How to value a start-up business
From the July/August 2019 issue of BCC Advisers Litigation & Valuation Report
stablished businesses have track records of earnings and cash flow that can be used to predict future financial performance and estimate value. Start-ups present valuation challenges because they lack such track records — but that doesn’t mean they have no value. Business valuation experts must look to other factors, many of them subjective, to estimate value.
Compared to mature businesses, start-ups are generally perceived as riskier ventures. So, potential buyers or investors demand a greater rate of return to compensate for that risk.
Management’s business plans and financial projections are critical when valuing a start-up business. No one knows the company’s products and services, the industry and the market better than the company’s founders and senior executives. If an entrepreneur hasn’t prepared business plans and projections, it could raise a red flag that management hasn’t thought through all the potential pitfalls of starting a new business in that industry.
To value start-ups, experts typically use management’s projections, if they’re realistic and based on reasonable assumptions. In some cases, a valuation expert may need to discount internal projections to account for management’s natural optimism. Experts need to dig deep to fully understand what differentiates the start-up’s products and services in the marketplace and how much growth potential the company has.
To this end, valuation experts also consider external factors. Examples include the experience and value of comparable companies, industry and market statistics, and the value of intellectual property or other assets that give the company a competitive advantage.
Another critical factor is time. How long will it take before a start-up is expected to become profitable? In general, the shorter the time frame, the lower the risk and the more valuable the venture is. That’s because a buyer or investor need not wait as long to achieve an “exit.”
A related factor is the company’s stage of development. For example, a company in the earliest stages of development — with little more than an idea and perhaps some “friends and family” financing — may be less valuable than one with well-developed products and services.
Financing from venture capital firms and other professional investors is another important indicator. These investors perform thorough due diligence in scrutinizing a company’s management team, business plan and financial projections, providing greater confidence in a company’s ability to succeed and meet its earnings targets.
Understanding a start-up’s value is critical when trying to attract potential investors. But the precursor to valuing a start-up is developing realistic business plans and financial projections. A valuation professional can help vet management’s projections and identify potential threats and weaknesses that may present roadblocks to achieving management’s financial projections.
An independent expert takes an unbiased look at the company’s financial projections, using objective sources, such as industry publications, economic data, and business records of similar companies. Then he or she blends management’s optimistic projections with the rational concerns of a hypothetical investor.
The value of professional expertise
Even though start-ups have limited operating histories, they can sometimes have significant value. Business valuation experts can provide objective sources of market data and experience to keep entrepreneurs grounded — and help them reduce risk and build value.