Why Standard Valuation Methods Don’t Work for Startups

Generally it makes sense to consult with professionals when it comes to buying – or selling – a  business.   An M&A specialist or a chartered business valuator can provide excellent value when it comes to later stage investments. At the growth financing stage, the acquiring company is likely to be a fairly large organization and will almost certainly have professional representation.  Start-ups  – and most angels for that matter – will require mentoring and support to stickhandle their way through negotiations at that stage. Certainly any company involved on the buy or sell side should use a professional when valuations are in the millions of dollars.

However these professionals simply aren’t interested in dealing with seed stage and pre-revenue companies. For one thing their fees are simply too high. In the case of most pre-revenue or early revenue companies, the cost of performing a valuation will likely exceed the value of the company….and about  45% of angel deals involve pre-revenue companies.

3 Standard Approaches to Valuation

  1. The Asset Approach – looks at the fair market value of the underlying assets and subtracts liabilities to arrive at the value of the business. Unfortunately the assets in most angel-backed start-ups are intangible and very difficult to value (see below).
  2. The Market Approach – compares the target company with other, similar companies. However comparing the value of small, privately owned companies that are pre-revenue or without meaningful amounts of revenue, is often pointless.
  3. The Income Approach – is generally considered to be the most appropriate valuation approach, and is the most commonly used of these 3 approaches.

For a pre-revenue company, assets are almost invariably intangibles such as software, websites, equipment prototypes, or patents.  For a specialist, the valuation of intangible assets will likely involve the measurement of earnings attributable to the intangible assets. Valuations could then be developed using the present value of cash flows deriving from ‘excess earnings’. Of course in a pre-revenue company this would mean determining ‘projected excess earnings’ which is a pretty ephemeral concept for a business valuation.

On occasion interesting companies may attract a lot of investor attention – with a group of  them setting a market price. In such cases the price is likely not negotiable. Instead we effectively have a market value. The decision becomes one of whether or not a company meets the investor’s own investment criteria.

As you can see, there is precious little here of use in the valuation of a very early stage company – particularly one that is pre-revenue or at least without meaningful and predictable revenue streams.

One possible variant of the asset approach, is to ‘normalize’ the cost to develop the intellectual property. For example the valuator might estimate the cost to rebuild the existing intellectual property from scratch – and subtract estimated costs to complete.

However understanding what an asset costs is a long way from knowing its value to a business. If this ‘IP’ is the primary asset of the company that we’re valuing – and there is as yet only a ‘business concept’ and not a business – the value of the company must be heavily discounted. If the IP requires further development, this introduces further risk – and should result in an even greater discount.

Still, if standard methodologies don’t work very well, we need to understand how US angel investors decided to invest $20.1 billion in some 61,900 companies in 2010?