Assessments of start ups in financing
Walter Fries Corporate Finance GmbH
28. October 2014
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.