-stage start-ups may have a cost of capital between 40 to 60 percent; and late-stage start-ups may have a cost of capital between 30 to 50 percent. As a comparison, many old economy companies with a more mature track record may have a cost of capital ranging from 10 to 25 percent. Despite the reliance on numerous projections to estimate fair market value, the income approach often proves most useful in valuing start-up companies. It is the only approach based solely on future economic performance, where a great majority of the value in a start-up company lies.
Asset-Based Approach The asset-based approach is based on the principle of substitution. This basic economic principle asserts that the cost of replacement of an asset is an indication of the fair market value of that asset. In other words, a prudent investor would pay no more for an asset than the cost of acquiring a substitute asset with the same utility as the subject. This approach presents the most factual data, often based upon the money spent in the development of the start-up company. The negative aspect of the asset-based approach is the assumption that money spent equals value. The investment in the idea may not account for all of the intangible value related to the operations of a start-up company. Additionally, the asset-based approach may not account for the value of all of the projected economic benefits. Thus, in the case of start-ups, the asset-based approach may conclude the lowest indication of value. DISCOUNT FOR LACK OF MARKETABILITY The fair market value estimated using all of the business valuation approaches discussed assumes that the ownership interest is readily marketable and can be easily converted into cash. However, the common stock of start-up companies that require valuation services is not publicly traded and therefore, not readily marketable. When marketability is reduced, it creates additional investment risk. This component of investment risk is appropriately referred to as "liquidity risk." Generally, a price concession for this "liquidity risk" is required to equate the risk/return relationship of the closely held security to that of comparative alternative public market investments. The discount for lack of marketability may be magnified when valuing a start-up company. A start-up company is characterized by opportunities for significant growth far into the future that result in additional risk. There is also a limited pool of potential investors willing to invest in these companies. The inability to dispose of ownership interests within a reasonable period nay necessitate a discount for lack of marketability that is higher than the normal discount for the average closely held business. It is within the judgement of the business appraiser to estimate the discount that is appropriate based on the specific circumstances related to each company. SUMMARY AND CONCLUSION This article discussed various reasons why the valuation of a start-up company is generally more complex than the valuation of a typical closely held business. Generally accepted business valuation approaches often provide conclusions that are not meaningful. Additionally, the application of the approaches proves difficult due to a start-up company's limited financial history. However, the business appraiser should not blindly remove generally accepted valuation approaches from the analysis. Instead, the business appraiser should consider all approaches in the analysis, relying on the approaches where relevant data exist. This will ultimately allow the business appraiser to provide a reasonable estimate of fair market value.