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Startup Valuation


Although technology startups rank among the most risky possible investments, they can provide substantial returns to investors who base choices on sound methodology. From investors’ standpoint, the highest risks are presented by closely held technology startups whose price per share is unknown. This is why the founders of a technology startup should make business valuation the focus of his or her company's annual strategic planning process. At a minimum, an independent appraisal is a useful tool for obtaining financing – potential investors will likely give more credence to a startup seeking financing with an independent valuation in hand. However, there are other situations when valuation of a startup is necessary.

Granting employees share options as a form of incentive compensation is another common trigger for a valuation. When a startup lacks adequate capital to pay competitive wages, share options are often the lure used to attract qualified personnel. The effectiveness of the options depends on the state of the economy and the markets. A valuation is fundamental to estimating properly the fair market value of the options as of the date of issue and to preparing for possible future review by the Ontario Securities Commission. In addition, in anticipation of going public, a valuation of warrants may be prudent for financial reporting purposes.

Like any company, a startup may become involved in litigation issues such as shareholder disputes, marital dissolution of one of its principals, infringements of intellectual property, and contract disputes. The startup may also consider hiring an appraiser in connection with the formation of a buy-sell agreement or the purchase of key person life insurance. Perhaps the most compelling situation is the key role the valuation process can play in achieving the startup's primary financial goal: maximizing shareholder value. Only through annual strategic planning with a focus on value can shareholders and management chart the best and brightest future for the startup. With valuation at the center of the planning process, management can continually assess the startup's strategic position and value as a stand alone business, versus its increased value through a sale or merger.

Tech Startup Specifics

Technology startups typically have a limited track record, little or no revenues, and no operating profits. They are operating in new or emerging markets or in industries lacking traditional business models and performance benchmarks. Further heightening the uncertainty is the fact that a startup may be developing new products that are experimental or completely unknown to their potential customer base or the market at large. Because a startup's success is so closely tied to the time and cost involved in product development, production, and marketing, forecasts must be accurate and detailed. Reluctance to set and address key forecast parameters rigorously, including prices, volume, costs, and capital investments at each development stage, is frequently the first step toward miscalculating the company's true performance, and ultimately its value.

Tangible asset holdings and the size of the startup's asset base are less important in a technology company. When technology is the primary asset, most or all of the value in the startup comes from intangibles, including intellectual property and human capital. Such fragile and dynamic assets can quickly diminish in value, more so than property, plant, and equipment. Thus, the startup must have ongoing internal controls to identify newly formed intellectual property and obtain the appropriate patents and legal protection.

Lack of adequate capital is a common constraint because initial funding, whether from founders, angel investors, or venture capitalists, is generally made to move the startup to the next development stage within a predetermined time and cost. This critical cash “burn rate” imposes a discipline on the startup to stay within forecasted cost and time deadlines, because technology startups generally have little or no borrowing capacity. Lack of a proven product, service, or customer base, and few tangible assets mean that the startup can leverage only limited debt funding, which usually carries high rates and imposes tight constraints on management.

External Analysis

Traditionally, investors look at significant financial signs - sales and sales growth, operating margins, asset efficiency, and cash flow - as a basis for their decision-making. These measures, however, reflect results rather than causes. For an accurate valuation, the focus must identify what creates the cash flow and the value. This is done through external and internal assessment of the company's strategic position - the competitive analysis. Sales growth prospects can change rapidly as a technology develops and its resulting products and customers are identified. Value fluctuates accordingly.

This uncertainty spurs the high return demands of venture capitalists during the early funding rounds of a new technology startup. Without more reliable information about a startup's potential products, customers, and competitors, the resulting higher risk requires higher rates of return. Customer concentrations frequently occur in emerging markets where lack of information or inadequate marketing or distribution capabilities preclude startups from full access to all potential customers in the marketplace. The typical startup, particularly in the early stages, lacks one or more core competencies in production, marketing, sales/distribution, or finance that prevent the startup from capitalizing on the value of its technology. Startups that recognize these limitations and acquire the needed competencies can increase their value dramatically as they move their technology from concept, to products, to customers, to cash flow.

This progression also emphasizes the potential distinction between a startup's stand-alone fair market value, which could be very low, or even zero, and its potentially much higher value to strategic buyers. Such buyers often have means to move a technology to the cash flow stage much more quickly, efficiently, and successfully than a startup. Thus, management must continually identify the missing capabilities that stand as barriers to success. This includes ongoing revisions in the time and cost to bring a product to market, which can precipitate major swings in value as the company's technology develops or fails to develop. Setbacks or delays may leave a company particularly vulnerable on a stand-alone basis when its burn rate and borrowing limitations threaten its viability. Therefore, exit strategies, including positioning the company for merger partners or strategic buyers, must also be part of the startup's ongoing strategic planning.

Internal Analysis

Most important in the internal analysis is continual examination of how the technology will lead and lend itself to products or services, and ultimately cash flows. This begins with a review of the business plan and forecast, particularly an assessment of the financial investment required to complete and perfect the product. The competitive advantages that support the forecasted volume, pricing, and margins must be carefully scrutinized. Uncertainties may require adjustments to the forecast - either in dollars or timing delays - or thorough application of probability analysis to quantify possible outcomes. Because key people are usually essential in a development stage business, particular attention must be paid to both management and technical personnel. Executives are often scientists with little management expertise or experience, and gaps may exist in sales and marketing, production, or finance. While competence in these functional areas may be less critical in the earlier stages, the management team in place must have or develop the required professional background and experience to advance the startup to growth and maturity. Gaps in capabilities do not doom a startup. They do, however, create limits, and frequently signal the need for an exit strategy that positions the business for its next growth stage.

The company's ability to replace key employees must also be investigated, particularly in tight labor markets. Finally, legal protection of research results and advances in product development should be examined, and non-disclosure and non-compete agreements assessed. Most startups offer share options to attract and keep key employees, and these options can have a big effect on value per share. The cost of these options does not appear as an expense on the income statement, but can be deducted on the corporate tax return. The startup must then either buy back the options, which typically vest over three to five years, or experience a dilution in share value as a consequence. Management should also recognize how share option value is computed for nonpublic shares. The well-known Black-Scholes model generally overstates the value of a startup share options due to their lack of liquidity, so either appropriate modifications to Black-Scholes or alternative valuation procedures should be considered to value them accurately.

Quantifying Value of Startup

Two widely used valuation methodologies, price-to-earnings (P-E) multiples and single-period capitalization, are seldom appropriate in the appraisal of technology startup companies. The startup's income or cash flow, if any, is hardly ever representative of the long term potential, and successful startups experience very rapid growth, after which increased competition or new technology slows and normalizes growth. Neither the earnings multiple nor the capitalization process can accurately capture these changes. Thus, technology multiples of 100 times earnings are probably based on unrealistically low earnings in comparison with the startup's future earnings potential, and short term versus long term growth expectations are very different. The resulting value seldom makes sense. Multiples that have been derived from strategic transactions may suffer from the two factors just described. Furthermore, strategic transactions often reflect synergies that only a specific buyer could achieve. Similar distortions occur when multiples are derived from industry leaders. For a startup companies to derive multiples based on the performance of Amazon, Yahoo!, and Google is to attribute to that startup the size, growth, customer base, and brand recognition of these highly successful businesses when the startup possesses few, if any, of these strengths.

With these cautions in mind, are there any procedures available to compute reliable and defendable values for startups? One clear choice is a multiple-period discounting computation that includes a forecast that can reflect the variations in the startup's return as it moves through development stages. It also conveniently accommodates sensitivity and probability analysis. Because market multiples, such as multiples of revenues or various levels of earnings, are so widely quoted, they can also be employed, but with appropriate precautions. Market multiples are often used in valuing startup companies because they are relatively simple to understand and easy to apply. The fundamental problem with using multiples for startups is that they impose a static application to a very volatile situation. As implied earlier, the traditional P-E multiples are rarely applicable in valuing startups, and even EBIT and EBITDA multiples are seldom applicable. Instead, multiples of revenue are commonly seen, largely because startups often have no earnings to which a multiple could be applied. However, given the basic fact that so much can happen in a company below the revenue line, a multiple of some level of earnings is preferable as a supplement to a revenue multiple. One such multiple is EBITRAD (i.e., earnings before interest, taxes, research and development), because certain startups incur high levels of R&D expenses.