3 questions to smart minds
Photo: C. Eckhardt

Assessments of start ups in financing

For this 3 questions to Christian Eckhardt

Walter Fries Corpo­rate Finance GmbH
Photo: C. Eckhardt
28. Octo­ber 2014

Every start-up company looking for venture capi­tal finan­cing must ask itself the ques­tion: How many shares should be given in a finan­cing round and what is the start-up company worth in such a venture capi­tal round? Of course, one does not want to give away too many shares in a venture capi­tal round and should ther­e­fore deal inten­si­vely with the company valuation.

For this 3 ques­ti­ons to Walter Fries Corpo­rate Finance GmbH

1. What are the valua­tion prac­ti­ces at VC firms? What are the special features of the valua­tion of start-ups?
In the case of VC finan­cing, valua­tions of start-ups are mainly to be carried out in the context of capi­tal increa­ses. Often, highly simpli­fied multi­plier models are used in prac­ti­cal appli­ca­ti­ons, and in some cases only esti­ma­ted values are used. Although these methods can be used to deter­mine a value very quickly and easily, this value is usually not very well foun­ded. A survey of VC firms also showed that the return expec­ta­ti­ons of indi­vi­dual VC firms differ greatly. Thus, the valua­tion prac­tice does not show a uniform picture. Well-foun­ded, more elabo­rate valua­tion models are often dispen­sed with. Start-ups have very speci­fic charac­te­ristics, which are also reflec­ted to a considera­ble extent in the valua­tion of the company. Since there are hardly any empi­ri­cal values due to the short company history, methods based on histo­ri­cal data are only suita­ble to a limi­ted extent. Young compa­nies are focu­sed on future indus­tries or markets as invest­ment objects. As a result, invest­ments by VC compa­nies are subject to a high degree of uncer­tainty with regard to the future deve­lo­p­ment of the markets. This uncer­tainty of the busi­ness model is taken into account as a risk premium and leads, among other things, to extra­or­di­na­rily high equity costs. Here 50–70% are not uncom­mon. For this reason, the stan­dard methods of deter­mi­ning the value of a company are not directly appli­ca­ble or at least need to be modi­fied. With regard to the company valua­tion, it should gene­rally be noted that this must be conside­red inde­pendently of the pricing, as indi­vi­dual value concepts and contrac­tual arran­ge­ments still have a considera­ble influence, espe­ci­ally in the case of start-up companies.
2. What are the proce­du­res for start up assessment?
The appli­ca­ble valua­tion methods for start-up compa­nies can be subsu­med under four main areas. The real opti­ons approach deter­mi­nes a value taking into account future uncer­tainty using option pricing models (e.g. Black-Scho­les model). This proce­dure is rela­tively complex and very theo­re­ti­cal. Clearly more common are the market-orien­ted proce­du­res. A peer group of compa­ra­ble compa­nies can be used to deter­mine a multi­plier for a key perfor­mance indi­ca­tor to be defi­ned. By multi­ply­ing the factor by the ratio of the company to be valued, the value of the young company can finally be deter­mi­ned. Howe­ver, since the short history of start-up compa­nies means that earnings indi­ca­tors are not very meaningful, suita­ble indi­ca­tors must first be iden­ti­fied for the company and the respec­tive indus­try. One valua­tion method that can be used speci­fi­cally for start-ups is the venture capi­tal method. The valua­tion is carried out from the investor’s point of view. As with stan­dard market proce­du­res, the valua­tion is carried out using a multi­plier. This refers here to a key figure plan­ned for the future. The enter­prise value at the investor’s exit date is calcu­la­ted and discoun­ted to the current valua­tion date using the target return. The last method to be mentio­ned is the discoun­ted cash flow method. The prere­qui­site for this is sound P&L, balance sheet and cash flow plan­ning. By means of a calcu­la­ted capi­ta­liza­tion rate, which should corre­spond to the indi­vi­dual risk profile of the company, the future plan­ned cash flows are discoun­ted and a company value is determined.
3. What about the feasi­bi­lity of the evalua­tion proce­du­res in practice?
The feasi­bi­lity of an evalua­tion proce­dure depends on four main factors. The proce­dure should be prac­ti­ca­ble, i.e. rela­tively easy to apply, and accepted in prac­tice, as well as adequa­tely reflect the company and take into account the future orien­ta­tion neces­sary for start-ups. Unfort­u­na­tely, there is no proce­dure that fully meets the afore­men­tio­ned speci­fic requi­re­ments for a valua­tion of young, growth-orien­ted compa­nies. While the real opti­ons approach, as a very complex proce­dure, tends to be ruled out for appli­ca­tion in prac­tice, the other proce­du­res can and should be used in a comple­men­tary way to make a meaningful assess­ment. In any case, well-foun­ded assump­ti­ons should be made in order to avoid miscal­cu­la­ti­ons in the return calcu­la­tion of an invest­ment. Since in many cases only simple esti­ma­tion methods have been used in valua­tion prac­tice to date, the appli­ca­tion of theo­re­ti­cally sound models should also be given grea­ter conside­ra­tion there in the future. In parti­cu­lar, success factor-based valua­tion methods can gene­rate considera­ble added value when deter­mi­ning the value of a company. Quali­ta­tive risk crite­ria can be asses­sed using a scoring model and can be meaningfully inte­gra­ted into a valua­tion method such as the DCF method via a risk premium within the capi­ta­liza­tion rate. In parti­cu­lar, the team, the busi­ness model, the market & compe­ti­tion as well as the custo­mer and supplier struc­ture and the exit oppor­tu­ni­ties should be conside­red and evalua­ted in detail.

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