At times, valuation projects can be straight forward; other times, not so much. Accepted valuation methodologies are well-developed in an academic and theoretical sense, but the real-world application often gets messy. This sentiment is perfectly explained by every valuation professional’s favorite quote: “Valuing a business is part art and part science.” -Warren Buffet
As technology improves, valuation firms have been attempting to evolve their practice. By completely automating the valuation process using technology, the number of valuations that a single firm can produce skyrockets while the cost to create each report drops. Numbers are pumped through a template, generating a valuation. However, using an approach such as this to determine the value of company ignores the art of valuation – the art of weighing the risk against the opportunity and constructing an informed judgment on a company’s position. In a recent valuation of a startup, I was reminded just how idiosyncratic valuations are.
Selected Issues in Startup Valuation
To give a little bit of background, the valuation project involved a software startup. The company was not fully functional but had a product idea in the early-stage of development, with access to financial resources to put their idea into motion. As a result of industry factors, the company needed approval from a regulatory agency. Without this approval, the business plan would not be viable, and the company would fail.
Income Approach Issues
When utilizing a discounted cash flow (“DCF”) analysis, one of the important decisions surrounds the selected discount rate which should capture the risk of the projected cash flows. In the case of our valuation example, the regulatory obstacle presented an important risk point for the business. It was a singular, significant hurdle for the company that prompted some interesting valuation questions. Could this event be accurately incorporated into the discount rate? How do you quantify the level of risk surrounding an event which could cause the company’s immediate failure? Can a realistic discount rate be selected?
Instead of attempting to quantify additional increases to the discount rate for this risk, the projected cash flows were analyzed as a binomial tree which is consistent with the Real Options Theory approach to economic investment decisions. In one scenario, the company failed as a result of the regulatory barrier. In the other scenario, the company received the regulatory approval and continued to develop the business. In the second scenario, additional consideration was used in selecting a discount rate. The risk profile was reassessed assuming a major risk to the feasibility of the company was removed. The probability weighted outcomes of both scenarios ultimately led to a concluded value for the company. In nearly every startup valuation exercise, unique circumstances exist which call for an in-depth assessment of the company.
Asset Approach Issues
Due to the limited operating history and difficulty of projecting financial performance, asset approaches are often used to value startups. This makes intuitive sense: a company in infancy is only worth as much as the expenses which brought it to its current state. Another company could, in theory, incur the same costs to create a business of similar utility, which can be a proxy for the company’s value.
However, when applying a cost approach to our example, another question arose that challenged the prevailing wisdom. What happens when a startup completely changes their strategic focus? In the case of our software startup, the company pursued a product line that didn’t materialize. They spent time, energy, and, most importantly, financial resources developing a product that was ultimately scrapped. After this failure, the management team reconfigured the company’s DNA and pursued a different line of business.
This complicates the asset approach – is the cost spent on a failed attempt truly an indication of value of the company? Are there any factors from failure that will provide future benefits to the new product line? What would it have costed another company to recreate the business as it stands today, and would that be an indication of value? The list of questions can go on and on, with each answer unique to the company being valued. It takes extreme prudence on the part of the valuation professional to address questions as they arise and how they might impact valuation conclusions.
Surely, this isn’t the only example of a startup that faces unique obstacles. Entrepreneurs have heard the odds against them, with startup failure rates being estimated anywhere from 50.0 to 90.0 percent. Startups face many risks that are unforeseen, and those that are anticipated still represent significant road blocks to overcome. These companies must be able to adapt quickly to changing environments. Similarly, appraisers must remain flexible with their approach to valuation in order to understand the company and determine its value.
In bringing up an endless list of questions on a single example, the main takeaway is that businesses come in many shapes and sizes – there isn’t a one-size-fits-all solution to valuation exercises. Each project requires a valuation professional to scrutinize the methodologies used in order to pragmatically capture a business’ value. Creativity and common sense are inherent principles of valuation, and if a valuation professional is not constantly challenging their own assumptions and processes, the quality of work is lost. Without careful judgment applied to a valuation, a business owner can face some serious consequences.